Troubled Banks: Why Don't They All Fail?

A wealth of literature examines the determinants of bank failures and of bank mergers or consolidations. Also numerous are studies that develop failure- prediction models and early-warning systems. But both groups of studies use samples of all banks, and therefore most of this research focuses on pairs of outcomes: failure versus nonfailure, merger versus consolidation,1 or problem bank versus nonproblem bank. But in reality, future status is more than a binary choice. Here we study only troubled banks - banks that receive a composite CAMELS rating of either 4 or 5 when examined.2 A focus on troubled banks is valuable to the FDIC and bank researchers for four reasons. First, when a bank is troubled, failure is but one possible outcome; alternative outcomes are recovery, merger, or continuation as a problem. Second, between 1990 and 2002, 96 percent of all banks that failed had first been troubled banks. Including nonproblem banks would add bias towards non-failure as a possible outcome since a vast majority of nonproblem banks do not fail. Third, if the FDIC can better predict the number of troubled banks that will not fail, it will be better able to estimate the size of its contingent loss reserve. Finally, development of a multistate model identifying financial characteristics that contribute to recovery as well as to failure is important for the FDIC's long-term strategic planning: accurate predictions of the future states of problem banks would affect the resources applied to these banks.