Ninth District banks and the 1997 flood

Bankers make money by assuming risks, such as the chance that a borrower will not repay a loan, and then managing those risks, for example, by lending money only to those borrowers who pass tests of financial strength. Risk management, however, is not risk elimination. The most prudent bank cannot guard against every rare but potentially costly future event and remain viable.

Thus, bank regulators had good reason to pay close attention to banks' response to the extremely destructive flood that hit the Red River Valley this spring. Likewise, regulators at the Federal Reserve Bank of Minneapolis continue to monitor the effects of the flood on banks' financial condition.

Immediate response

A bank contingency plan for events that render normal operations impossible and require relocation proved essential during the Red River Valley flood; indeed, bank regulators require banks to develop and test such contingency plans. These plans led banks to reroute their telephone calls, move their computers and electronic data processing to unaffected branches and establish temporary facilities in everything from trailers to truck stops. The moves allowed many banks to continue to provide some level of service during and immediately after the floods.

Flood and loan repayment

The ability and willingness of borrowers in the valley to repay loans may have been reduced in ways lenders may not have anticipated. A residential homeowner whose employer is put out of business may lose the income they rely on to repay their mortgage.

Moreover, a borrower whose home is destroyed and not covered by flood insurance may be reluctant to continue making mortgage payments. Only 10 percent of homeowners in the Grand Forks and East Grand Forks area were covered by flood insurance.

A business owner whose place of work, inventory, equipment or production capability is incapacitated may be unable to repay their commercial loan. Finally, the farmer whose crop or livestock production is wiped out may face increased difficulty in making loan repayments.

Of course, those borrowers already close to the brink of default are most likely to be pushed over the edge by an extraordinary event like the flood.

Bank financial health is dependent on loan repayment. The cumulative effect of significant loan defaults could adversely affect a bank's financial condition. Like borrowers, some banks will have a thinner cushion of funds, called capital and loss reserves, to absorb losses.

Determining the effect of the flood requires both data on a bank's exposure to loan defaults and actual loan performance. Only knowing that 20 percent of a bank's commercial and industrial (C&I) loans defaulted, for example, could raise false specters of gloom because the bank could have two small C&I loans and, more generally, could have sufficient funds to absorb loan losses. In other words, reviewing exposure is the first step in evaluating the impact of the flood.

The accompanying table reviews the loan exposure of banks based in the North Dakota and Minnesota counties bordering the Red River. Exposure is measured as loans outstanding divided by a basic measure of the funds banks hold to absorb loan losses (equity capital plus loan loss reserves). An exposure of 100 percent means that all of the loans in that category would have to default for the bank to exhaust its capital and loss reserves while a 300 percent exposure would deplete capital and loss reserves after a third of the loans failed.

However, it is too early to know how the flood will impact banks because information on whether banks will receive full repayment on loans is not yet available. Exposure data analysis is the initial review and must be augmented with default data to measure the impact on banks. Only with time and more complete information will the public, analysts and bank regulators be able to determine precisely how the Red River Valley flood affected banks.