Bank failures likely to remain rare in 2021 even with worsening credit

U.S. banks are bracing for worse credit quality in 2021 as COVID-19 remains active, triggering new lockdown orders and weighing on consumer confidence.

But a more drastic outcome for banks — a substantial increase in failures — looks improbable over the next 12 months thanks to the industry's focus on building capital and the renewal of a COVID-19 stimulus package that gave banks more breathing room to offer widespread forbearance.

Bank failures spiked after the Great Recession but have been rare in recent years. Some lawyers say failures are likely to rise in 2021, but not to the levels seen following the financial crisis.

"I don't have any sense right now that people are thinking there's a new wave of failures that's about to occur," said Christina Grigorian, a partner specializing in financial regulation at Katten Muchin Rosenman LLP.

Still, problem loans are growing as borrowers struggle to handle the pandemic's effect on the economy. There is concern the number of bank failures could pick up once government stimulus ends, Stanley Ragalevsky, a partner specializing in finance at K&L Gates LLP, said in an interview.

"We could see a gigantic spike in the number of nonperforming loans across the economy," Ragalevsky said.

That scenario appears to be pushed further out into the future since President Donald Trump signed an additional stimulus bill into law. The relief package extends banks' ability to avoid the troubled debt restructuring classification for pandemic-related forbearance, which could prevent losses from being realized until 2022 and offer businesses a bridge to normalcy.

"Now that it's all pushed out to January of '22, that is a game changer," said Christopher Marinac, director of research at Janney Montgomery Scott LLC, in an interview.

Failures take time

There may still be a handful of failures, with banks with Tier 1 leverage ratios between 2% and 5% the most likely to fail, Marinac said. According to S&P Global Market Intelligence, there were five banks in that range as of Sept. 30, 2020.

It can take years for a bank to "death spiral" to failure once it starts having bad loans, Ragalevsky said. One of the most recent bank closures, Fort Walton Beach, Fla.-based First City Bank of Florida, had reported a leverage ratio under 3% but above 2% since the first quarter of 2017. The bank reported a leverage ratio of 1.41% in the quarter before it closed on Oct. 16, 2020.

The only other bank to report a leverage ratio below 2% as of Sept. 30, 2020, was Almena State Bank in Almena, Kan. It reported a leverage ratio of only 0.3%, and the bank failed Oct. 23, 2020.

Once a bank begins to receive poor regulatory examinations across a number of categories, regulators can reassess the loan portfolio, and determine more loans should be categorized as losses, which often accelerates the failure, Ragalevsky said.

"Equity can disappear overnight in one of these troubled institutions," Ragalevsky said.

Since 2016, four banks that hit a leverage ratio of 2% or lower were acquired and an additional 15 failed. But a handful of banks during that time have managed to remain open after a brush with closure. Since 2016, four troubled institutions were able to bring their leverage ratios back above the regulatory minimum, according to S&P Global Market Intelligence data.

Most recently, Columbus, Ohio-based Nationwide Trust Co. FSB fell below the 2% ratio in the fourth quarter of 2018 but has since brought its ratio back up over 25%. In the fourth quarter of 2018, the bank sold $2.4 billion in deposits to San Diego-based Axos Bank.

Danville, Va.-based Movement Bank fell below the 2% leverage ratio in the fourth quarter of 2016 before being recapitalized by a private investor in 2017.

A number of banks fail because of a lack of liquidity, said Ragalevsky. If liquidity is the issue, regulators will move quickly to close the bank to ensure depositors can access their cash. Lately, banks have been holding excess liquidity, making that an unlikely risk.

Banks are also well-capitalized on the whole. Peter Winter, managing director at Wedbush Securities, pointed to the Federal Reserve's resumption of buybacks as a vote of confidence for the industry.

"We just don't see this pandemic accelerating what we've seen in the past," Winter said.