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Although the American economy and the global economy both appear to be stabilizing, the U.S. banking sector nevertheless continues to struggle. By late 2009, more than 100 banks had collapsed in the U.S. during the year. That compares to just three bank failures in 2007 and 25 bank collapses in 2008. The Federal Deposit Insurance Corp. maintains a “watch list” of problem banks, those with troubled finances. In August 2009, that watch list contained 416 banks, so experts predict that half or more of those banks could also fail in the coming years.

Why Banks Face Long Road to Recovery

Even if the economy were to miraculously bounce back to complete health overnight, it would not safeguard many financial institutions. “Banking industry performance is, as always, a lagging indicator,” FDIC Chairwoman Sheila Bair said in 2009, reminding the public that problems always take longer to work their way through the banking system.

Speaking of the FDIC, it is important to note its role in keeping banks healthy – and how that ultimately plays a key role in banks’ ability and willingness to extend credit or loans to you. In 1933, under the Glass-Steagall Act, President Franklin D. Roosevelt created the FDIC to provide deposit insurance to banks. The goal of this deposit insurance was to assure the public that money put into any FDIC member bank was safe, secure and “backed by the full faith and credit of the United States government.” So since Jan. 1, 1934, the FDIC has insured bank deposits in America. Back then FDIC insurance coverage guaranteed your deposits to the tune of $2,500 (a lot of money during the Great Depression). Before that time, if you had money in a bank, and that bank failed, your hard-earned savings was often completely wiped out.

The FDIC, Banks, and Your Ability to Get a Loan

Fast forward 65-plus years later. If you currently have money sitting in a deposit account at a bank, and that bank is FDIC insured, then your money is protected up to $250,000. In 2008, during the height of the biggest financial crisis most of us have ever experienced, the FDIC raised the limits on insured accounts to $250,000 from $100,000. This $250,000 limit – per depositor, per account – will be in place until Jan. 1, 2014, at which time it is scheduled to go back to $100,000. The FDIC insures so-called deposit accounts, which include the following:

Checking Accounts
Savings Accounts
Negotiable Order of Withdrawal Accounts (also called NOW accounts, which are savings accounts that allow you to write checks on them)
Time Deposit Accounts, (including Certificates of Deposit or CDs)
Negotiable Instruments (such as interest checks, outstanding cashier’s checks, or other items drawn on the accounts of the bank)

The good news for most people is that even if your bank goes out of business, if you’ve put your money in a FDIC-insured institution, you can rest assured that your money – up to the limits described – is perfectly safe. In fact, since the FDIC’s inception, not a single dime of insured deposits has ever been lost.

Banks Lend (or Not) Based on Their Ability To Meet FDIC Rules

In order for a bank to declare that it is FDIC insured, it must meet certain financial requirements imposed by the FDIC. Specifically, banks must maintain healthy, federally-mandated “capital ratios.” This refers to the amount of capital (or dollars) a bank must have set aside in reserves in order to guard against future, potential losses. One key capital ratio for banks is called a “risk-based capital ratio.” It measures the capital a bank has (such as its common stock, preferred stock, and undistributed net income/profits) versus the amount of “risk-weighted” assets that bank has. These risk-weighted assets can be anything from corporate bonds and consumer loans (including mortgages, auto loans and leases, student loans, credit cards and personal lines of credit) to government notes and cash. The former – corporate bonds and consumer loans – all carry a risk rating of 100%, meaning they are highly risky since there’s no guarantee at all that they will be repaid. Meanwhile, government notes and cash are deemed risk-free.

If the notion of a loan being both an “asset” and something that is “risky” seems a little tricky, let me explain it briefly. A loan/credit line is called a “risk-weighted” asset because on the one hand, it is an asset, inasmuch as it represents a promise by a borrower to repay that loan/credit line (most often with interest). At the same, a loan is also considered a “risk-weighted” asset (emphasis on the word “risk”) because there’s always a chance, no matter how small or large, that the borrower will not repay a bank as agreed.

OK, now stay with me here. To get the highest stamp of approval from the FDIC, a bank’s capital must total 10% or more of its risk-weighted assets. Put another way, for every $10 that it loans, a bank must maintain $1 in capital reserves. For example, if a Bank A has $1 billion in capital, and that bank has made $10 billion in loans (or extended $10 billion in credit to its customers), then Bank A’s capital ratio is 1 to 10, or 10%. But if Bank B also has $1 billion in capital, and has made $20 billion in loans (or extended $20 billion in credit to its clients), then Bank B’s capital ratio is 1 to 20, or 5%. These are critical measures because the FDIC insists that member banks have a more than ample amount of capital on hand to deal with any financial scenario. Thus, the FDIC categorizes banks into five groups:

FDIC Classification of a Bank based on their Capital Ratio

Well Capitalized – 10% or higher
Adequately Capitalized – 8% or higher
Undercapitalized – Less than 8%
Significantly Undercapitalized – Less than 6%
Critically Undercapitalized – Less than 2%

As you can see, the more credit a bank extends, the more capital it must be able to show the FDIC as proof of its financial strength – especially in the event of potential losses or other unforeseen circumstances. Without a healthy amount of capital, a bank runs into trouble with federal regulators. Once the FDIC labels a bank as “Undercapitalized,” it issues a warning to that institution, telling it to shore up its reserves. If the bank fails to perform, and its capital ratio falls below 6%, into “Significantly Undercapitalized” territory, the FDIC has the right to step in, change the company’s management, and insist that the bank take appropriate steps to remedy its capital shortfall. If a bank’s finances become so dire that its capital ratio drops to less than 2%, and it is deemed “Critically Undercapitalized,” that’s the point at which the FDIC declares the bank insolvent and can take over management of the institution. These illiquid banks are either run by the FDIC, as is currently the case with IndyMac, which failed in 2008, or the insolvent institutions get sold off by the FDIC to another bank.

The Long-Term Implications of the Financial Meltdown

So what does all this mean for you? If you went through the ringer during the downturn, say you lost a good-paying job or maybe you even lost your home to foreclosure, you may have thought that those setbacks represented the single-biggest impact on you resulting from the financial crisis. If you believe that, however, you are sadly mistaken. Don’t get me wrong: Unemployment and foreclosure are major challenges, and they can have a host of far-reaching implications. But in the scheme of things, those are one-time obstacles. In truth, the single-biggest impact on you stemming from the financial crisis is that the credit environment has dramatically changed – mainly because the entire banking landscape has been forever altered. This new economic, banking and credit environment have the power to impact you, your family and your financial dealings for decades to come, likely for the rest of your life. You might miss that old job, or your previous home, but their loss will not impact your credit, or your ability to get a much-needed loan in a decade from now, let alone two or three decades into the future. The new credit environment, however, will continue to have reverberations for decades.

Considering the enormous upheaval the financial community has undergone, can you see why banks, credit card companies and others have become a lot pickier about to whom they lend money? They had to. It’s a matter of survival. Otherwise, making too many bad loans can mean the death of a financial institution – even a century old bank that was once seemingly rock solid. Look no further than the spectacular collapse of Washington Mutual in September 2008. WaMu was founded in 1889. For many decades, it was considered a great and mighty financial powerhouse. But with $307 billion in assets, and $188.3 billion in deposits at some 2,239 branches, WaMu went under in what is to date the single largest bank failure in U.S. history. In fact, as of October 2009, if you examined the biggest American bank failures ever, where insolvent banks had $1 billion or more in assets, you’ll find that 72% of those bank collapses (more than 7 out of 10!) occurred in 2008 or 2009. These bank failures have cost the FDIC billions of dollars and, some say, threatened the stability of the FDIC, the very institution that is supposed to back up banks.

Is the FDIC on Shaky Financial Ground?

As of June 2009, the FDIC had about $42 billion in total resources; this includes money in its Deposit Insurance Fund, plus amounts set aside in the agency’s “contingent loss reserves,” funds earmarked for current and future losses. While the FDIC takes pains to tell the public that the agency is in no imminent financial danger and that it will not need to be bailed out by U.S. taxpayers, the agency did publicly propose on Sept. 29, 2009 that all insured banks pre-pay (on Dec. 30, 2009) their estimated quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012. These quarterly premiums are the fees that banks pay in order to receive FDIC deposit insurance. The FDIC asked for these $45 billion worth of early payments from its member institutions because the FDIC said it had under-estimated the cost of taking over failed banks, and needs to immediately replenish its available funds. However, some observers saw the FDIC request as a “gimmick” move to help the banking industry because the $45 billion would be treated as an asset on banks’ balance sheets (a prepaid expense, to be exact), and would not diminish banks’ capital or hamper their ability to lend money.

Credit Delinquencies on the Rise

Regardless of the real reason for the FDIC move, it is clear that federal regulators and banks alike have been painfully reminded that although loaning money can be very profitable, it can also be very risky. Just look at these statistics regarding 2009 mortgage delinquencies, as well as credit cards delinquencies and charge-offs. Home loan delinquencies surged to 8.84% in the second quarter of 2009. That meant roughly 1 in every 11 homeowners was late on their mortgage. Credit card delinquencies, which include payments that are more than 30 days late, rose to 6.7% during that period. And credit card charge-offs, which are debts that banks call “uncollectable,” hit 9.55% at the end of the second quarter of 2009. These delinquency and charge-off rates were at their highest level since the Federal Reserve began tracking that data, according to CreditCards.com.

Anytime you or I don’t pay back a loan we borrowed from a bank or credit that we utilized from a lender, what once was listed as a “risk-weighted asset” on that bank’s books now is labeled as something else – something ugly and potentially fatal to banks. You’ll hear these items described in different ways, such as “bad debts,” “soured loans,” and “illiquid,” “toxic” or “non-performing” assets. No matter what they’re called, they all represent the same thing: loans made or credit extended by a bank that never got repaid.

This is the heart of why banks have been slashing credit lines, rejecting loan applications, and closing credit accounts. Not only do banks fear not getting repaid, but they also must constantly keep their finances in top-notch shape to comply with FDIC requirements and standards. You might have considered yourself a good bank customer. Perhaps you had a credit card with a $10,000 limit, or even a $100,000 home equity line of credit that you rarely, if ever, tapped. In your mind, you thought that paying on time each month, or using only a modest amount of your credit would put you in the bank’s good graces. Well, I hate to be the bearer of bad news.

But you’ve got it all wrong. From the bank’s perspective, whatever charges you rack up on that credit card simply amount to a “risk-weighted asset,” an unsecured loan that may or may not get ever repaid. And that untapped home equity line? That could be considered worse. Not only is the bank not making any money off you – after all, you’re not paying any interest on a credit line with a $0 balance – but you’re also costing them money. Remember: to keep supplying you with that $100,000 equity line, the bank has to keep 10% of that amount – $10,000 – as capital to make the FDIC happy. Little wonder then, that banks in 2008 and 2009 stepped up their efforts to close dormant home equity lines and other lines of credit.

From the bank’s perspective, every open credit line, every outstanding mortgage loan, and every credit card debt owed represent a serious risk that must be managed and minimized by all means necessary. JP Morgan Chase CEO Jamie Dimon may have summed up the feelings of the financial community, when he was quoted by the Financial Times in February 2009 as saying: “The worst of the economic situation is not yet behind us. It looks as if it will continue to deteriorate for most of 2009. In terms of our sector, we expect consumer loans and credit cards to continue to get worse. When we look back at industry excesses in areas such as highly leveraged lending and securitization, it is clear that some of these markets will never come back.”

Note Dimon’s use of the word: “never.” Clearly, he sees the financial arena as having been permanently changed. Now that you understand the environment in which bankers are operating, it’s imperative that you do everything possible to optimize your credit rating in this new and challenging environment.

This article excerpted from Perfect Credit: 7 Steps to a Great Credit Rating, by Lynnette Khalfani-Cox. All rights reserved.

Author: Lynnette Khalfani-Cox
Article Source: EzineArticles.com
Provided by: Digital Camera Times