Financial Institutions

Doral Bank Failure

Introduction

Brief description

Doral Bank started as a federal bank which was mutually owned in 1981. In 1997, the bank changed from being a federal savings bank to become a state non-member bank under the Federal Deposit Insurance Corporation (FDIC) regulation. This was a part of the plan by the bank to expand its market size and market share. The bank assets were able to increase peaking to $11.2 billion by December 2004. At this time, the bank had focused on residential mortgage lending while its commercial real estate portfolio grew (FDIC, 2015). After restating the financial statements in 2000 to 2004, the bank financial condition started weakening (Elnahas, 2016). After many years of difficulty, Doral bank was closed by the regulators in February 27th 2015. This was the largest bank closure since 2010 and led to a lot of complications (FDIC, 2015).

Immediate implications to stakeholders

After the closure, none of the customers lost their deposit. Doral Bank had been offering their customers competitive rates and the customers were forced to look for new places where they could get low rates. This was a period marked with uncertainty by the Doral bank stakeholders (FDIC, 2015). The Doral direct and Doral bank customers had to wait to know what was to happen to their rates. The failure of Doral bank did not only lead to loss for FDIC but also led to loss in several US financial institutions (Elnahas, 2016). The failure was seen as a major embarrassment to the FDIC. The collapse led to a loss of $748.9 million in FDIC deposit insurance fund (FDIC, 2015).

Why the failure occurred

The main cause of failure for Doral Bank was poor asset quality. Puerto Rico had been under severe economic decline which was coupled with poor underwriting and risk management practices (Maldonado-Bear and Walter, 2007). These also played a major part in the deterioration of the loan portfolio at Doral bank. The management strategies that were used to handle the poor loan portfolio relied on overly optimistic assumptions. These strategies proved to be highly ineffective over time due to the actual economic situation (FDIC, 2015). It was also established that Doral used a flawed allowance for loan as well as their lease loss methodology. These masked the bank deteriorating loan portfolio (Papadimitriou, Gogas and Tabak, 2013). Doral bank board lacked appropriate oversight for the management considering its size, financial situation and challenges (FDIC, 2015).

The bank gained negative earnings which were as a result of its loan portfolio which was eroding its capital in a progressive manner. During 2014, FDIC was able to determine that $286 million that was in form of prepaid tax assets to the bank book should not have been put in the regulatory capital until collection form Hacienda by the bank (FDIC, 2015). Thus, the bank had failed to comply with the capital requirements based on enforcement by FDIC (Elnahas, 2016). The bank could no longer enhance liquidity which led to OCFI closing it and appointing FDIC as the receiver (FDIC, 2015).

Early signs

The failure of Doral Bank started with early signs some of which could have been detected. The first sign was the deficient loan portfolio by the bank. Between 2005 and 2014, Doral Bank loan portfolio was mainly made up of Commercial Real Estate (CRE) which included Acquisition, Construction and Development (ACD) loans. The loans were entirely secured through the real estate (Elnahas, 2016). This posed high risk to the bank and should have been an obvious sign of failure. In the real estate, the risk in a loan is based on loan amount in comparison with the collateral value, interest charged and the ability of the borrower to pay (Papadimitriou, Gogas and Tabak, 2013). In case of a downturn in the economy, real estate loans are highly affected and borrower’s ability to repay is reduced. The bank residential mortgages had the largest concentration of 42% and peaked to 69% in 2009 (FDIC, 2015). The bank was engaging in high risk lending in both CRE and commercial loans. As asserted by Haig (2005), the bank was making lending decisions without looking at the associated risks. Delinquent loans were another sign which was ignored. By December 2009, the bank residential loans represented about 50% of the bank total nonaccrual loans. The bank portfolio was deteriorating and the Puerto Rico economy was poor (FDIC, 2015). Borrowers were finding it hard to repay their loans and there was weak credit administration (Fortin, Goldberg and Roth, 2010). All these were warning signs that the bank was collapsing.

Doral bank financial performance and position vis‐à‐vis industry peers during the 5 years leading to the failure

Doral Bank financial performance from 2009 to 2014

Financial ($)

Total assets

$7,662,627

$7,241,449

$7,797,099

$7,970,729

$5,898,515

Total loans

$5,341, 856

$5,814,860

$6,231,270

$6,381,657

$4,652,078

Total deposits

$4,465,896

$4,440,693

$4,667,578

$5,022,196

$4,097,734

Equity capital

$651,764

$648,121

$654,253

$699,967

$427,219

Deposits (brokered)

$423,420

$187,000

$259,382

$592,080

$378,673

Borrowings

$2,349,163

$2,157,808

$1,996,235

$1,426,3

$703,891

Total net income (loss)

$(260,744)

$(11,930)

$ (90,929)

$(80,884)

$(336,269)

Table 1. AnnualReports.com, 2015.

POPULAR, INC (Banco Popular de Puerto Rico)

Financial ($)

Averages

Total assets

38,318,896

38,066,268

36,264,031

36,266,993

35,181,857

Total loans

25,821,778

23,156,980

22,786,545

22,799,878

22,366,750

Total deposits

26,650,497

25,185,910

24,702,622

24,571,382

24,647,355

Borrowings

7,448,021

5,845,407

4,414,483

4,291,861

3,514,203

Total net income (loss)

(190,510)

Table 2. Popular.com, 2016.

Comparing the annual reports for Banco Popular de Puerto Rico and Doral Bank, it is evident that Doral Bank had been performing poorly five years prior to collapse. Doral suffered net loss for the five years prior to collapse while Banco Popular de Puerto Rico shows a strong financial performance. Banco Popular de Puerto Rico has high quality assets portfolio and the total deposits are high. Despite high borrowing, Banco Popular de Puerto Rico was able to maintain a better assets portfolio. The fact that Doral bank had high investment in volatile real estate made it more venerable (FDIC, 2015).

Risk management strategies used and their effectiveness / implications

Initially, it was assumed that the bank management had required skills to manage changing bank environment. The examiners saw the management team in place to be proactive in managing the ADC lending portfolio. Despite this, Doral Bank management team failed in taking plans and strategies which could address the actual economic environment situation and trends (Elnahas, 2016). The accounting methods that were used led to understatement of loss which was occurring in its loan portfolio (FDIC, 2015).

When problems were initially noted in the ADC portfolio, both Doral and DFC management came up with a strategic decision to restrict their lending. Lending was to be done only to the clients who had a proven track record. The new ADC lending was suspended by the end of 2007. In 2009, the firm entered into a contract with a real estate consultant firm with an aim of gaining advisory services related to ADC portfolio (FDIC, 2015). Despite the efforts to reduce non performing loans, the quality of the assets continued deteriorating (Elnahas, 2016). The firm saw a 51% loss in ADC loan portfolio (FDIC, 2015). This risk management effort proved to be less important.

To manage risks in residential loans, the bank implemented a program with an aim of assisting delinquent mortgage borrowers to restructure their loans. The plan was based on assumption that the delinquency trends were to improve and economy become stable. The program masked the problem in loans and leading to poor documentation. There was lack of prudent procedures in Doral underwriting making this strategy to fail (FDIC, 2015). The risk management practiced used by the bank helped in masking the real problem of deteriorating loan portfolio (Elnahas, 2016). There was poor risk management controls which included poor loan reviews, loan underwriting and appraisal practices.

The underwriting practices adopted by Doral were weak. Through loan underwriting practise, it is possible to reduce loan risk. This is through validating the borrower ability to repay and looking at the collateral being offered (FDIC, 2015). Having a diligent underwriting is needed for a bank to control inherent credit risk (Sankaran, Saxena and Erickson, 2011). In 2011, it was found that 50% of the loans had been exempted from underwriting (FDIC, 2015). The bank weak underwriting practices contributed highly to its falls when combined with weak Puerto Rico economy.

How the failure could have been avoided

The failure at Doral Bank could have been avoided if the early signs were acted on. The bank had experienced eight consecutive years of loss and signs of failure had been evident. As explained, poor asset quality was the major cause of failure for the bank (Fortin, Goldberg and Roth, 2010). If there was proper oversight of the management based on the bank size and assets, the bank would have highly reduced the risk of failure. Lack of adequate considerations when looking at the associated risks when lending could have been avoided (Bennett, Güntay and Unal, 2015). This would have helped in ensuring that lending was only done to qualified customers to reduce defaulters (Papadimitriou, Gogas and Tabak, 2013). The bank suffered a lot from the borrowers’ inability to pay loans due to poor economic condition in Puerto Rico. Efficient management of the problem loans could have eliminated this problem (FDIC, 2015). Through risk management and good credit administration practices, it would have been possible to avoid failure at Doral.

The parties to blame for failure

The failure of Doral Bank can be blamed on the new management team the board and CEO. The new management team failed in adopting strategies and plans which would have addressed accounting practices and loss in the bank loan portfolio which was in major problem (FDIC, 2015). The way in which Doral management team handled the loan portfolio problem makes them liable to failure. At Doral, the board involvement was low considering the bank situation. The board lacked oversight which made it easy for the bank poor risk management practices to go on unchecked (Haig, 2005). This contributed highly to the bank low asset quality. As the bank situation became poor, the board members started resigning which also affected oversight. The blame on the board can be supported by the fact that their minutes failed to show their involvement in bank affairs (Elnahas, 2016). In this case, they made it possible for conflict of interest to occur through lack of control by the bank management.

A report done showed that the board and the CEO were overcompensated. While the shareholders value was declining from 2009 to 2011 by 87%, the compensation for the CEO rose by 30%. This was an increment without any link to the bank performance. The board members compensation was found to be 63% higher than those of similar institutions (FDIC, 2015). Lastly, the bank president played a major role in the bank failure. The board relied on the bank president advice and all policies decisions were being dominated by him. Being a dominant official, the bank president was a key risk factor (FDIC, 2015). This is due to singular policies, strategy and high influence in the decision making procedure (Elnahas, 2016). All these parties played a role in the failure of Doral bank and hence carried the main blame.

Bankruptcy process and implications

The closure and takeover of Doral Bank by FDIC was announced after 8 years of making loss. At this time, the bank had assets worth $5.9 billion while the deposits were at $4.1 billion. In the agreement, Banco popular committed to purchase $3.25 billion of the bank assets. FDIC was to be paid 1.59% as a premium based on the assumed deposits. In this case, FDIC entered into two other agreements with different firms and sold $1.3 billion of the assets from the bank. The rest remained with FDIC to be disposed later. The implication of this process was that the customers were not to lose their deposits. FDIC covered the customers deposit up to $250,000 (FDIC, 2015).

References

AnnualReports.com 2015, Doral Financial Corp. Retrieved 22nd September 2016 from, http://www.annualreports.com/Company/3998

Bennett, R.L., Güntay, L. and Unal, H 2015, Inside debt, bank default risk, and performance during the crisis. Journal of Financial Intermediation, vol. 24, no. 4, pp.487-513.

Elnahas, A.M 2016, Exploring the Manipulation Toolkit: The Failure of Doral Financial Corporation. Available at SSRN. Retrieved 22nd September 2016 from, http://poseidon01.ssrn.com/delivery.php?ID=86700408508210012111109811107507 512612500506407907502307806806801800808501109812010411801202712305102 812512612508108910502809205300205802301712112111310000601711402906506 400211809212409202712012006800901207008207902802612406812308600008012 1121066014067&EXT=pdf

FDIC, September 2015, Material Loss Review of Doral Bank, San Juan, Puerto Rico Office of Audits and Evaluations. Report No. AUD-15-007, Retrieved 22nd September 2016 from, https://www.fdicig.gov/reports15%5C15-007AUD.pdf

Fortin, R., Goldberg, G.M and Roth, G 2010, Bank risk taking at the onset of the current banking crisis. Financial Review, vol. 45, no. 4, pp.891-913.

Haig, M 2005, Brand failures: the truth about the 100 biggest branding mistakes of all time, Philadelphia, PA., Kogan Page Publishers.

Maldonado-Bear, R and Walter, I 2007, Financing Economic Development. The Economy of Puerto Rico: Restoring Growth, p.399.

Papadimitriou, T., Gogas, P and Tabak, B.M 2013, Complex networks and banking systems supervision. Physica A: Statistical Mechanics and its Applications, vol. 392, no. 19, pp.4429-4434.

Popular.com 2016, Annual Financial Reports 2015, Retrieved 22nd September 2016 from, http://www.popular.com/en/investor-relations/annual-reports/

Sankaran, H., Saxena, M. and Erickson, C.A 2011, Average Conditional Volatility: A Measure Of Systemic Risk For Commercial Banks. Journal of Business & Economics Research (JBER), 9(2): 79-94.