The GAO recently put out a study of small bank failures caused by bad loans in commercial real estate. This kind of important work sometimes escapes wider public notice, although CFO Magazine noted this study's implications. The incurred-loss model banks use to estimate CRE loan failures may be too flawed for the extremely leveraged world we have created.
My concern with the incurred-loss model (and its possible replacement, the expected-loss model) is its reliance upon a limited set of historical data. Assessing losses based on the historical experience of a single bank would be fine if that bank never expands geographically or never expands its balance sheet faster than its long-term average growth rate. The US economy's present credit bubble, with overall debt-to-GDP at historic highs, puts even historically sound banks in danger by tempting them to make irresponsible loans just to match competitors' asset base growth. The GAAP approach to incurred or expected losses requires calculations to be performed in a vacuum, as if banks were atomized from the larger economy. These limited accounting-based models invite unpreparedness for losses triggered by six sigma Black Swan macroeconomic conditions.
The Basel III regime's approach to measuring risk capital should apply to small banks too, not just systemically important ones. Basel III capital rules add a leverage ratio to the assets banks must count as their Tier 1 and Tier 2 reserves. Small US banks applying this standard will be discouraged from attracting yield-chasing depositors by offering CDs with abnormally high yields. The usefulness of the Basel standard is that it applies across all national accounting standards. Banks won't be able to hide behind GAAP if they get in trouble.
Small banks, here's your chance to act like the SIFIs you try to emulate by offering "financial supermarket" services. Use every single one of Basel's designated shock absorbers, not just the ones designed for TBTF banks. Jump on the Basel III bandwagon and use its countercyclical safeguards to stay healthy during the next credit crunch.
