Community Banks Suffered the Most While the Big Banks Continue with High Derivative Exposure

Remi Lukosiunas

Last week’s article about community banks revealed that while they may be large in number, they don’t represent as much of the overall industry in terms of assets.

After the article went online, some readers asked additional questions.

They wanted to know how community banks fared during the 2007-2009 financial collapse, how Weiss arrives at a letter rating for a bank, and what levels of derivative exposure they have. So today, I’m going to answer all of those questions.

First, let’s have a look at the overall bank failure trend. As you can see in the graph below, it was all quiet on the failure front up until 2008. This was the first year after the turn of the century with a larger number of banks shutting their doors — and it just got worse after that. Failures went from single digits in 2007 to triple digits in 2009 and 2010.

Now let’s focus on how many community banks went out of business during this time. Only three banks closed their doors in 2007, making it quite an uneventful year for failures. One bank had over $2.5 billion in assets, while the other two had well under $100 million. So, based on asset size, two community banks and one big bank failed in 2007.

The numbers picked up quite a bit in 2008, with a total of 25 failures. Two banks with assets of $1 billion or more failed, while the rest had well under that. Failures then skyrocketed in 2009, with 26 large banks and 114 community banks going out of business.

In total, 168 banks failed during 2007-2009 time period. Large banks with assets of $1 billion or more had 29 casualties, while community banks under $1 billion lost 139 institutions.

The graph below shows the Weiss Ratings distribution at the time of failure for those 168 banks. As you can see, nearly all of them were rated D or E by Weiss at the time they went out of business.

Why are our ratings so accurate? When we rate banks, we look at many factors before arriving at a final rating. The Weiss bank safety ratings are calculated based on a complex analysis of hundreds of factors that are synthesized into five indexes: capitalization, asset quality, profitability, liquidity and stability.

A weak score on any one index can result in a low rating, as financial problems can be caused by any one of a number of factors. They include inadequate capital, non-performing loans and poor asset quality, operating losses, poor liquidity, or the failure of an affiliated company.

Now let’s switch gears and focus on the banking industry’s derivative exposure. As you can see below, derivative exposure (futures and forward contracts, swaps, options, etc.) kept climbing quite aggressively from $40.2 trillion in 2000 all the way to a whopping $195.4 trillion in 2008.

You might think that risky securities such as derivatives would drop during and especially after the financial crisis. It kept climbing instead, reaching a peak of $224.8 trillion in 2013. As of Q2 2017, derivative exposure was at $180.6 trillion, well below the 2013 figure but up from $160 trillion in 2016.

As far as the amount of exposure goes, banks with $1 billion or more in assets completely dominate the arena, with over 99% of the $180.6 trillion of derivatives in Q2 2017. Community banks had only $13.7 billion. This was also the case during the financial crisis, when large banks were involved in the derivative business the most.

The bottom line is that most failed banks during the financial collapse were the little guys. However, due to their small size, the impact of them going out of business wasn’t as influential as the downfall of some of the major financial institutions.

It also appears that the large banks continue with high derivative exposure. That’s fine for now, with the U.S. economy and the stock market staying fairly stable. But things could go downhill fast if we start experiencing another recession.

So be sure to check your bank rating on the Weiss Ratings website, as we consider many factors in assigning a final rating.

Think Safety,

Remi Lukosiunas

 

 

Remi Lukosiunas

Money and Banking Edition, By Remi Lukosiunas, Financial Analyst

Remi Lukosiunas, a Financial Analyst, joined Weiss Ratings in 2014 with a financial services background in internal audit and the credit union industry. Remi conducts banking, credit union, insurance and investment research. He has also written extensively on stocks and investing using ratings as a guide. Remi is a graduate of Florida State University with a degree in multinational business.

Top Tech Stocks
See All »
B
MSFT NASDAQ $415.50
B
AAPL NASDAQ $179.66
B
NVDA NASDAQ $822.79
Top Consumer Staple Stocks
See All »
B
WMT NYSE $58.76
Top Financial Stocks
See All »
B
B
V NYSE $283.16
B
JPM NYSE $185.29
Top Energy Stocks
See All »
Top Health Care Stocks
See All »
Top Real Estate Stocks
See All »
Weiss Ratings