The Growing Number of Bank Failures and the D&O Insurance Marketplace

In what has become a ritual, each Friday evening the Federal Deposit Insurance Corp. (FDIC) announces the names of the banks it has taken over that week. As of May 19, 2009, the number of year-to-date bank closures stands at 33, which exceeds 2008’s year-end total of 25, and already represents the highest annual total since 1993, at the end of the last era of failed banks. All signs are that the number of bank failures will continue to grow, a prospect that is affecting the director’s and officers insurance marketplace.

After the end of the savings and loan crisis in the early ’90s, bank failures had become rare. No banks failed between June 2004 and February 2007, and only three banks failed during all of 2007. Beginning in 2008, and accelerating after mid-year, the number of bank failures has increased to the point that now the FDIC is taking control of several banks virtually every week.

As might be expected, many recent bank failures have taken place in certain geographic areas. California, has had four bank failures so far during 2009. Georgia, which the Wall Street Journal called “the bank failure capital of the world,” has had six bank failures during 2009, bringing the state’s total number of bank failures since Jan. 1, 2008 to 11. According to the Journal, the state is “haunted by overabundant home building, years of risky lending, and one of the most relaxed regulatory environments in the U.S. for starting new banks.”

Even more surprising than the concentration in certain states is how widespread the failures have been. Banks have failed in 17 states this year, sprinkled across the nation. Even states whose banks in the past showed remarkable stability are now experiencing failures for the first time in year. In February, Maryland had its first bank failure since 1992.

Another surprising attribute of the bank closures so far this year has been the concentration in the community banking sector. According to one standard definition, a “community bank” is one that has assets under $1 billion. Based on that definition, the vast majority of 2009 bank failures have involved community banks. Twenty-eight of the 33 failures year-to-date have involved banks with assets under $1 billion. Many of those are very small; only eight of the 33 failed banks have had assets more than $500 million.

Relevant indicators suggest the bank closures will continue for some time to come. In the FDIC’s most recent Quarterly Banking Profile, it counted 252 institutions with assets of $159 billion on its “problem list,” up from 171 institutions with $116 billion in assets at the end of the third quarter of 2008, which in turn was up from 117 institutions with $78.3 billion in assets as of the end of the second quarter.

Of the many developments arising as part of the current credit crisis, the deterioration of some community banks may be among the most surprising and troubling. For many years, community banks represented the very essence of stability — and, it should be emphasized, most community banks still do. However, growing problems in commercial real estate and rising unemployment levels are raising problems even in the community banking sector, as the number of bank closures described above demonstrates.

The growing bank failures have consequences, including related litigation. Failed bank litigation was a prominent feature of the S&L crisis, and that may be the case now. Of the 25 banks that failed in 2008, six are involved in securities class action litigation, though only 11 were publicly traded. The prospects for litigation, particularly involving actions brought by the regulators, seems likely with the rising number of bank failures.

The D&O insurers, who were already cautious regarding companies in the financial sector as a result of the subprime meltdown and general economic turmoil, have registered these recent events in the banking sector. Along with their overall wariness of financial companies, the carriers are now increasingly careful with respect to community banks.

Until recently, the D&O insurance marketplace for community banks had been a quiet area featuring broad terms at relatively low prices. Due to the recent deterioration, the D&O insurance marketplace for community banks has begun to change. Several carriers are now taking more defensive positions. Some carriers are reducing their limits exposed. Several key players have even begun non-renewing banks with certain characteristics or attributes, or in certain geographic areas.

More restrictive terms and conditions, some of which had largely disappeared, are suddenly reappearing in coverage proposals for some accounts. Indeed, the regulatory exclusion, which had become relatively rare, may be making a comeback. Banks exposed to commercial lending or with elevated levels of nonperforming assets are finding they can place their coverage only for significantly increased premiums. The D&O insurance marketplace for community banks is placid no more.

Perhaps the most noteworthy thing about the changes may be how quickly they have occurred. The speed of the change in the community banking sector represents the type and velocity of adjustment that can occur in a market turn. It is premature to say definitively that we are headed into a hard market any time soon, even just for community banks. But there may be some evidence to suggest that a harder market may well lie ahead.