Bank Regulation
Modified Prompt Corrective Action Framework Would Improve Effectiveness Gao ID: GAO-11-612 June 23, 2011More than 300 insured depository institutions have failed since the current financial crisis began in 2007, at an estimated cost of almost $60 billion to the deposit insurance fund (DIF), which covers losses to insured depositors. Since 1991, Congress has required federal banking regulators to take prompt corrective action (PCA) to identify and promptly address capital deficiencies at institutions to minimize losses to the DIF. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires GAO to study federal regulators' use of PCA. This report examines (1) the outcomes of regulators' use of PCA on the DIF; (2) the extent to which regulatory actions, PCA thresholds, and other financial indicators help regulators address likely bank trouble or failure; and (3) options available to make PCA a more effective tool. GAO analyzed agency and financial data to describe PCA and DIF trends and assess the timeliness of regulator actions and financial indicators. GAO also reviewed relevant literature and surveyed expert stakeholders from research, industry, and regulatory sectors on options to improve PCA.
Although the PCA framework has provided a mechanism to address financial deterioration in banks, GAO's analysis suggests it did not prevent widespread losses to the DIF--a key goal of PCA. Since 2008, the financial condition of banks has declined rapidly and use of PCA has grown tenfold. However, every bank that underwent PCA because of capital deficiencies and failed in this period produced a loss to the DIF. Moreover, these losses were comparable as a percentage of assets to the losses of failed banks that did not undergo PCA. While regulators and others acknowledged PCA's limitations, regulators said that the PCA framework provides benefits, such as facilitating orderly closures and encouraging banks to increase capital levels. PCA's triggers limit its ability to promptly address bank problems, and although regulators had discretion to address problems sooner, they did not consistently do so. Since the 1990s, GAO and others have noted that the effectiveness of PCA, as currently constructed, is limited because of its reliance on capital, which can lag behind other indicators of bank health. That is, problems with the bank's assets, earnings, or management typically manifest before these problems affect bank capital. Once a bank falls below PCA's capital standards, a bank may not be able to recover regardless of the regulatory action imposed. GAO tested other financial indicators, including measures of asset quality and liquidity, and found that they were important predictors of future bank failure. These indicators also better identified those institutions that failed and did not undergo the PCA process during the recent crisis. Although regulators identified problematic conditions among banks well before failure, the presence and timeliness of enforcement actions were inconsistent. For example, among the banks that failed, more than 80 percent were on a regulatory watch list for more than a year, on average, before bank failure. However, GAO's analysis of regulatory data and material loss reviews showed that actions to address early signs of deterioration were inconsistent and, in many cases, regulators either took no enforcement action or acted in the final days before an institution was subject to PCA or failed. Without an additional early warning trigger, the regulators risk acting too late, thereby limiting their ability to minimize losses to the DIF. Most stakeholders (23 of 29) GAO surveyed agreed that PCA should be modified and identified three top options to make it more effective. The first option--incorporating an institution's risk profile into PCA capital categories--would add a measure of risk to the capital category thresholds beyond the existing risk-weighted asset component. The second option was increasing the capital ratios that place banks in PCA capital categories. The third most popular option was including another trigger for PCA, such as asset quality or asset concentration. Each option has advantages and disadvantages. For example, while an additional trigger could account for other factors often found to precede capital deterioration, it might be difficult to implement. Although stakeholders supported these broad options, they cautioned that the manner in which any option was crafted would determine its success. GAO recommends that the bank regulators consider additional triggers that would require early and forceful regulatory action to address unsafe banking practices as well as the other options identified in the report to improve PCA. The regulators generally agreed with the recommendation.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Angela N. Clowers Team: Government Accountability Office: Financial Markets and Community Investment Phone: (202) 512-4010GAO-11-612, Bank Regulation: Modified Prompt Corrective Action Framework Would Improve Effectiveness
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United States Government Accountability Office:
GAO:
Report to Congressional Committees:
June 2011:
Bank Regulation:
Modified Prompt Corrective Action Framework Would Improve
Effectiveness:
GAO-11-612:
GAO Highlights:
Highlights of GAO-11-612, a report to congressional committees.
Why GAO Did This Study:
More than 300 insured depository institutions have failed since the
current financial crisis began in 2007, at an estimated cost of almost
$60 billion to the deposit insurance fund (DIF), which covers losses
to insured depositors. Since 1991, Congress has required federal
banking regulators to take prompt corrective action (PCA) to identify
and promptly address capital deficiencies at institutions to minimize
losses to the DIF. The Dodd-Frank Wall Street Reform and Consumer
Protection Act requires GAO to study federal regulators‘ use of PCA.
This report examines (1) the outcomes of regulators‘ use of PCA on the
DIF; (2) the extent to which regulatory actions, PCA thresholds, and
other financial indicators help regulators address likely bank trouble
or failure; and (3) options available to make PCA a more effective
tool. GAO analyzed agency and financial data to describe PCA and DIF
trends and assess the timeliness of regulator actions and financial
indicators. GAO also reviewed relevant literature and surveyed expert
stakeholders from research, industry, and regulatory sectors on
options to improve PCA.
What GAO Found:
Although the PCA framework has provided a mechanism to address
financial deterioration in banks, GAO‘s analysis suggests it did not
prevent widespread losses to the DIF-”a key goal of PCA. Since 2008,
the financial condition of banks has declined rapidly and use of PCA
has grown tenfold. However, every bank that underwent PCA because of
capital deficiencies and failed in this period produced a loss to the
DIF. Moreover, these losses were comparable as a percentage of assets
to the losses of failed banks that did not undergo PCA. While
regulators and others acknowledged PCA‘s limitations, regulators said
that the PCA framework provides benefits, such as facilitating orderly
closures and encouraging banks to increase capital levels.
PCA‘s triggers limit its ability to promptly address bank problems,
and although regulators had discretion to address problems sooner,
they did not consistently do so. Since the 1990s, GAO and others have
noted that the effectiveness of PCA, as currently constructed, is
limited because of its reliance on capital, which can lag behind other
indicators of bank health. That is, problems with the bank‘s assets,
earnings, or management typically manifest before these problems
affect bank capital. Once a bank falls below PCA‘s capital standards,
a bank may not be able to recover regardless of the regulatory action
imposed. GAO tested other financial indicators, including measures of
asset quality and liquidity, and found that they were important
predictors of future bank failure. These indicators also better
identified those institutions that failed and did not undergo the PCA
process during the recent crisis. Although regulators identified
problematic conditions among banks well before failure, the presence
and timeliness of enforcement actions were inconsistent. For example,
among the banks that failed, more than 80 percent were on a regulatory
watch list for more than a year, on average, before bank failure.
However, GAO‘s analysis of regulatory data and material loss reviews
showed that actions to address early signs of deterioration were
inconsistent and, in many cases, regulators either took no enforcement
action or acted in the final days before an institution was subject to
PCA or failed. Without an additional early warning trigger, the
regulators risk acting too late, thereby limiting their ability to
minimize losses to the DIF.
Most stakeholders (23 of 29) GAO surveyed agreed that PCA should be
modified and identified three top options to make it more effective.
The first option-”incorporating an institution‘s risk profile into PCA
capital categories-”would add a measure of risk to the capital
category thresholds beyond the existing risk-weighted asset component.
The second option was increasing the capital ratios that place banks
in PCA capital categories. The third most popular option was including
another trigger for PCA, such as asset quality or asset concentration.
Each option has advantages and disadvantages. For example, while an
additional trigger could account for other factors often found to
precede capital deterioration, it might be difficult to implement.
Although stakeholders supported these broad options, they cautioned
that the manner in which any option was crafted would determine its
success.
What GAO Recommends:
GAO recommends that the bank regulators consider additional triggers
that would require early and forceful regulatory action to address
unsafe banking practices as well as the other options identified in
the report to improve PCA. The regulators generally agreed with the
recommendation.
View [hyperlink, http://www.gao.gov/products/GAO-11-612] or key
components. For more information, contact A.Nicole Clowers at (202)
512-8678 or clowersa@gao.gov. [End of section]
Contents:
Letter:
Background:
PCA Did Not Prevent Widespread Losses to the DIF:
Other Indicators Provide Early Warning of Deterioration, and although
Regulators Identified Conditions Early, Responses Were Inconsistent:
While Most Stakeholders Favored Modifying PCA, Their Preferred Options
Involve Some Trade-offs:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Objectives, Scope, and Methodology:
Appendix II: The Resolution Process Also Can Help Minimize Losses to
the Deposit Insurance Fund:
Appendix III: Econometric Analysis of Leading Indicators of Bank
Failure and Determinants of Losses to the Deposit Insurance Fund:
Appendix IV: PCA Survey Respondents:
Appendix V: Responses to Questions from GAO's Second Delphi Survey on
the Prompt Corrective Action Framework:
Appendix VI: Comments from the Federal Deposit Insurance Corporation:
Appendix VII: Comments from the Board of Governors of the Federal
Reserve System:
Appendix VIII: Comments from the Office of the Comptroller of the
Currency:
Appendix IX: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: PCA Capital Categories:
Table 2: Select Leading Indicators of Bank Failure:
Table 3: Key Regulatory Activities and Milestones of Case Studies,
First Quarter 2006-Third Quarter 2010:
Table 4: First Enforcement Action in Relation to Other Key Regulatory
Milestones of Case Studies, First Quarter 2006ñThird Quarter 2010:
Table 5: Rank Ordering of Survey Policy Options:
Table 6: Select Leading Indicators of Bank Failure:
Table 7: Logit Model of Bank Failure with Standard Financial Ratios,
Four-Quarter Horizon:
Table 8: Logit Model of Bank Failure with Standard Financial Ratios,
Eight-Quarter Horizon:
Table 9: Logit Model of Bank Failure with HHI 1, Four-Quarter Horizon:
Table 10: Logit Model of Bank Failure with HHI 2, Four-Quarter Horizon:
Table 11: Logit Model of Bank Failure with CRE, Four-Quarter Horizon:
Table 12: Logit Model of Bank Failure with CRE and HHI 2, Four-Quarter
Horizon:
Table 13: Logit Model of Bank Failure with HHI 2, Eight-Quarter
Horizon:
Table 14: Logit Model of Bank Failure with CAMELS, Four-Quarter
Horizon:
Table 15: Logit Model of Bank Failure with CAMELS, Eight-Quarter
Horizon:
Table 16: Logit Model of Bank Failure with CAMELS and Financial
Indicators, Four-Quarter Horizon:
Table 17: Logit Model of Bank Failure with CAMELS and Financial
Indicators, Eight-Quarter Horizon:
Table 18: Potential Factors Affecting DIF Losses:
Table 19: Model of DIF Losses with Nonperforming Loans and Total
Deposits, First Quarter 2007-Third Quarter 2010:
Table 20: Model of DIF Losses with Nonperforming Loans and Small
Deposits, First Quarter 2007-Third Quarter 2010:
Table 21: Model of DIF Losses with Nonperforming Assets and Small
Deposits, First Quarter 2007-Third Quarter 2010:
Table 22: Survey Respondents:
Table 23: Stakeholder Views on Potential Positive Elements of the PCA
Framework:
Table 24: Stakeholder Views on Potential Shortcomings of the PCA
Framework:
Table 25: Stakeholder Views on Potential Impact of Each Option to Make
the PCA Framework More Effective in Minimizing Losses to the DIF:
Table 26: Stakeholder Views on Potential Feasibility for Federal
Regulators to Implement Each Option:
Table 27: Stakeholder Ranking of 12 Potential Options to Modify PCA:
Table 28: Stakeholder Views on the Potential Impact of Potential
Additional PCA Triggers:
Figures:
Figure 1: Key Regulatory Milestones Associated with Bank Deterioration:
Figure 2: Number of Banks on FDIC's Problem Bank List, First Quarter
2006 - Third Quarter 2010:
Figure 3: Number of Banks by Composite CAMELS Rating, First Quarter
2006 - Third Quarter 2010:
Figure 4: Number of Failed Banks, 2006-2010:
Figure 5: Deposit Insurance Fund Balance, First Quarter 2006 - Fourth
Quarter 2010:
Figure 6: Number of Banks That Underwent the PCA Process, First
Quarter 2006 - Third Quarter 2010:
Figure 7: Banks Undergoing the PCA Process for the First Time, First
Quarter 2006 - Third Quarter 2010:
Figure 8: Failures and Nonfailures of Banks That Underwent the PCA
Process, First Quarter 2006 - Third Quarter 2010:
Figure 9: Status of 569 Banks That Underwent the PCA Process, First
Quarter 2006 - Third Quarter 2010:
Figure 10: Median Loss to the Insurance Fund of Failed Banks That Did
and Did Not Undergo the PCA Process, First Quarter 2006 - Third
Quarter 2010:
Figure 11: Nonperforming Loans (Asset Quality) at Failed and Peer
Banks, First Quarter 2006-Second Quarter 2009:
Figure 12: Liquidity at Failed and Peer Banks, First Quarter 2006-
Second Quarter 2009:
Figure 13: Loan Concentration at Failed and Peer Banks, First Quarter
2008:
Figure 14: Initial PCA Action of Failed Banks, First Quarter 2006-
Third Quarter 2010:
Figure 15: Trends in Use of Shared-loss Agreements, First Quarter 2006-
Third Quarter 2010:
Figure 16: Equity Capital and Regulatory Capital at Failed Banks,
First Quarter 2006-Second Quarter 2009:
Figure 17: Stakeholder Views on Potential Additional PCA Trigger That
Would Have the Most Positive Impact on PCA Effectiveness:
Figure 18: Stakeholder Overall Opinion of the PCA Framework:
Abbreviations:
ADC: acquisition, development, and construction:
CAMELS: Uniform Financial Institutions Rating System:
C&I: commercial and industrial:
CRE: commercial real estate:
DIF: deposit insurance fund:
DRR: Division of Resolutions and Receiverships:
FDIA: Federal Deposit Insurance Act:
FDIC: Federal Deposit Insurance Corporation:
FDICIA: Federal Deposit Insurance Corporation Improvement Act:
FSOC: Financial Stability Oversight Council:
HHI: Herfindahl-Hirschman Index:
IG: inspector general:
OCC: Office of the Comptroller of the Currency:
OLS: ordinary least-squares:
OTS: Office of Thrift Supervision:
PCA: prompt corrective action:
SCOR: Statistical CAMELS Off-site Rating:
SR-SABR: Supervision and Regulation Statistical Assessment of Bank
Risk:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
June 23, 2011:
The Honorable Tim Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Spencer Bachus:
Chairman:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
After the savings and loan crisis, federal regulators were criticized
for failing to take timely and forceful action to address the causes
of bank failures and prevent losses to taxpayers and the deposit
insurance fund (currently and hereinafter referred to as the DIF).
[Footnote 1] In response, Congress passed the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) of 1991, which made
significant changes to the Federal Deposit Insurance Act (FDIA).
[Footnote 2] In particular, FDICIA created sections 38 and 39 of FDIA
to improve the ability of regulators to identify and promptly address
deficiencies at depository institutions--banks and thrifts--and better
safeguard and minimize losses to the DIF. Section 38 requires
regulators to classify banks into one of five capital categories and
take increasingly severe actions, known as prompt corrective action
(PCA), as a bank's capital deteriorates. Section 38 primarily focuses
on capital as an indicator of bank health; therefore, supervisory
actions under it are designed to address a bank's deteriorating
capital level.[Footnote 3] Section 39 requires the banking regulators
to prescribe safety and soundness standards related to noncapital
criteria, including operations and management; compensation; and asset
quality, earnings, and stock valuation.[Footnote 4] Section 39 allows
the regulators to take action if a bank fails to meet one or more of
these standards.
Before 2007, PCA was largely untested by a financial crisis that
resulted in a large number of bank failures. After the passage of
FDICIA, sustained growth in the U.S. economy meant that the financial
condition of banks was generally strong. For instance, as a result of
positive economic conditions, the number of bank failures declined
from 180 in 1992 to 4 in 2004. And from June 2004 through January
2007, no banks failed.
Since 2007, failures have increased significantly. In 2010, 157 banks
failed, the most in a single year since the savings and loan crisis of
the 1980s and 1990s. The 157 banks had combined assets of
approximately $93 billion, costing the DIF an estimated $24 billion.
Overall, more than 300 banks have failed since the current financial
crisis began in 2007, at an estimated cost of almost $60 billion to
the DIF to cover losses to insured depositors. During this time, the
balance of the DIF has declined dramatically, becoming negative in
2009. As of December 31, 2010, the DIF had a negative balance of $7.4
billion. During this same period, beginning late in 2008, the federal
government provided significant financial assistance to many financial
institutions through the Troubled Asset Relief Program and other
actions taken by the Federal Reserve System and FDIC to stabilize the
U.S. banking system.[Footnote 5] For example, regulators used certain
emergency authorities to enable assistance to some large banks because
in their view the failure of these institutions would have imposed
large losses on creditors and threatened to undermine confidence in
the banking system.[Footnote 6]
The number and size of failures during the recent financial crisis
have raised questions about the ability of PCA to help turn around
troubled banks and minimize losses to the DIF. Section 202(g) of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act) requires GAO to study the federal regulators' use of PCA and
report our findings to the Financial Stability Oversight Council.
[Footnote 7] The Dodd-Frank Act also requires that the Financial
Stability Oversight Council report to the Committee on Banking,
Housing, and Urban Affairs of the Senate and the Committee on
Financial Services of the House of Representatives on actions taken in
response to our report, including any recommendations made to the
federal banking regulators. Specifically, this report (1) analyzes the
outcomes of regulators' use of PCA on the DIF; (2) evaluates the
extent to which regulatory actions, capital thresholds, and other
financial indicators helped regulators to address likely bank trouble
or failure; and (3) identifies options available to make PCA a more
effective tool to prevent or minimize losses to the DIF.
To describe trends in and outcomes from the implementation of PCA, we
analyzed banking data from regulators, including FDIC Quarterly
Banking Reports and the quarterly "problem" bank lists. We analyzed
data on banks that underwent the PCA process, failed from the first
quarter of 2006 through the third quarter of 2010 (i.e., from January
1, 2006, through September 30, 2010), or both, and identified their
outcomes.[Footnote 8] To determine the number of banks that produced
losses to the DIF--including those banks that underwent the PCA
process before failure and those that did not--we used the 2010
estimate of losses to the DIF from loss data obtained from FDIC, which
we determined to be sufficiently reliable for our purpose of
enumerating failed banks and the losses associated with these failures
based on our ongoing work related to the DIF.[Footnote 9] We also
interviewed representatives from FDIC, the Board of Governors of the
Federal Reserve System (Federal Reserve), the Office of the
Comptroller of the Currency (OCC), and the Office of Thrift
Supervision (OTS).
To assess the utility of various financial indicators in predicting
bank distress, we developed a model of leading indicators of bank
failure based on financial ratios researchers identified in the 1990s
that predicted bank failures in previous stress periods. We used these
financial ratios, regulatory ratings, and an indicator we developed of
sector loan concentration to forecast bank failure within 1 to 2 years
(for failed banks and peers from 2006 through the third quarter of
2010). We used this model to assess the predictive power of indicators
other than bank capital. To do this, we relied on data from FDIC and
SNL Financial. We assessed the reliability of data used in our
analysis and found the data sufficiently reliable for our purposes.
To examine the extent to which various regulatory activities and
enforcement actions, including PCA, detected and addressed troubled
banks, we examined the type and timing of regulatory actions across
the oversight cycle. This work encompassed analyzing the extent to
which existing regulatory steps provided warning of likely bank
deterioration or failure. Specifically, we reviewed off-site
monitoring tools and examined if these tools provided effective
warnings of bank distress. For all bank failures that occurred from
the first quarter of 2006 through the third quarter of 2010, we also
reviewed formal and informal enforcement actions in the 2-year period
before a bank failed to identify the earliest enforcement action taken
in relation to other regulatory milestones associated with financial
deterioration. We also reviewed the timing and nature of PCA
enforcement actions in relation to bank failure. Upon receiving
enforcement data provided by FDIC, the Federal Reserve, OCC, and OTS,
we determined that the enforcement data provided could not be relied
upon without additional verification. In particular, the enforcement
data the Federal Reserve, OCC, and OTS provided could not be used
alone to make distinctions among different types of enforcement
actions that may or may not have been relevant to safety and soundness
issues of banks that were deteriorating financially. While enforcement
data provided by FDIC did make such distinctions, we did not rely
exclusively on the enforcement data provided by the regulators, but
rather, used these data to corroborate information on enforcement
actions from material loss reports prepared by the inspectors general
(IG) of the banking regulators and conducted case studies of 8 banks
to highlight examples of oversight steps taken by each of the
regulators and various outcomes. We selected a nongeneralizable sample
of banks that is diverse with respect to geography, asset size,
franchise value, primary regulator, date of failure, sequence of
enforcement actions, outcome (failure or a return to financial
stability), and losses to the DIF. The inspectors general for the
FDIC, the Department of the Treasury, and the Board of Governors of
the Federal Reserve System are currently conducting a joint evaluation
of the PCA framework that will address the use of both sections 38 and
39 of FDICIA during the last few years, among other issues.
To identify options to make PCA more effective, we surveyed informed
stakeholders from the regulatory agencies, research, and industry
sectors. We used a two-part Delphi survey to gather ideas from the
stakeholders, who were identified through professional credentials,
authorship of research, and membership in relevant research and
industry groups. The first survey, using open-ended questions, asked
respondents to identify options, including those outside the PCA
framework, which could be more effective in minimizing losses to the
DIF. The second survey, through a set of closed-ended questions
created from a content analysis of the responses from the first
survey, asked the same stakeholders to rate and rank the options in
terms of feasibility and impact. To further illustrate the options
that may be considered to improve PCA effectiveness, we interviewed
supervisory and research staff at the four regulators about PCA and
bank failures during the financial crisis and any additional options
that could improve PCA effectiveness. Finally, we conducted a
literature review on PCA and early intervention and synthesized any
additional options presented in the literature that could make PCA
more effective. Appendix I contains a more detailed description of our
scope and methodology.
We conducted this performance audit from July 2010 through June 2011
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Background:
Bank Supervision:
Four federal regulators oversee banks and savings associations
(thrifts) in the United States. The Federal Reserve is the primary
regulator for state-chartered member banks (i.e., state-chartered
banks that are members of the Federal Reserve System) and bank holding
companies, OCC is the primary regulator of federally chartered banks,
and OTS is the primary regulator of federally and state-chartered
thrifts and thrift holding companies.[Footnote 10] FDIC is the primary
regulator for state-chartered nonmember banks (i.e., state-chartered
banks that are not members of the Federal Reserve System). In
addition, FDIC insures the deposits of all federally insured banks,
generally up to $250,000 per depositor, and monitors their risk to the
DIF.[Footnote 11]
Regulators examine banks' risk management systems to help ensure the
safe and sound operation of banks and protect the well-being of
depositors--those individuals and organizations that act as creditors
by "loaning" their funds in the form of deposits to banks for lending
and other activities. Regulators are responsible for supervising the
activities of banks and taking corrective action when their activities
and overall performance present supervisory concerns or could result
in financial losses to the DIF or violations of law. Losses to the DIF
may occur when a bank does not have sufficient assets to reimburse
customers' deposits and FDIC's administrative expenses in the event of
closure or merger.
All the regulators assess the condition of banks through off-site
monitoring and on-site examinations. Examiners use Report of Condition
and Income (Call Report) and Thrift Financial Report data to remotely
assess the financial condition of banks and thrifts, respectively, and
to plan the scope of on-site examinations. Historically, banking
regulators have used tools to monitor the financial condition of banks
between on-site bank examinations. The off-site monitoring or
surveillance activities rely largely on self-reported information from
banks, filed through quarterly Call Reports to the banking regulators.
Off-site monitoring and surveillance activities help alert regulators
to potentially problematic conditions arising in a financial
institution. Using these tools, each of the regulators identifies and
flags banks with potential signs of financial distress for further
regulatory scrutiny and prepares lists or reports of such institutions
requiring further regulatory scrutiny (e.g., watch list, review list,
high risk profile list, etc.).
As part of on-site examinations, regulators closely assess banks'
exposure to risk and assign ratings, under the Uniform Financial
Institutions Rating System, commonly known as CAMELS. The ratings
reflect a bank's condition in six areas: capital, asset quality,
management, earnings, liquidity, and sensitivity to market risk. Each
component is rated on a scale of 1 to 5, with 1 being the best and 5
the worst. The component ratings are then used to develop a composite
rating, also ranging from 1 to 5. Banks with composite ratings of 1 or
2 are considered to be in satisfactory condition, while banks with
composite ratings of 3, 4, or 5 exhibit varying levels of safety and
soundness problems. Banks with composite ratings of 4 or 5 are
included on FDIC's problem bank list, which designates banks with
weaknesses that threaten their continued financial viability. Also as
part of the examination and general supervision process, regulators
may direct a bank to address issues or deficiencies within specified
time frames. However, as figure 1 illustrates, a bank's condition can
rapidly deteriorate and bypass the various regulatory steps that
usually occur as a bank's condition deteriorates.
Figure 1: Key Regulatory Milestones Associated with Bank Deterioration:
[Refer to PDF for image: illustration]
Banks may deteriorate quickly and bypass key regulatory steps.
Regulatory actions:
* Off-site monitoring and surveillance;
* On-site examinations;
* CAMELS ratings downgrade;
* Informal and formal enforcement actions.
Key regulatory steps: Healthy bank;
Potential Outcomes: Healthy bank;
Status: Favorable.
Key regulatory steps: Watch list bank;
Potential Outcomes: Healthy bank; Watch list bank;
Status: Less favorable.
Key regulatory steps: Problem bank;
Potential Outcomes: Healthy bank; Watch list bank; Problem bank;
Status: Less favorable.
Key regulatory steps: Banks that underwent the PCA process;
Potential Outcomes: Healthy bank; Watch list bank; Problem bank;
Status: Less favorable.
Key regulatory steps: Nonsurviving failed banks;
Potential Outcomes: No loss to DIF; Loss to DIF;
Status: Unfavorable.
Source: GAO analysis of data from federal banking regulatory agencies.
[End of figure]
When regulators determine that a bank or thrift's condition is less
than satisfactory, they may take a variety of supervisory actions,
including informal and formal enforcement actions, to address
identified deficiencies and have some discretion in deciding which
actions to take. Regulators typically take progressively stricter
actions against more serious weaknesses. Informal actions generally
are used to address less severe deficiencies or when the regulator has
confidence that the bank is willing and able to implement changes.
Examples of informal actions include commitment letters detailing a
bank's commitment to undertake specific remedial measures, resolutions
adopted by the bank's board of directors at the request of its
regulator, and memorandums of understanding that note agreements
between the regulator and the bank's board of directors. Informal
actions are not public agreements (regulators do not make them public
through their Web sites or other channels) and are not enforceable by
sanctions. In comparison, regulators publicly disclose and enforce
formal actions. The regulators use formal actions to address more
severe deficiencies. Formal enforcement actions include PCA
directives, cease-and-desist orders, removal and prohibition orders,
civil money penalties, and termination of a bank's deposit insurance.
[Footnote 12]
PCA:
A principal goal of PCA is to prevent losses to the DIF for the vast
majority of bank failures. Section 38 of FDIA requires regulators to
categorize banks into five categories on the basis of their capital
levels (see table 1). Regulators use four different capital measures
to determine a bank's capital category: (1) a total risk-based capital
ratio, (2) a Tier 1 risk-based capital ratio, (3) a leverage ratio (or
non-risk-based capital ratio). The fourth PCA measure is a tangible
equity to assets ratio for the Critically Undercapitalized category.
[Footnote 13] To be well capitalized, a bank must significantly exceed
the minimum standard for all three capital measures. Depending on the
level of deficiency, banks may be considered undercapitalized or
significantly undercapitalized if they fail to meet any one of the
ratios necessary to be considered at least adequately capitalized. A
bank that fails to meet the tangible equity to total assets ratio is
considered critically undercapitalized. For example, a bank that is
experiencing significant growth, with 9 percent total risk-based
capital and 6 percent Tier 1 risk-based capital but only 3.5 percent
leverage capital, would be undercapitalized for PCA purposes.
Table 1: PCA Capital Categories:
Capital category: Well capitalized[C];
Total risk-based capital[A]: 10% or more and;
Tier 1 risk-based capital: 6% or more and;
Leverage capital[B]: 5% or more.
Capital category: Adequately capitalized;
Total risk-based capital[A]: 8% or more and;
Tier 1 risk-based capital: 4% or more and;
Leverage capital[B]: 4% or more[D].
Capital category: Undercapitalized;
Total risk-based capital[A]: Less than 8% or;
Tier 1 risk-based capital: Less than 4% or;
Leverage capital[B]: Less than 4%.
Capital category: Significantly undercapitalized;
Total risk-based capital[A]: Less than 6% or;
Tier 1 risk-based capital: Less than 3% or;
Leverage capital[B]: Less than 3%.
Capital category: Critically undercapitalized;
Total risk-based capital[A]: An institution is critically
undercapitalized if its tangible equity is equal to or less than 2% of
total assets regardless of its other capital ratios.[E]
Sources: Capital measures and capital category definitions: FDIC--12
C.F.R. § 325.103, Federal Reserve--12 C.F.R. § 208.43, OCC--12 C.F.R.
§ 6.4, and OTS--12 C.F.R. § 565.4.
[A] The total risk-based capital ratio consists of the sum of Tier 1
and Tier 2 capital divided by risk-weighted assets. Tier 1 capital
consists primarily of tangible equity (see note e). Tier 2 capital
includes limited amounts of subordinated debt, loan loss reserves, and
certain other instruments.
[B] Leverage capital is Tier 1 capital divided by average total assets.
[C] An institution that satisfies the capital measures for a well-
capitalized institution but is subject to a formal enforcement action
that requires it to meet and maintain a specific capital level is
considered to be adequately capitalized for purposes of PCA.
[D] CAMELS 1-rated institutions not experiencing or anticipating
significant growth need have only 3 percent leverage capital to be
considered adequately capitalized.
[E] Tangible equity is equal to the amount of Tier 1 capital elements
plus outstanding cumulative perpetual preferred stock minus all
intangible assets not previously deducted, except certain purchased
mortgage-servicing rights. Cumulative perpetual preferred stock is
stock that has no maturity date, cannot be redeemed at the option of
the holder, has no other provisions that will require future
redemption of the issue, and provides for the accumulation or future
payment of unpaid dividends. Intangible assets are those assets that
are required to be reported as intangible assets in a bank's Call
Report or thrift's Thrift Financial Report.
[End of table]
Under section 38, regulators must take increasingly stringent
supervisory actions as a bank's capital level deteriorates. For
example, all undercapitalized banks must implement capital restoration
plans to restore capital to at least the adequately capitalized level,
and regulators generally must close critically undercapitalized banks
within a 90-day period.[Footnote 14] Section 38 also authorizes
several non-capital-based supervisory actions designed to allow
regulators some flexibility in achieving the purpose of section 38.
Specifically, under section 38(g) regulators can reclassify or
downgrade a bank's capital category to apply more stringent operating
restrictions or requirements if they determine, after notice and
opportunity for a hearing, that a bank is in an unsafe and unsound
condition or engaging in an unsafe or unsound practice.[Footnote 15]
Under section 38(f)(2)(F), regulators can require a bank to make
improvements in management--for example, by dismissing officers and
directors who are not able to materially strengthen a bank's ability
to become adequately capitalized.
Section 39 directs regulatory attention to a bank's operations and
activities in three areas aside from capital that also can affect
safety and soundness: (1) operations and management; (2) compensation;
and (3) asset quality, earnings, and stock valuation. Under section
39, if a regulator determines that a bank has failed to meet a
prescribed standard, the regulator may require that the institution
file a safety and soundness plan specifying how it will correct the
deficiency. If the bank fails to submit an acceptable plan or fails to
materially implement or adhere to an approved plan, the regulator must
require the institution, through the issuance of a public order, to
correct identified deficiencies and may place other restrictions or
requirements on the bank pending the correction of the deficiency. We
previously reported that regulators made limited use of their section
39 authority.[Footnote 16]
Changing Condition of the Banking Industry:
During the last few years, the condition of the bank and thrift
industry has declined, particularly when compared with conditions in
the relatively positive period beginning in the early 1990s following
the passage of FDICIA. Indicators of bank health, such as the number
of banks on FDIC's problem bank list, show the deteriorating condition
of banks since 2007 (see figure 2). For example, in the first quarter
of 2007, 53 banks were on the "problem" bank list, but by the third
quarter of 2010, 860 banks were on this list.
Figure 2: Number of Banks on FDIC's Problem Bank List, First Quarter
2006 - Third Quarter 2010:
[Refer to PDF for image: line graph]
2006, Q1;
Number of problem banks: 48.
2006, Q2;
Number of problem banks: 50.
2006, Q3;
Number of problem banks: 47.
2006, Q4;
Number of problem banks: 50.
2007, Q1;
Number of problem banks: 53.
2007, Q2;
Number of problem banks: 61.
2007, Q3;
Number of problem banks: 65.
2007, Q4;
Number of problem banks: 76.
2008, Q1;
Number of problem banks: 90.
2008, Q2;
Number of problem banks: 117.
2008, Q3;
Number of problem banks: 171.
2008, Q4;
Number of problem banks: 252.
2009, Q1;
Number of problem banks: 305.
2009, Q2;
Number of problem banks: 416.
2009, Q3;
Number of problem banks: 552.
2009, Q4;
Number of problem banks: 702.
2010, Q1;
Number of problem banks: 775.
2010, Q2;
Number of problem banks: 829.
2010, Q3;
Number of problem banks: 860.
Source: GAO analysis of FDIC data.
[End of figure]
Moreover, the number of banks with CAMELS composite ratings of 1 and 2
has declined steadily since 2007 and 2008, respectively, and the
numbers of 3, 4, and 5 ratings have increased over this period (figure
3).
Figure 3: Number of Banks by Composite CAMELS Rating, First Quarter
2006 - Third Quarter 2010:
[Refer to PDF for image: multiple line graph]
2006, Q1;
CAMELS Rating 1: 3,137;
CAMELS Rating 2: 5,069;
CAMELS Rating 3: 360;
CAMELS Rating 4: 48;
CAMELS Rating 5: 6.
2006, Q2;
CAMELS Rating 1: 3,117;
CAMELS Rating 2: 5,063;
CAMELS Rating 3: 358;
CAMELS Rating 4: 46;
CAMELS Rating 5: 7.
2006, Q3;
CAMELS Rating 1: 3,088;
CAMELS Rating 2: 5,064;
CAMELS Rating 3: 353;
CAMELS Rating 4: 43;
CAMELS Rating 5: 7.
2006, Q4;
CAMELS Rating 1: 3,046;
CAMELS Rating 2: 5,054;
CAMELS Rating 3: 355;
CAMELS Rating 4: 47;
CAMELS Rating 5: 5.
2007, Q1;
CAMELS Rating 1: 2,994;
CAMELS Rating 2: 5,077;
CAMELS Rating 3: 353;
CAMELS Rating 4: 59;
CAMELS Rating 5: 5.
2007, Q2;
CAMELS Rating 1: 2,940;
CAMELS Rating 2: 5,078;
CAMELS Rating 3: 361;
CAMELS Rating 4: 63;
CAMELS Rating 5: 6.
2007, Q3;
CAMELS Rating 1: 2,869;
CAMELS Rating 2: 5,072;
CAMELS Rating 3: 390;
CAMELS Rating 4: 64;
CAMELS Rating 5: 6.
2007, Q4;
CAMELS Rating 1: 2,805;
CAMELS Rating 2: 5,064;
CAMELS Rating 3: 402;
CAMELS Rating 4: 77;
CAMELS Rating 5: 12.
2008, Q1;
CAMELS Rating 1: 2,686;
CAMELS Rating 2: 5,050;
CAMELS Rating 3: 484;
CAMELS Rating 4: 99;
CAMELS Rating 5: 10.
2008, Q2;
CAMELS Rating 1: 2,578;
CAMELS Rating 2: 5,008;
CAMELS Rating 3: 566;
CAMELS Rating 4: 136;
CAMELS Rating 5: 24.
2008, Q3;
CAMELS Rating 1: 2,440;
CAMELS Rating 2: 4,922;
CAMELS Rating 3: 692;
CAMELS Rating 4: 183;
CAMELS Rating 5: 32.
2008, Q4;
CAMELS Rating 1: 2,286;
CAMELS Rating 2: 4,790;
CAMELS Rating 3: 819;
CAMELS Rating 4: 254;
CAMELS Rating 5: 60.
2009, Q1;
CAMELS Rating 1: 2,115;
CAMELS Rating 2: 4,717;
CAMELS Rating 3: 960;
CAMELS Rating 4: 295;
CAMELS Rating 5: 88.
2009, Q2;
CAMELS Rating 1: 1,968;
CAMELS Rating 2: 4,606;
CAMELS Rating 3: 1,046;
CAMELS Rating 4: 376;
CAMELS Rating 5: 145.
2009, Q3;
CAMELS Rating 1: 1,824;
CAMELS Rating 2: 4,383;
CAMELS Rating 3: 1,189;
CAMELS Rating 4: 462;
CAMELS Rating 5: 202.
2009, Q4;
CAMELS Rating 1: 1,674;
CAMELS Rating 2: 4,219;
CAMELS Rating 3: 1,293;
CAMELS Rating 4: 541;
CAMELS Rating 5: 259.
2010, Q1;
CAMELS Rating 1: 1,552;
CAMELS Rating 2: 4,131;
CAMELS Rating 3: 1,377;
CAMELS Rating 4: 564;
CAMELS Rating 5: 292.
2010, Q2;
CAMELS Rating 1: 1,478;
CAMELS Rating 2: 4,026;
CAMELS Rating 3: 1,438;
CAMELS Rating 4: 581;
CAMELS Rating 5: 300.
2010, Q3;
CAMELS Rating 1: 1,422;
CAMELS Rating 2: 3,993;
CAMELS Rating 3: 1,437;
CAMELS Rating 4: 604;
CAMELS Rating 5: 296.
Source: GAO analysis of FDIC data.
[End of figure]
Since the financial crisis began, the number of bank failures
increased yearly from 2007 to 2010, with more than 300 banks failing
during this time (see figure 4). In 2010, 157 banks failed.
Figure 4: Number of Failed Banks, 2006-2010:
[Refer to PDF for image: vertical bar graph]
Year: 2006;
Number of failed banks: 0.
Year: 2007;
Number of failed banks: 3.
Year: 2008;
Number of failed banks: 25.
Year: 2009;
Number of failed banks: 140.
Year: 2010;
Number of failed banks: 157.
Source: GAO analysis of FDIC data.
[End of figure]
As a result of the rise in bank failures, the DIF balance has
decreased dramatically (see figure 5). Since the first quarter of
2007, the DIF balance has decreased by about $57 billion. The DIF
balance was $50.7 billion at the start of 2007, hit a low point of
negative $20.8 billion in the fourth quarter of 2009, and had a
balance of negative $7.4 billion as of December 31, 2010.
Figure 5: Deposit Insurance Fund Balance, First Quarter 2006 - Fourth
Quarter 2010:
[Refer to PDF for image: vertical bar graph]
2006, Q1;
DIF balance: $49.193 billion.
2006, Q2;
DIF balance: $49.654 billion.
2006, Q3;
DIF balance: $49.992 billion.
2006, Q4;
DIF balance: $50.165 billion.
2007, Q1;
DIF balance: $50.745 billion.
2007, Q2;
DIF balance: $51.227 billion.
2007, Q3;
DIF balance: $51.754 billion.
2007, Q4;
DIF balance: $52.413 billion.
2008, Q1;
DIF balance: $52.843 billion.
2008, Q2;
DIF balance: $45.217 billion.
2008, Q3;
DIF balance: $34.588 billion.
2008, Q4;
DIF balance: $17.276 billion.
2009, Q1;
DIF balance: $13.007 billion.
2009, Q2;
DIF balance: $10.368 billion.
2009, Q3;
DIF balance: -$8.243 billion.
2009, Q4;
DIF balance: -$20.862 billion.
2010, Q1;
DIF balance: -$20.717 billion.
2010, Q2;
DIF balance: -$15.247 billion.
2010, Q3;
DIF balance: -$8.009 billion.
2010, Q4;
DIF balance: -$7.352 billion.
Source: GAO analysis of FDIC data.
[End of figure]
PCA Did Not Prevent Widespread Losses to the DIF:
Most Banks That Underwent the PCA Process Either Failed or Remained
Troubled:
As the recent financial turmoil unfolded, the number of banks that
fell below one of the three lowest PCA capital thresholds--
undercapitalized, significantly undercapitalized, or critically
undercapitalized--increased dramatically. All four regulators told us
that PCA was not designed for the type of precipitous economic decline
that occurred in 2007 and 2008. As figure 6 illustrates, the total
number of banks in undercapitalized and lower capital categories
averaged fewer than 10 per quarter in 2006 and 2007, whereas the total
averaged approximately 132 from 2008 through the third quarter of 2010.
Figure 6: Number of Banks That Underwent the PCA Process, First
Quarter 2006 - Third Quarter 2010:
[Refer to PDF for image: vertical bar graph]
2006; Q1;
PCA Banks: 7.
2006; Q2;
PCA Banks: 4.
2006; Q3;
PCA Banks: 4.
2006; Q4;
PCA Banks: 8.
2007; Q1;
PCA Banks: 12.
2007; Q2;
PCA Banks: 13.
2007; Q3;
PCA Banks: 13.
2007; Q4;
PCA Banks: 16.
Average, 2006-2007: 9.6.
2008; Q1;
PCA Banks: 22.
2008; Q2;
PCA Banks: 33.
2008; Q3;
PCA Banks: 45.
2008; Q4;
PCA Banks: 102.
2009; Q1;
PCA Banks: 125.
2009; Q2;
PCA Banks: 164.
2009; Q3;
PCA Banks: 177.
2009; Q4;
PCA Banks: 222.
2010, Q1;
PCA Banks: 197.
2010, Q2;
PCA Banks: 199.
2010, Q3;
PCA Banks: 172.
Average 2008-2010: 132.5.
Source: GAO analysis of FDIC data.
[End of figure]
The number of banks that entered the PCA process for the first time
each quarter also increased dramatically. In 2006 and 2007, the number
of banks newly entering undercapitalized or lower capital categories
averaged fewer than 5 per quarter, compared with an average of 48 from
2008 through the third quarter of 2010 (see figure 7).
Figure 7: Banks Undergoing the PCA Process for the First Time, First
Quarter 2006 - Third Quarter 2010:
[Refer to PDF for image: vertical bar graph]
2006; Q1;
PCA Banks: 7.
2006; Q2;
PCA Banks: 1.
2006; Q3;
PCA Banks: 1.
2006; Q4;
PCA Banks: 7.
2007; Q1;
PCA Banks: 7.
2007; Q2;
PCA Banks: 2.
2007; Q3;
PCA Banks: 4.
2007; Q4;
PCA Banks: 9.
Average, 2006-2007: 4.8.
2008; Q1;
PCA Banks: 10.
2008; Q2;
PCA Banks: 24.
2008; Q3;
PCA Banks: 29.
2008; Q4;
PCA Banks: 73.
2009; Q1;
PCA Banks: 57.
2009; Q2;
PCA Banks: 63.
2009; Q3;
PCA Banks: 64.
2009; Q4;
PCA Banks: 95.
2010, Q1;
PCA Banks: 35.
2010, Q2;
PCA Banks: 48.
2010, Q3;
PCA Banks: 32.
Average 2008-2010: 48.3.
Source: GAO analysis of FDIC data.
[End of figure]
The vast majority of banks that underwent the PCA process from 2006
through the third quarter of 2010 had not returned to a condition of
financial stability by the end of this period. As shown in figure 8,
of the 569 banks that fell into the undercapitalized or lower capital
categories of PCA, 270 failed. Another 25 banks failed without first
being identified as falling into the undercapitalized or lower capital
categories of PCA, bringing total bank failures to 295 during this
period. Banking regulators told us that because of the sharp economic
downturn in 2008, banks could deteriorate more rapidly than PCA was
designed to handle.[Footnote 17] For example, nearly half failed after
being undercapitalized for two or fewer quarters. In addition, three
regulators told us that early in the economic turmoil, banks that
encountered sudden liquidity problems often did not trigger the PCA
process before failure.
Figure 8: Failures and Nonfailures of Banks That Underwent the PCA
Process, First Quarter 2006 - Third Quarter 2010:
[Refer to PDF for image: concentric circles]
Underwent PCA: 299 (did not fail);
Underwent PCA and then failed: 270;
Failed (did not first undergo the PCA process): 25;
Total failed: 295.
Source: GAO analysis of FDIC data.
[End of figure]
Although the remaining banks that underwent the PCA process did not
fail, most of them continue to struggle financially. Specifically, 299
of the 569 banks that underwent the PCA process did not fail during
the period of analysis. Of these 299 banks, 223 remained
undercapitalized or on the problem bank list through the third quarter
of 2010 (see figure 9). According to regulators and industry
representatives, the large number of troubled banks may be due to
sustained economic weakness during the period of analysis, which
likely has hindered the ability of these banks to raise additional
capital. Another 46 of the 299 undercapitalized banks were dissolved
with minimal or no losses to the DIF.[Footnote 18] And the remaining
30 banks remained open and were neither undercapitalized nor on the
problem bank list at the end of the period.
Figure 9: Status of 569 Banks That Underwent the PCA Process, First
Quarter 2006 - Third Quarter 2010:
[Refer to PDF for image: horizontal bar graph]
Failed: 270;
Not failed: 299 (Dissolved: 46; Active: 253).
Active: On problem bank list?
* No: 32:
- Still undercaptialized: No: 32; Yes: 2;
* Yes:
- Still undercaptialized: No: 51; Yes: 170.
Source: GAO analysis of FDIC data.
[End of figure]
All Banks That Failed after Undergoing the PCA Process Caused Losses
to the Deposit Insurance Fund:
Although PCA was intended to prevent or minimize losses to the DIF
when banks failed, this goal was not achieved during the recent
financial crisis. All 270 banks that failed after undergoing the PCA
process during the period we reviewed caused losses to the fund, and
these losses were comparable as a percentage of assets with those of
the generally larger banks that did not undergo PCA. Thus, whether or
not a bank underwent the PCA process before failure, its losses to the
fund totaled approximately a third of its assets. Specifically, for
banks that underwent the PCA process before failure, the minimum loss
to the DIF as a percentage of assets was 1 percent, the median loss
was 27.7 percent, and the maximum loss was 87 percent (see figure 10).
For banks that did not undergo the PCA process before failure, the
minimum loss to the DIF as a percentage of assets was 0 percent, the
median loss was 29.1 percent, and the maximum loss was 61 percent.
[Footnote 19] However, after controlling for the financial condition
of banks before they failed, we found that PCA had a small, positive
impact on losses to the DIF as a percentage of assets. In particular,
banks that went through PCA had losses that were 1 to 3 percentage
points lower than those that did not undergo PCA before failure, but
this difference was not statistically significant.[Footnote 20]
Figure 10: Median Loss to the Insurance Fund of Failed Banks That Did
and Did Not Undergo the PCA Process, First Quarter 2006 - Third
Quarter 2010:
[Refer to PDF for image: horizontal bar graph]
Hit PCA:
Minimum loss: 1%;
Median loss: 27.7%;
Maximum loss: 87%.
Dit not hit PCA:
Minimum loss: 0%;
Median loss: 29.1%;
Maximum loss: 61%.
Source: GAO analysis of FDIC data.
Note: The mean loss to the DIF for banks that did not undergo the PCA
process was 25.6 percent versus 28 percent for banks that did undergo
the PCA process, though this difference was not statistically
significant. After controlling for the financial condition of banks
before they failed, we found that PCA had a small, positive (1-3
percent) impact on losses to the DIF as a percentage of assets, but
the difference remained statistically insignificant.
[End of figure]
The 25 banks that failed without first being identified as
undercapitalized or in lower capital categories generated losses that
were larger in absolute terms, averaging $443 million compared with
$246 million for the 270 banks that underwent PCA before failure.
However, the 25 banks that did not first undergo the PCA process
tended to be larger--their median size, as measured by assets held the
quarter before failure, was $372 million, versus $263 million for the
270 banks that underwent the PCA process.[Footnote 21] In addition,
our analysis suggests that the banks that did not undergo PCA before
failure may have had characteristics that made them less likely to
trigger the undercapitalized or lower capital thresholds of PCA
because these banks may have possessed more capital. However, they
also may have held fewer liquid securities or relied to a greater
degree on unstable sources of funding, such as high-yield deposits
from large financial investors.
Regulators Highlighted Benefits and Limitations of the PCA Framework:
According to federal banking regulators, the PCA framework has
provided them with a useful tool to address deteriorating banks.
Federal regulators told us that the PCA process is most effective in
combination with other enforcement tools and it has multiple benefits
in addressing financial deterioration in bank. They most frequently
cited the following benefits:
* First, the PCA process may serve as a backstop or a safeguard to be
used if other enforcement actions were delayed (for example, because a
troubled bank contested a consent order).
* Second, the PCA program empowers state banking regulators to close
critically undercapitalized banks--often in the face of significant
pressure to forbear--and provides a road map for doing so.[Footnote
22] Furthermore, officials from FDIC told us that state regulatory
agencies had few occasions to close banks since the savings and loan
crisis of the 1980s and 1990s, making such a road map more important
because they could not draw on recent institutional memory of bank
closures.
* Third, the 90-day closure provision in PCA facilitates an orderly
resolution from the perspective of FDIC's Division of Resolutions and
Receiverships (DRR), which manages the closures of failed federally
insured banks. FDIC DRR officials told us that the 90-day provision
provides advance notice of a potential failure, enabling both FDIC DRR
and potential buyers to conduct due diligence on the assets and
liabilities of the deteriorating bank. According to FDIC DRR
officials, the PCA advance notice results in higher bids for the
failed bank. For more information on the resolution methods used to
close failed banks, see appendix II.
* Fourth, the PCA framework encourages banks to hold more capital than
otherwise would be the case. According to FDIC officials, banks often
hold capital in excess of the required PCA capital thresholds to
minimize the possibility of triggering mandatory supervisory action
under section 38 of FDIA.
The banking regulators cited other benefits of PCA, including the
specific authorities that section 38 affords. For example, OTS, OCC,
and Federal Reserve officials said the ability to dismiss officers and
directors from deteriorating banks was helpful, and FDIC officials
said it was useful to be able to restrict the use of brokered deposits
by banks categorized as adequately capitalized under the PCA
framework.[Footnote 23] Regulators also noted that PCA increases
consistency across the various regulatory agencies, which creates
shared expectations about the process of monitoring, managing, and
closing deteriorating banks. However, they emphasized that the
effectiveness of PCA depended on making early and forceful use of
their other enforcement tools.
Although regulators cited benefits of the PCA framework, they and
industry groups also recognized several potential drawbacks of it.
Some representatives specifically noted that PCA may discourage
potential investors from investing in the troubled bank because of
concerns that the bank's closure will wipe out their investment. In
addition, some officials and an industry group said that large banks
with capital deficiencies are more likely to receive financial
assistance or time to recapitalize than are smaller banks.[Footnote
24] Finally, one industry group said that PCA is procyclical--that is,
it magnifies the impact of wider economic trends on banks by
compelling them to maintain, rather than draw down, their capital
buffers. According to this industry group, by preventing banks from
using their capital cushions, PCA hinders their ability to recover
from financial distress.
Other Indicators Provide Early Warning of Deterioration, and although
Regulators Identified Conditions Early, Responses Were Inconsistent:
Because they rely on capital, PCA's triggers have weaknesses, and the
PCA framework does not take full advantage of early warning signs of
bank distress that other financial indicators we tested can provide.
Capital can lag behind other indicators of bank health, and once a
bank's capital has deteriorated to the undercapitalized level, it may
be too late for the bank to recover. Leading indicators of bank
failure beyond capital--including measures of asset quality and
liquidity--provided early warning of bank distress during the period
we reviewed. Collectively, we found these indicators better identified
those banks that did not undergo the PCA process before failure.
Regulators generally were successful in identifying early warning
signs of bank distress, but the presence and timeliness of subsequent
enforcement actions were often inconsistent. While their off-site
monitoring tools and CAMELS ratings often indicated deteriorating
conditions more than a year before banks failed, regulators did not
consistently take enforcement actions before banks underwent the PCA
process.
PCA's Triggers Have Weaknesses:
PCA's triggers have weaknesses in terms of initiating regulatory
action upon early warning signs of bank distress. In the 1990s,
several researchers at the bank regulatory agencies, as well as GAO,
identified significant concerns associated with using the PCA bank
capital thresholds to determine when to intervene in troubled banks.
For example, one study found that capital is likely to trigger
intervention after examiners already were aware of problems at a bank.
[Footnote 25] Another study found that most banks with a significant
risk of failure in 1984-1989 (prior to the existence of PCA) would not
have been considered undercapitalized under PCA.[Footnote 26]
Similarly, we have found that while capital was a valid measure of a
bank's financial health, waiting until the capital standards have been
violated may be too late for a bank to be able to address its
problems. Banks had other identifiable issues before they were
reflected in capital.[Footnote 27] As discussed earlier we found that
most banks that underwent the PCA process either failed or remained on
the problem bank list. Furthermore, nearly 1 in 10 banks failed
without undergoing the PCA process.
Other Leading Indicators or a Composite Indicator Provided Early
Warning of Bank Distress and Impending Failure:
Other leading indicators, or a composite indicator, provided
additional early warning of bank distress.[Footnote 28] Several
studies published in the 1990s demonstrated that in addition to
capital, indicators based on earnings, asset quality, liquidity, and
reliance on unstable funding provide early warning of bank distress.
Capital on its own may provide some early warning of bank failure but
does not capture weaknesses that manifest--perhaps earlier--in other
areas of the bank's operations. We developed a model based on this
earlier research to determine if these leading indicators would have
been useful tools to predict bank failures during the current crisis.
[Footnote 29] As discussed below, our analysis confirmed that these
same indicators (see table 2), as well as an indicator we developed
based on sector loan concentration, would have provided early warning
of problems in the banking system during this crisis.
Table 2: Select Leading Indicators of Bank Failure:
Indicator: Capital;
Definition: Equity capital divided by assets;
Explanation: Measure of the net worth or solvency of the institution.
Indicator: Earnings;
Definition: Net income divided by assets;
Explanation: Measure of the profitability of the institution.
Indicator: Nonperforming loans;
Definition: The sum of past due loans, nonaccrual loans, and real
estate owned divided by assets;
Explanation: Measures the quality of loans (asset quality) held by the
institution that may include losses not yet reflected in capital.
Indicator: Securities;
Definition: Securities divided by liabilities;
Explanation: Measures the capacity of the institution to sell assets
quickly to meet obligations.
Indicator: Unstable funding;
Definition: Large ($100,000 plus) certificates of deposit divided by
liabilities;
Explanation: Measures the reliance of the institution on certain high-
cost and volatile funding sources.
Source: GAO analysis of academic studies.
Note: We relied on two widely cited studies. See Cole and Gunther,
"Separating the Likelihood and Timing of Bank Failure," and Cole and
Gunther, "Predicting Bank Failure: A Comparison of On-and Off-site
Monitoring Systems."
[End of table]
In general, those key indicators identified by researchers in the
1990s are both statistically and practically significant predictors of
bank failure during this crisis period (see appendix III for more
information).[Footnote 30] Indicators of earnings, liquidity, and
asset quality, in addition to capital, contain information about the
condition of the bank that provides warning of bank distress up to 1-2
years in advance. For example, large differences in the level of
nonperforming loans between healthy banks (our peer group) and banks
that ultimately failed were evident well before the bulk of bank
failures in 2009-2010 (see figure 11). Starting in 2006, the
difference between the two groups of banks increased as nonperforming
loans grew dramatically over the next 3-4 years for banks that
ultimately failed, but only modestly for healthy banks.
Quantitatively, a one standard deviation increase in the level of
nonperforming loans increased the chance of failure from roughly 2.8
percent to 7.8 percent over the next year.
Figure 11: Nonperforming Loans (Asset Quality) at Failed and Peer
Banks, First Quarter 2006-Second Quarter 2009:
[Refer to PDF for image: multiple line graph]
2006, Q1;
Failed banks: 0.72%;
Peer banks: 0.52%.
2006, Q2;
Failed banks: 0.75%;
Peer banks: 0.52%.
2006, Q3;
Failed banks: 0.9%;
Peer banks: 0.56%.
2006, Q4;
Failed banks: 1.07%;
Peer banks: 0.58%.
2007, Q1;
Failed banks: 1.29%;
Peer banks: 0.64%.
2007, Q2;
Failed banks: 1.6%;
Peer banks: 0.69%.
2007, Q3;
Failed banks: 2.22%;
Peer banks: 0.78%.
2007, Q4;
Failed banks: 3.18%;
Peer banks: 1%.
2008, Q1;
Failed banks: 4.54%;
Peer banks: 1.25%.
2008, Q2;
Failed banks: 5.73%;
Peer banks: 1.48%.
2008, Q3;
Failed banks: 6.9%;
Peer banks: 1.78%.
2008, Q4;
Failed banks: 8.66%;
Peer banks: 2.19%.
2009, Q1;
Failed banks: 10.13%;
Peer banks: 2.67%.
2009, Q2;
Failed banks: 11.28%;
Peer banks: 2.98%.
Source: GAO analysis of FDIC and SNL Financial data.
[End of figure]
Similarly, large differences in the level of liquid assets
(securities) between healthy banks and banks that ultimately would
fail are evident well before the bulk of bank failures (see figure
12). The degree of liquidity fell somewhat over time, both at banks
that ultimately would fail and healthy banks. Quantitatively, a one
standard deviation increase in the level of securities decreased the
chance of failure from roughly 2.8 percent to 2.3 percent over the
next year. The Basel Committee has proposed two liquidity standards
designed to promote resilience in the banking system.[Footnote 31]
Figure 12: Liquidity at Failed and Peer Banks, First Quarter 2006-
Second Quarter 2009:
[Refer to PDF for image: multiple line graph]
2006, Q1;
Failed banks: 15.08%;
Peer banks: 23.43%.
2006, Q2;
Failed banks: 15.72%;
Peer banks: 22.32%.
2006, Q3;
Failed banks: 14.4%;
Peer banks: 22.7%.
2006, Q4;
Failed banks: 14.11%;
Peer banks: 22.82%.
2007, Q1;
Failed banks: 13.36%;
Peer banks: 26.1%.
2007, Q2;
Failed banks: 13.1%;
Peer banks: 27%.
2007, Q3;
Failed banks: 13.49%;
Peer banks: 24.26%.
2007, Q4;
Failed banks: 12.7%;
Peer banks: 23.3%.
2008, Q1;
Failed banks: 12.32%;
Peer banks: 21.97%.
2008, Q2;
Failed banks: 12.36%;
Peer banks: 21.27%.
2008, Q3;
Failed banks: 11.73%;
Peer banks: 20.45%.
2008, Q4;
Failed banks: 11.81%;
Peer banks: 20.18%.
2009, Q1;
Failed banks: 10.88%;
Peer banks: 19.82%.
2009, Q2;
Failed banks: 9.87%;
Peer banks: 19.96%.
Source: GAO analysis of FDIC and SNL Financial data.
[End of figure]
As with indicators of earnings, liquidity, and asset quality, a
measure of sector loan concentration we developed contains information
about the condition of the bank that provides warning of bank distress
up to 1-2 years in advance. Sector loan concentration is calculated as
an index that incorporates the shares of an institution's loan
portfolio allocated to certain broad economic sectors (e.g.,
residential real estate, consumer lending, etc.).[Footnote 32] Our
concentration index also proved to be an important predictor of bank
failure--it is both statistically and practically significant (see
appendix III for more information). Banks that ultimately failed had
considerably more concentrated loan portfolios than healthy banks well
before the bulk of bank failures. Specifically, a one standard
deviation increase in the degree of concentration increased the chance
of failure from roughly 2.8 percent to 3.7 percent over the next year.
Our concentration index partly reflects banks heavily invested in
commercial real estate (see figure 13)--a troubled sector during the
recent downturn. Failed banks had roughly 20 percent more loans in
commercial real estate than their peers. However, even among banks
with the same degree of commercial real estate exposure, those with
less diversified lending were more likely to fail. The concentration
index we developed would be a more flexible forward-looking indicator
than commercial real estate concentration alone because the next
episode of banking stress will not necessarily be driven by commercial
real estate.
Figure 13: Loan Concentration at Failed and Peer Banks, First Quarter
2008:
[Refer to PDF for image: 2 pie-charts]
Failed banks:
Farm-related loans: 3%;
Consumer loans: 2%;
Commercial and industrial loans: 12%;
Residential real estate loans: 21%;
Commercial real estate loans: 59%;
Other loans: 3%.
Peer banks:
Farm-related loans: 5%;
Consumer loans: 6%;
Commercial and industrial loans: 14%;
Residential real estate loans: 32%;
Commercial real estate loans: 39%;
Other loans: 4%.
Source: GAO analysis of FDIC and SNL Financial data.
[End of figure]
The PCA framework does not take full advantage of early warning signs
that financial indicators we tested can provide. Because PCA relies
only on capital-based indicators, it may not capture institutional
vulnerabilities that can manifest in, for example, limited liquidity,
low asset quality, or high loan concentrations in particular sectors.
Early warning signs in earnings, liquidity, asset quality, or
concentration could be identified by assessing each indicator
individually and setting indicator-specific thresholds. Later in this
report we discuss indicators that could be used for triggers that
respondents to our expert survey favored.
Composite indicators based on the model we developed or based on an
existing regulatory tool (such as CAMELS ratings) provide a convenient
way of combining information from a number of financial indicators,
and can better identify risks in banks that did not undergo the PCA
process before failure. Our analysis showed that a model incorporating
these well-known leading indicators of bank distress better identified
those banks that did not undergo the PCA process before failure--that
is, the model placed them at a much higher risk of failure than
healthy banks--than capital-based triggers alone. The average failure
rate estimated by our model over the next year was about 20 percent
for banks that ultimately would fail without triggering PCA (similar
to the rate for all failures), and about 3 percent for healthy banks,
as of the first quarter of 2008. Similarly, CAMELS ratings were higher
(inferior) than ratings of peers at banks that did not undergo the PCA
process before failure. The CAMELS ratings were on average 2.13 for
banks that failed without first undergoing the PCA process (similar to
the ratings for all failures), and about 1.75 for healthy banks. While
regulators use information from noncapital financial indicators in
their supervision and off-site monitoring of banks, as we describe in
the next section of this report, this does not always lead to timely
enforcement action at problem banks. Two researchers also recently
have suggested that PCA would benefit from the use of a composite
indicator, such as those embodied in existing FDIC and Federal Reserve
models, rather than only capital-based indicators.[Footnote 33]
Regulators face a challenging trade-off between false positives (in
this context, taking an action based on an incorrect prediction of
bank distress) and false negatives (in this context, failing to take
an action based on an incorrect prediction of bank health) in
establishing a threshold or thresholds for capital or other indicators
that might trigger intervention in potentially troubled banks.
Striking the right balance between these two errors depends on the
relative costs of each error, and other considerations. For example,
the cost of acting on false positives could be quite high if healthy
banks undertook costly and unnecessary measures to avoid regulatory
triggers or similarly if regulators and banks expended significant
resources during unnecessary interventions. Comparatively, the cost of
failing to act on false negatives could be quite high if bank failures
imposed dramatic costs on the DIF and the economy. In general, setting
a high threshold for action only rarely would trigger unnecessary
intervention in healthy banks but also might yield failures to
intervene in some genuinely troubled banks. On the other hand, a low
threshold would be more likely to trigger intervention unnecessarily
in healthy banks but would correctly identify the bulk of troubled
banks.
Regulators Used Tools other than PCA to Identify Early Signs of Bank
Distress:
All of the regulators used off-site monitoring or surveillance tools
as well as CAMELS ratings to identify early signs of potentially
problematic conditions among banks. In general, these regulatory
tools, which incorporate assessments of bank characteristics beyond
capital, provided early warnings of bank distress. For instance, FDIC
and Federal Reserve models are key tools used for off-site monitoring
or surveillance activities and contain many similar indicators of
capital, liquidity, asset quality, and earnings.[Footnote 34] As
mentioned earlier, such models and other tools help regulators flag
deteriorating conditions in banks for further regulatory scrutiny
(e.g., placing banks on watch or review lists).
In our review of 252 banks that failed from the first quarter of 2008
through the third quarter of 2010, most (82.5 percent) had been
identified on review or watch lists within 2 years of their failure.
[Footnote 35] For these banks (regulated by FDIC, OCC, and the Federal
Reserve), the median time between being placed on a watch or review
list and failure was 631 days.
CAMELS ratings also provided early warning signs of bank failure. As
described earlier, regulators formulate the CAMELS composite ratings
using the individual component ratings, but the rating is not a
mathematical average of the components. Individual component ratings
may be lower or higher compared with the overall composite rating
assigned. Any factor bearing significantly on the condition and
soundness of the institution may be incorporated.[Footnote 36] Banking
regulators generally consider banks with a composite rating of 1 or 2
to be healthy, while banks receiving an unsatisfactory examination
warrant a composite rating of 3 or above. We found that most banks
that failed degraded from a CAMELS composite rating of 2 to a 4 in one
quarter, though they generally had at least one component rating of a
3 prior to failure.
Specifically, among the 292 failed banks we reviewed (across all
regulators), most (76 percent) received at least one individual
component CAMELS rating of a 3 before failure.[Footnote 37] At the
same time, most (65 percent) also moved past the composite CAMELS 3
rating in a single quarter (e.g. moving from a 2 to 4) before failure,
as the CAMELS composite ratings generally deteriorated precipitously.
Our case studies of 8 banks also provided examples of this phenomenon,
as banks frequently received multiple downgrades in the CAMELS
composite ratings in a single quarter (see table 3 below).
For the failed banks that received either a CAMELS component or
composite rating of 3, these ratings demonstrated the utility of
CAMELS to provide early warning of bank distress. For example, among
the failed banks that received a CAMELS component rating of 3, the
median number of days between this component rating and bank failure
was 459 days. Similarly, for failed banks that received a CAMELS
composite rating of 3, the median number of days between banks
receiving this composite rating and their subsequent failure was 508
days. In a separate analysis comparing peer and failed banks, we found
that CAMELS ratings were useful leading indicators of bank failure.
See appendix III for more information.
Table 3: Key Regulatory Activities and Milestones of Case Studies,
First Quarter 2006-Third Quarter 2010:
Institution: 1;
Watch/review list: 12/31/07;
CAMELS 3 component: 12/31/07;
CAMELS 3 composite: DROP (2 to 4);
CAMELS 4 component: 12/1/08;
CAMELS 4 composite: 12/1/08;
Problem bank list: 12/31/08;
Failed (as of 3/30/11): Yes.
Institution: 2;
Watch/review list: 12/31/06;
CAMELS 3 component: 4/2/07;
CAMELS 3 composite: 4/2/07;
CAMELS 4 component: 4/2/07;
CAMELS 4 composite: 6/17/08;
Problem bank list: 9/30/08;
Failed (as of 3/30/11): No.
Institution: 3;
Watch/review list: 6/30/07;
CAMELS 3 component: 7/9/07;
CAMELS 3 composite: 7/9/07;
CAMELS 4 component: 4/9/08;
CAMELS 4 composite: 4/9/08;
Problem bank list: 6/30/08;
Failed (as of 3/30/11): Yes.
Institution: 4;
Watch/review list: 12/31/07;
CAMELS 3 component: 7/14/08;
CAMELS 3 composite: DROP (2 to 4);
CAMELS 4 component: 7/14/08;
CAMELS 4 composite: 7/14/08;
Problem bank list: 9/30/08;
Failed (as of 3/30/11): Yes.
Institution: 5;
Watch/review list: N/A;
CAMELS 3 component: 4/10/06;
CAMELS 3 composite: 4/10/06;
CAMELS 4 component: 1/29/09;
CAMELS 4 composite: 1/29/09;
Problem bank list: 3/31/09;
Failed (as of 3/30/11): Yes.
Institution: 6;
Watch/review list: N/A;
CAMELS 3 component: 1/1/06[A];
CAMELS 3 composite: 1/1/06[A];
CAMELS 4 component: 11/13/07;
CAMELS 4 composite: 3/17/09;
Problem bank list: 3/31/09;
Failed (as of 3/30/11): Yes.
Institution: 7;
Watch/review list: 1/1/06[A];
CAMELS 3 component: 1/1/06[A];
CAMELS 3 composite: 1/1/06[A];
CAMELS 4 component: 9/19/07;
CAMELS 4 composite: DROP (3 to 5);
Problem bank list: 3/31/08;
Failed (as of 3/30/11): Yes.
Institution: 8;
Watch/review list: 9/16/09;
CAMELS 3 component: 10/1/09;
CAMELS 3 composite: DROP (2 to 5);
CAMELS 4 component: 10/1/09;
CAMELS 4 composite: DROP (2 to 5);
Problem bank list: 12/31/09;
Failed (as of 3/30/11): No.
Source: GAO Summary of data from FDIC, OCC, OTS, and Federal Reserve.
Note: N/A means not applicable.
[A] Institutions placed on a watch/review list prior to the beginning
of our review period for this analysis, beginning January 2006.
[End of table]
While the Presence and Timeliness of Enforcement Actions Were
Inconsistent, Regulators Have Incorporated Lessons Learned from the
Financial Crisis:
Although regulators generally were successful in identifying early
warning signs of bank distress, the presence and timeliness of
subsequent enforcement actions were often inconsistent. Most banks
that failed had received an enforcement action (informal or formal)
before undergoing the PCA process. The banking regulators told us that
they typically issued enforcement actions to troubled banks--such as
an informal enforcement action when a bank was downgraded to a CAMELS
composite score of 3, and a formal enforcement action when it was
downgraded to a 4--before these banks received a PCA directive.
However, some banks did not receive any enforcement action before
undergoing the PCA process, and many did not receive timely
enforcement action prior to bank failure.
In our review of enforcement information available in material loss
reviews or other evaluations on 136 failed banks, we found that the
timeliness of enforcement actions was inconsistent.[Footnote 38]
However, we also noted that the timeliness of enforcement actions
appeared to have improved during the banking crisis. Specifically,
among 60 banks that failed between January 2008 and June 2009,
approximately 28 percent did not have an initial informal or formal
non-PCA enforcement action until 90 days or less before bank failure.
Further, 50 percent of these failed banks did not have an enforcement
action until 180 days or less prior to failure. After June 2009, these
percentages improved, with approximately 8 percent not having an
enforcement action until 90 days or less before failure, and
approximately 22 percent not having an action until 180 days or less
before failure.
Our case studies also provided examples of inconsistent enforcement
actions. While some banks received an enforcement action before being
subject to PCA, being placed on the problem bank list, or receiving a
CAMELS 4 composite rating, others did not receive any enforcement
action before these milestones. Table 4 highlights examples from our
case studies of inconsistent regulatory attention tied to key
regulatory activities and milestones. Furthermore, our findings
related to presence and timeliness of enforcement actions were
consistent with findings we reported in 1991.[Footnote 39]
Specifically, we found then that the banking regulators did not always
use the most forceful actions available to correct unsafe and unsound
banking practices.
Table 4: First Enforcement Action in Relation to Other Key Regulatory
Milestones of Case Studies, First Quarter 2006ñThird Quarter 2010:
Institution: 1;
First enforcement action (non-PCA):
Date: 6/30/09;
Prior to CAMELS 4 composite?: No;
Prior to problem bank list?: No;
Prior to PCA?: Yes;
Initial PCA: 9/30/09;
Capital levelat initial PCA: Undercapitalized;
Failed (as of 3/30/11): Yes.
Institution: 2;
First enforcement action (non-PCA):
Date: 7/16/07;
Prior to CAMELS 4 composite?: Yes;
Prior to problem bank list?: Yes;
Prior to PCA?: Yes;
Initial PCA: 9/30/08;
Capital levelat initial PCA: Undercapitalized;
Failed (as of 3/30/11): No.
Institution: 3;
First enforcement action (non-PCA):
Date: 7/15/08;
Prior to CAMELS 4 composite?: No;
Prior to problem bank list?: No;
Prior to PCA?: N/A;
Initial PCA: No PCA;
Capital levelat initial PCA: N/A;
Failed (as of 3/30/11): Yes.
Institution: 4;
First enforcement action (non-PCA):
Date: 8/25/08;
Prior to CAMELS 4 composite?: No;
Prior to problem bank list?: Yes;
Prior to PCA?: Yes;
Initial PCA: 9/30/09;
Capital levelat initial PCA: Critically undercapitalized;
Failed (as of 3/30/11): Yes.
Institution: 5;
First enforcement action (non-PCA):
Date: 1/8/08;
Prior to CAMELS 4 composite?: Yes;
Prior to problem bank list?: Yes;
Prior to PCA?: N/A;
Initial PCA: No PCA;
Capital levelat initial PCA: N/A;
Failed (as of 3/30/11): Yes.
Institution: 6;
First enforcement action (non-PCA):
Date: 1/22/08;
Prior to CAMELS 4 composite?: Yes;
Prior to problem bank list?: Yes;
Prior to PCA?: Yes;
Initial PCA: 3/31/09;
Capital levelat initial PCA: Critically undercapitalized;
Failed (as of 3/30/11): Yes.
Institution: 7;
First enforcement action (non-PCA):
Date: 1/17/08;
Prior to CAMELS 4 composite?: N/A;
Prior to problem bank list?: Yes;
Prior to PCA?: No;
Initial PCA: 12/31/07;
Capital levelat initial PCA: Undercapitalized;
Failed (as of 3/30/11): Yes.
Institution: 8;
First enforcement action (non-PCA):
Date: 8/26/09;
Prior to CAMELS 4 composite?: N/A;
Prior to problem bank list?: Yes;
Prior to PCA?: No;
Initial PCA: 3/31/09;
Capital levelat initial PCA: Significantly undercapitalized;
Failed (as of 3/30/11): No.
Source: GAO Summary of data from FDIC, OCC, OTS, and Federal Reserve.
Note: N/A means not applicable.
[End of table]
Use of the current PCA mechanism as an enforcement tool was also
inconsistent. As stated earlier, 25 banks (8 percent of the failed
banks we reviewed) did not undergo the PCA process. For instance, in
our case studies, we noted two institutions that were never subject to
PCA prior to failure. For those that were, the initial PCA capital
category triggering enforcement actions frequently occurred at a more
distressed capital threshold--significantly or critically
undercapitalized--than the undercapitalized level. For instance, of
the 270 failed banks we reviewed that underwent the PCA process, 40
percent were subject to an initial PCA enforcement action below the
undercapitalized threshold, with 25.5 percent triggering PCA at the
significantly undercapitalized level and 14.4 percent triggering PCA
at the critically undercapitalized level. Figure 14 illustrates how
PCA was used among 295 failed banks, including the initial capital
thresholds triggering PCA enforcement actions. Similarly, our case
studies provided examples of different initial capital thresholds that
triggered PCA, including those occurring at the significantly
undercapitalized and critically undercapitalized levels, as
highlighted in table 4.
Figure 14: Initial PCA Action of Failed Banks, First Quarter 2006-
Third Quarter 2010:
[Refer to PDF for image: pie-chart and subchart]
No PCA: 25;
PCA: 270:
- Undercapitalized: 162;
- Significantly Undercapitalized: 69;
- Critically Undercapitalized: 39.
Source: GAO analysis of FDIC data.
[End of figure]
Regulators have begun to incorporate a number of lessons learned from
the financial crisis into their regulatory processes, including IG
report findings. For instance, FDIC has developed and initiated
training to be delivered in phases to reinforce and enhance its
supervisory program. These efforts include identifying lessons learned
from the results of the IG material loss reviews, emphasizing the
importance of implementing timely and effective corrective programs,
mandatory training for risk management and compliance examination
staff to emphasize a forward-looking approach to examination analysis
and ratings assessment activities, and providing enhanced guidance
regarding supervision and examination procedures for de novo
institutions.[Footnote 40] At OCC, the Mid-Size and Community Banks
Division issued a Matters Requiring Attention Reference Guide that
provides examiners with OCC policy guidance on how to report, follow
up on, and keep records related to Matters Requiring Attention. OTS
has enhanced its Regulatory Action Data system to better flag matters
requiring increased regulatory attention. We also noted that the
Federal Reserve incorporated a new liquidity measure into its model
used to identify banks that warrant being placed on its watch list.
While Most Stakeholders Favored Modifying PCA, Their Preferred Options
Involve Some Trade-offs:
Most of the informed stakeholders we surveyed told us the PCA
framework should be retained but changed. We asked stakeholders from
research organizations, regulatory agencies, and the banking industry
whether PCA should be changed and, if so, to identify and rank broad
options to change the current framework to make it more effective in
minimizing losses to the DIF. In response, 23 of 29 stakeholders said
that PCA should be modified using one or more of the survey's listed
options.[Footnote 41] More specifically, they preferentially ranked
three options--incorporating additional risk measures, raising capital
thresholds, and adding an additional trigger--to make the PCA
framework more effective. See table 5 for the full list of options in
the survey and appendix V for full survey results. While each of these
three options could improve the PCA framework, each presents certain
advantages and disadvantages to consider. Furthermore, a few
stakeholders emphasized that if PCA were modified, the specific
details to implement such a policy change would determine whether the
goal of minimizing losses to the DIF would be realized.
Table 5: Rank Ordering of Survey Policy Options:
Option to change the PCA framework: Incorporate an institution's risk
profile (concentration exposure, etc.) into the PCA capital category
thresholds;
Number of respondents indicating option among top three that should be
considered:
First: 5;
Second: 6;
Third: 1;
Weighted score: 28.
Option to change the PCA framework: Raise all capital category
thresholds;
Number of respondents indicating option among top three that should be
considered:
First: 7;
Second: 2;
Third: 1;
Weighted score: 26.
Option to change the PCA framework: Include an additional trigger for
PCA (that is, another measure of bank soundness or performance);
Number of respondents indicating option among top three that should be
considered:
First: 3;
Second: 4;
Third: 5;
Weighted score: 22.
Option to change the PCA framework: Change accounting rules used to
measure capital levels (make greater use of market values to assess
assets, change rules for loan loss reserves, etc.);
Number of respondents indicating option among top three that should be
considered:
First: 3;
Second: 3;
Third: 1;
Weighted score: 16.
Option to change the PCA framework: Enhance restrictions and
requirements at the holding company level;
Number of respondents indicating option among top three that should be
considered:
First: 3;
Second: 2;
Third: 3;
Weighted score: 16.
Option to change the PCA framework: Make PCA restrictions and
requirements less prescriptive (more flexibility in timelines, more
discretion in application of restrictions, etc.);
Number of respondents indicating option among top three that should be
considered:
First: 4;
Second: 1;
Third: 1;
Weighted score: 15.
Option to change the PCA framework: Raise the critically
undercapitalized threshold;
Number of respondents indicating option among top three that should be
considered:
First: 2;
Second: 3;
Third: 3;
Weighted score: 15.
Option to change the PCA framework: Encourage greater uniformity
across regulators (more consistency in capital definitions across
state regulators and in closure authority across federal regulators,
etc.);
First: 0;
Second: 3;
Third: 5;
Weighted score: 11.
Option to change the PCA framework: Raise capital category thresholds
for larger institutions;
Number of respondents indicating option among top three that should be
considered:
First: 0;
Second: 3;
Third: 2;
Weighted score: 8.
Option to change the PCA framework: Eliminate the PCA framework;
Number of respondents indicating option among top three that should be
considered:
First: 1;
Second: 0;
Third: 1;
Weighted score: 4.
Option to change the PCA framework: Strengthen PCA restrictions and
requirements (shorter time frames, earlier use of restrictions
available under the significantly undercapitalized category, etc.);
Number of respondents indicating option among top three that should be
considered:
First: 0;
Second: 1;
Third: 2;
Weighted score: 4.
Option to change the PCA framework: Make no changes to the PCA
framework;
Number of respondents indicating option among top three that should be
considered:
First: 0;
Second: 0;
Third: 0;
Weighted score: 0.
Source: GAO.
Note: We calculated the weighted score by translating each
respondent's ranking of options into points: 3 points to a first
choice, 2 points to a second choice, and 1 point to a third choice.
The process of assigning weights to ranked preferences can produce
multiple outcomes. We acknowledge that alternate weights may change
the sequencing of the top three options.
[End of table]
Incorporate an Institution's Risk Profile into the PCA Capital
Category Thresholds:
Stakeholders responding to our survey were most supportive of
incorporating a bank's risk profile into the PCA capital category
thresholds. Specifically, 12 stakeholders selected this option among
the top three that should be considered, with 5 selecting it as their
first option and 6 selecting it as their second option (see table 5).
In addition, 21 of 29 stakeholders responded that incorporating an
additional measure of risk into the PCA capital category thresholds
would improve the effectiveness of PCA.[Footnote 42] This option would
add an additional risk element to the PCA capital measures beyond the
already existing risk-weighted asset component.[Footnote 43] All four
federal regulators told us that they can require banks to hold
additional capital through formal or informal enforcement actions, but
as noted earlier in the report, such actions are not always taken or
the actions are not timely. Stakeholders suggested a few ways this
change could be made. For example, in formulating the most appropriate
capital thresholds, banks could be required to maintain an appropriate
level of tangible equity or a capital buffer based on the level of
risk-weighted assets. Alternatively, specific risk areas such as
liquidity or concentration could be factored into the determination of
capital adequacy. Regulators already have the ability (on a case-by-
case basis) to require banks to hold more capital than the amount
required by PCA thresholds if they deem it necessary based on a bank's
risk exposure.
There are advantages and disadvantages to making this change to the
PCA framework.
* Potential advantages. Adding an additional risk component to PCA
capital measures may make PCA more responsive to specific trends. For
example, in the current crisis many banks failed, in part, because of
risks associated with high asset concentrations. A stakeholder told us
that incorporating early indicators of heightened risk into PCA
capital thresholds could be an additional way to minimize losses to
the DIF. Also, this change would not affect all banks but only those
banks engaging in riskier activities. Moreover, incorporating a bank's
risk profile into the PCA capital category thresholds would be an
opportunity to broaden the scope of the PCA framework, helping
mitigate the repeated concern among stakeholders that PCA, as
currently constructed, is too narrowly focused.
* Potential disadvantages. This option could complicate the process of
determining capital adequacy for PCA purposes, according to one
stakeholder responding to our survey. For example, banks would vary in
the levels of capital they needed to meet PCA capital thresholds,
depending on their risk level. A stakeholder also cautioned that risk-
based measures were complex and dependent on information from banks.
Finally, adding a risk component to PCA could be duplicative because
regulators already use risk-based capital ratios in PCA.
Raise All the PCA Capital Category Thresholds:
Raising all the PCA capital category thresholds had the second-highest
weighted score on our survey, and stakeholders selected it most often
as a first choice. Specifically, 10 stakeholders selected this option
among the top three that should be considered, with 7 selecting it as
their first option (see table 5). In addition, 17 of 29 stakeholders
told us increasing the capital category thresholds would improve the
effectiveness of PCA.[Footnote 44] This option would increase the
capital ratios required for a bank to be classified as well
capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized. Federal regulatory
agencies have amended and updated the regulations and rules on
measuring a bank's capital level in the past, often in conjunction
with recommendations from the Basel Committee on Banking Supervision.
However, the capital thresholds have not changed since the
implementation of the PCA provisions of FDICIA in 1992.[Footnote 45]
The Basel Committee recently released guidelines recommending
increased capital requirements to be phased in by January 1, 2015.
Federal regulators typically adopt, with some national discretion,
Basel Committee recommendations.
Raising only the critically undercapitalized threshold also was on our
list of options. Twenty of 29 stakeholders we surveyed told us that
raising the critically undercapitalized threshold would improve the
effectiveness of PCA, more than the number who told us raising all PCA
capital category thresholds would improve PCA effectiveness. However,
when asked to select top options to improve the PCA framework, fewer
stakeholders selected raising only the critically undercapitalized
threshold. Currently, a bank is categorized as critically
undercapitalized if its tangible equity is 2 percent or less.
Regulators generally must close critically undercapitalized banks
within a 90-day period.
Increasing PCA's capital category thresholds would change a nearly two-
decades-old policy and involve trade-offs among the following
advantages and disadvantages.
* Potential advantages. Raising thresholds would create an incentive
for banks to increase capital levels. According to our previous work
and the work of others, by holding more capital, a bank would have a
greater capacity to absorb losses and remain solvent, particularly
when a financial crisis occurred.[Footnote 46] Similarly, with more
capital, banks should be able to survive higher levels of borrower
defaults. Thus, if banks were required to hold more capital, this
might limit losses to the DIF in the event of failure by shifting
risks from the DIF and taxpayers to the providers of capital,
according to researchers. Moreover, increasing capital levels might
not be a major change, as banks sometimes hold more capital than PCA
requires.
* Potential disadvantages. If banks were required to hold more
capital, they might change the way they conduct business. For example,
banks might limit the amount of credit made available to businesses,
households, and governments; charge higher interest rates on loans; or
offer lower interest rates on deposits, according to
researchers.[Footnote 47] In addition, some banks might compensate for
having less to lend by investing in riskier assets to seek higher
returns. An industry group told us that raising the capital category
thresholds could be particularly harmful for community banks, which
often face additional challenges raising capital. A stakeholder told
us this option also could create more instances in which regulators
intervened in the operation of healthy banks (false positives)--that
is, more banks may fall below a higher set PCA capital ratio standard
even though they are not in financial distress. Additionally, 22 of 28
survey respondents said that PCA's focus on capital was a shortcoming
of the process, and this option would not broaden the scope of PCA to
other potential indicators of bank failure.
Add an Additional PCA Trigger:
As their third preference, our survey respondents selected adding
another PCA trigger. Specifically, 12 stakeholders selected this
option among the top three that should be considered, with 3 selecting
it as their first option, 4 selecting it as their second option, and 5
selecting it as their third option (see table 5). Overall, 18 of 29
respondents said this option would improve the effectiveness of
PCA.[Footnote 48] This option would require regulators to monitor
other aspects of a bank's performance, such as asset concentration,
asset quality, or liquidity, and if problems were identified, to take
increasingly severe actions to address problems in that area. While
regulators routinely monitor other aspects of bank safety and
soundness, making these additional factors part of the PCA process
would compel regulators to act when these areas were found to be
deteriorating. However, as discussed previously in this report, we
found that although regulators identified signs of bank distress, the
timeliness of subsequent enforcement actions was inconsistent.
Stakeholders responding to our survey who recommended adding an
additional PCA trigger were most supportive of using asset quality and
asset concentration triggers. As discussed earlier in this report, our
analysis of leading indicators of bank health found asset quality and
asset concentration provided early warning of bank deterioration. When
asked about the impact of an asset quality trigger, 26 of 28 survey
respondents told us that it would improve the effectiveness of PCA.
[Footnote 49] Twenty of 29 survey respondents said an asset
concentration trigger would improve the effectiveness of PCA. See
appendix V for more information on how the survey respondents rated
potential additional triggers.
Regulators have attempted to adopt additional triggers in the past.
For example, regulators and a stakeholder with whom we spoke said that
in the 1990s regulators tried to modify risk-based capital measures to
account for asset concentration but were unable to develop a
sufficiently reliable concentration metric. Instead, regulators
decided to take risky asset concentrations into account during bank
examinations. Additionally, FDIA (section 39) requires banking
regulators to prescribe safety and soundness standards related to
noncapital criteria, including operations and management;
compensation; and asset quality, earnings, and stock valuations,
allowing regulators to take action if a bank fails to meet one or more
of these standards. Initially, the standards for asset quality and
earnings were to be quantitative and intended to increase the
likelihood that regulators would address safety and soundness problems
before capital deteriorated. However, changes to FDIA in the Riegle
Community Development and Regulatory Improvement Act of 1994 gave
regulators considerable flexibility over how and when to use their
authority under the section to address safety and soundness
deficiencies at banks.[Footnote 50] After this change, we reported
that section 39, as amended, appeared to leave regulatory discretion
largely unchanged from what existed before the passage of FDICIA.
[Footnote 51] We also reported in 2007 that regulators made limited
use of this authority, preferring other formal and informal
enforcement actions.[Footnote 52]
Including another PCA trigger could also produce advantages and
disadvantages for regulators and banks.
* Potential advantages. Adding another trigger could mitigate the
limitations of capital as an indicator. As we discussed in this and
prior reports, regulatory actions focused solely on capital may have
limited effects because of the extent of deterioration that already
may have occurred.[Footnote 53] Capital typically does not begin to
decline until a bank has experienced substantial deterioration in
other areas, such as asset quality and the quality of bank management.
We previously recommended a "tripwire" approach to banking regulation,
urging regulators to consider an array of factors such as assets,
earnings, and capital deterioration and requiring banks to take
specific actions to address problems in those areas.[Footnote 54] We
concluded that complements to capital standards such as industrywide
measures for asset, management, and earnings conditions and a
prescribed set of enforcement responses would improve the outcomes of
the bank regulatory process.
* Potential disadvantages. Another trigger might duplicate other tools
regulators already use in their supervision of banks, thereby creating
inefficiencies in oversight. Also, the PCA trigger chosen might not be
applicable to all banks. For example, one stakeholder cautioned that
some triggers, such as asset concentration, sources of funding, and
liquidity, might not apply uniformly to all banks.
Finally, a few stakeholders responding to our survey and experts with
whom we spoke said that if PCA were modified, the specific details
that shape the broad policy ideas would ultimately determine if the
goal of minimizing losses to the DIF was realized. For example, some
regulatory officials told us that in order for an earlier trigger to
be effective, legislative changes would be needed to allow regulators
to use the same authorities under the current PCA framework, such as
the authority to dismiss bank officers and directors. Stakeholders
also told us that the details matter greatly and how regulators
ultimately crafted and applied the policies would determine if the
policies were successful.
Conclusions:
Before the current financial crisis, PCA was largely untested because
the financial condition of banks generally had been strong since PCA
was enacted. More than 300 bank failures later and despite some
benefits in closing banks, the current PCA framework repeatedly has
demonstrated its weaknesses for addressing deteriorating conditions in
banks. In turn, PCA has not achieved a principal goal of preventing
widespread losses to the DIF when banks fail.
Weaknesses in the current PCA framework stem primarily from tying
mandatory corrective actions to only capital-based indicators. We and
others have argued since 1991 that capital-based indicators have
weaknesses, particularly because they do not provide timely warnings
of bank distress. A number of alternative indicators exist or could be
developed, and their advantages derive primarily from the early
warnings of distress they could provide. In particular, a composite
indicator can integrate information from a number of noncapital
indicators in a single number. Regulators have stressed that the
effectiveness of the PCA framework depended on making early and
forceful use of other enforcement tools. However, while regulators
have their own authorities and PCA also authorizes other discretionary
actions, the regulators have not used these enforcement tools
consistently. Tying mandatory corrective actions to additional
indicators could mitigate these current weaknesses of PCA and increase
the consistency with which distressed banks would be treated. And,
enhancing the PCA framework in such a way would allow both regulators
and banks more time to address deteriorating conditions. More
important, banks facing such corrective actions likely would not be in
as weakened a condition as typically is the case when current capital
thresholds are triggered. Thus, the banks might have more options
available to them to bolster their safety and soundness and avoid
failure. Moreover, without an additional PCA trigger, the regulators
risk not acting soon enough to address a bank's deteriorating
condition, thereby limiting their ability to minimize losses to the
DIF.
Expert stakeholders we surveyed also called for modifications to the
PCA framework and identified several options for doing so. The top
three options they identified include (1) adding a measure of risk to
the capital category thresholds; (2) increasing the capital ratios
that place banks into PCA capital categories and (3) adding an
additional trigger. As the expert stakeholders noted and we also
recognize, making any changes to the PCA framework would entail some
trade-offs. Specifically, regulators would have to strike a balance
between more corrective actions and unnecessary intervention in
healthy banks. The Financial Stability Oversight Council could provide
a forum for vetting changes to the PCA framework and proposing these
changes to Congress. Building consensus for potential changes,
including working through the details of the changes and the
associated trade-offs, will not be easy. But, in light of significant
losses to the DIF in recent years, including at banks that underwent
the PCA process, changes to the PCA framework are warranted.
Recommendation for Executive Action:
To improve the effectiveness of the PCA framework, we recommend that
the heads of the Federal Reserve, FDIC, and OCC consider additional
triggers that would require early and forceful regulatory actions tied
to specific unsafe banking practices and also consider the other two
options--adding a measure of risk to the capital category thresholds
and increasing the capital ratios that place banks into PCA capital
categories--identified in this report to improve PCA. In considering
such improvements, the regulators should work through the Financial
Stability Oversight Council to make recommendations to Congress on how
PCA should be modified.
Agency Comments and Our Evaluation:
We provided a draft of this report to FDIC, the Federal Reserve, OCC,
and OTS for review and comment. All of the agencies provided technical
comments, which we considered and have incorporated as appropriate.
FDIC, the Federal Reserve, and OCC also provided written comments that
we have reprinted in appendices VI, VII, and VIII, respectively.
In written comments, FDIC, the Federal Reserve and OCC agreed with our
recommendation to consider options to make PCA more effective. All
three regulators noted that future enhancements to regulatory capital
requirements could lead to raising the PCA capital category
thresholds. FDIC and the Federal Reserve specifically stated that
enhancements to capital requirements will likely be addressed when the
regulators consider Basel III standards and that the PCA capital
category thresholds could be impacted by rules implementing the Basel
III standards. FDIC's written comments also reflected a concern
regarding using noncapital based triggers for PCA and suggested such
triggers "appear to have greater risk of unintended consequences" and
should not be implemented without further study. However, the basis
for FDIC's concern that triggers such as measuring concentrations,
liquidity, management, or overall risk profile would pose greater risk
of unintended consequences is unclear. As discussed in the report any
changes to PCA require considering both the advantages and
disadvantages. Our analysis demonstrated that adopting additional
triggers within PCA also offers the potential for valuable benefits
that must be considered. For example, our analysis demonstrated that
noncapital triggers are more effective in identifying those banks that
failed without undergoing the PCA process. The Federal Reserve also
commented that one of the other options covered in the survey--
changing accounting rules used to measure capital levels--but not
discussed in detail in the report also offered promise in enhancing
the effectiveness of PCA. As noted in the report, this was the fourth
ranked option along with enhancing restrictions and requirements at
the holding company level.
All three regulators noted in their written comments that they take
supervisory enforcement actions in addition to PCA, as discussed in
the draft report. Specifically, FDIC stated in its written comments
that it had taken many supervisory actions in response to problems
identified at the institutions it supervises and that it has strived
to improve its supervisory processes based on lessons learned from
material loss reviews. The Federal Reserve wrote that it did not find
its supervisory enforcement actions to be inconsistent. OCC commented
that it already imposes higher minimum capital standards for national
banks whose risk profile warrants it. The enforcement action
information presented in our report is compiled in aggregate from all
of the banking regulators where material loss reviews or other
evaluation reports were prepared subsequent to bank failure. However,
we found examples from each of the regulators where no enforcement
action (formal or informal) occurred until less than 180 days prior to
bank failure. The material loss reviews for all of the regulators also
commonly cited that earlier and more forceful supervisory action could
have helped address deteriorating conditions earlier. We also noted in
our report improvements over time in the overall timeliness of
enforcement actions and that all of the regulators had taken actions
to address previous weaknesses and lessons learned.
FDIC and the Federal Reserve also commented on the time period of our
analysis. In written comments, FDIC noted that our results were
"heavily influenced by the timing of the evaluation period" while the
Federal Reserve similarly noted that because of the time period of
analysis troubled banks had difficulty recovering due "to limited
access to capital more than to the ineffectiveness of PCA." While we
acknowledge that recent years have put considerable stress on the
banking system, we believe that circumstances like this are critically
important for assessing the performance of PCA--periods of bank
distress are when PCA will be most seriously tested. In addition,
changes to PCA based on options identified in our survey--such as
higher capital thresholds--could assist banks in recovering during
periods in which they have difficulty accessing capital from external
sources.
We are sending copies of this report to FDIC, the Federal Reserve,
OTS, and OCC, the Financial Stability Oversight Council, and other
interested parties. The report also is available at no charge on the
GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staffs have any questions about this report, please
contact A. Nicole Clowers at (202) 512-8678 or clowersa@gao.gov.
Contact points for our Offices of Congressional Relations and Public
Affairs may be found on the last page of this report. GAO staff that
made major contributions to this report are listed in appendix IX.
Signed by:
A. Nicole Clowers:
Acting Director:
Financial Markets and Community Investment:
Signed by:
Thomas J. McCool:
Director, Center for Economics Applied Research and Methods:
[End of section]
Appendix I: Objectives, Scope, and Methodology:
Data Sources and Period of Analysis:
To describe outcomes from and issues related to bank failures and
losses to the deposit insurance fund (DIF), we analyzed quarterly data
on the capitalization levels of federally insured banks from the
Federal Deposit Insurance Corporation (FDIC). We obtained these data
from FDIC Quarterly Banking Reports, which publish industry statistics
derived from Reports on Condition and Income (Call Reports) and Thrift
Financial Reports. All banks and thrifts must file Call Reports and
Thrift Financial Reports, respectively, with FDIC every quarter. We
have assessed the reliability of FDIC's Call and Thrift Financial
Report databases as part of previous studies and found the data to be
reliable for the purposes of our review.
Our period of analysis extended from January 2006, immediately after
the ending point of our previous study, GAO-07-242, through the third
quarter of September 2010. For this period, we calculated the total
number of banks in any of the lowest three categories for prompt
corrective action (PCA)--undercapitalized, significantly
undercapitalized, or critically undercapitalized--in each quarter. We
also calculated how many banks entered one of these capital categories
for the first time in each quarter.
Our analysis excludes 13 institutions that received other assistance,
such as assistance pursuant to systemic risk determinations. Although
FDIC classified these banks as resolved, we excluded them because they
remained operational.
Analysis of Bank Outcomes and Losses to the DIF:
We reviewed bank failure data provided by FDIC to determine the number
of banks that failed during our period of analysis, including their
associated losses. We also reviewed data from FDIC that identified
those banks that were subjected to PCA before failure and those that
were not. We determined that the information from these datasets,
related to DIF losses and capital levels from Call and Thrift
Financial Reports, was sufficiently reliable for the purposes of our
review based on ongoing and prior work using such data.
In addition, we used loss data from FDIC to identify the losses that
each failed bank caused to the DIF failure, which we determined to be
sufficiently reliable for our purpose of enumerating failed banks and
the losses associated with these failures. We also analyzed losses to
the DIF relative to the size of each failed bank. To do so, we
identified the total assets of each failed bank as reported on its
Call Report or Thrift Financial Report in the quarter before failure.
We used this measure and the losses that the bank caused the DIF (as
estimated in 2010) to determine losses as a percentage of assets.
To analyze the outcomes of banks in our analysis, we determined
whether by the third quarter of 2010 a bank (1) had failed; (2)
remained undercapitalized, was on the problem bank list, or both; (3)
was dissolved; or (4) was not undercapitalized or on the problem bank
list. We considered banks dissolved if they were not in the FDIC loss
dataset or classified as active by FDIC by the end of this period.
Many dissolved banks were merged into an acquiring bank without
governmental assistance, although some were merged with assistance or
were dissolved through a voluntary liquidation that did not result in
a new institution. Although components of these dissolved banks may
have remained active, they operated under the certification number of
their acquiring bank. We did not count banks as dissolved if they
operated under their original certification number and FDIC classified
them as active, regardless of whether a new entity had gained a large
or controlling stake in their operations.
We used a number of econometric models to estimate the impact of PCA
on losses to the DIF. We controlled for the financial condition of
banks before they fail by holding constant factors affecting the
quality of the balance sheet and the size of deposit liabilities. For
more information, see appendix III.
We also interviewed officials from FDIC, the Office of the Comptroller
of the Currency (OCC), the Office of Thrift Supervision (OTS), and the
Board of Governors of the Federal Reserve System (Federal Reserve) to
obtain their views on the effectiveness of PCA in minimizing losses to
the DIF.
Analysis of Indicators, Enforcement Data, and Case Studies of
Deteriorating Banks:
To assess the utility of various financial indicators in predicting
bank distress, we developed a model of leading indicators of bank
failure based on financial ratios researchers had identified in the
1990s that predicted bank failures in previous stress periods.
Specifically, we used these financial ratios, regulatory ratings, and
an indicator we developed of sector loan concentration to forecast
bank failure within 1 to 2 years (for failed banks and peers from 2006
through the third quarter of 2010). We used this model to assess the
predictive power of indicators other than bank capital. Additional
information concerning the methodology for this analysis can be found
in appendix III. To perform this work, we relied on data from FDIC and
SNL Financial. We assessed the reliability of data used in our
analysis and found the data sufficiently reliable for our purposes.
To assess the regulatory enforcement actions associated with banks
that had deteriorated, we examined the type and timing of regulatory
actions for failed banks with various outcomes, and analyzed the
extent to which regulatory indicators provided warning of likely bank
deterioration or failure. To conduct this work, we requested
enforcement data from FDIC, the Federal Reserve, OCC, and OTS. Upon
receipt of this information, we determined that the enforcement data
provided could not be relied upon for our specific analysis without
additional verification. In particular, the enforcement data the
Federal Reserve, OCC, and OTS provided could not be used alone to make
distinctions among different types of enforcement actions that may or
may not have been relevant to safety and soundness issues of banks
that were deteriorating financially. While enforcement data provided
by FDIC did make such distinctions, we did not rely exclusively on the
enforcement data provided by the regulators. We determined that it was
necessary to systematically pull relevant enforcement data on failed
banks from material loss reviews and other evaluation reports prepared
by the inspectors general (IG) of the banking regulators and
corroborated this information with the enforcement data provided by
regulators. Specifically, we reviewed material loss reviews and other
evaluation reports available on 136 institutions that failed in 2008,
2009, and 2010. From these reports, we systematically identified the
first enforcement action relevant to the regulator's efforts to
address deteriorating conditions in a 2-year period before failure.
Further, we conducted case studies to explore supervisory, managerial,
financial, and other characteristics commonly present in troubled or
failed banks and illustrate the sequence of steps between the onset of
trouble and a bank's closure. Specifically, we conducted case studies
of eight banks to highlight examples of oversight steps taken by each
of the regulators and various outcomes. For this work, we selected a
nongeneralizable sample of banks that is diverse with respect to
geography, asset size, franchise value, primary regulator, date of
failure, sequence of enforcement actions, outcome (failure or a return
to financial stability), and losses to the DIF. The case studies also
allowed us to observe the off-site monitoring tools employed by
regulators and examine whether these tools provided effective warnings
of likely bank deterioration or failure.
Identifying Options That Could Improve PCA:
To identify options that could help improve the effectiveness of PCA
in minimizing losses to the DIF, we gathered ideas from a range of
informed stakeholders from the regulatory, research, and industry
sectors through a series of surveys. We discuss the process used to
identify stakeholders later in this appendix. We also conducted a
literature review and interviewed agency officials and industry
groups, and we incorporated the results into the survey process.
Delphi Survey Method:
To gather options from informed stakeholders that could help improve
the effectiveness of PCA, we employed a modified version of the Delphi
method, which follows a structured process for collecting and
distilling knowledge from a group through a series of questionnaires.
For our purposes, we employed two iterative Web-based surveys.
Our first survey consisted of open-ended questions that asked
respondents to provide their views on the positive aspects and
shortcomings of the PCA framework, changes to the PCA framework that
could make it more effective in minimizing losses to the DIF, and
trade-offs associated with suggested changes to the framework. We
conducted the first survey between November and December 2010. We
distributed a link for the survey to 44 individuals by e-mail and also
subsequently e-mailed and telephoned nonrespondents to encourage a
higher response rate. We received completed surveys from 28
respondents (64 percent). Of the 28 completed responses, 17 were from
regulators and supervisors, 9 were from researchers and consultants,
and 2 were from industry participants. Of the 16 nonrespondents, 1 was
an industry participant, 1 was a regulator and supervisor, and 14 were
researchers and consultants. On the basis of the 28 completed surveys,
we performed a content analysis of the open-ended responses for all
questions on the survey. We categorized the responses on the positive
aspects and shortcomings into five categories each. We jointly
analyzed the responses to the two questions asking about changes to or
alternatives beyond the PCA framework and ultimately categorized the
responses into 12 broad options.
To help ensure that our list of options for the second survey was
thorough, we also reviewed literature on PCA and conducted interviews.
We performed a literature search of studies (dating from January 2000
through October 2010) from major electronic databases, such as
ProQuest and EconLit. We included studies that focused on PCA or
reducing losses to the DIF in the U.S. financial system. We only
included studies that came from one of the following sources: peer-
reviewed journals; federal regulatory agencies, GAO, Congressional
Research Service, IGs; conference proceedings; advocacy and think tank
organizations; or research institute, government, or think tank
working paper series. We then reviewed the resultant studies to
identify options that could improve the effectiveness of the PCA
framework. In addition, we synthesized options that federal
regulators, IGs, industry groups, and academics suggested during
interviews. Overall, the literature review and interviews did not
identify any broad options beyond those identified in the content
analysis of the first survey. However, we used specific examples for
the options--specifically the option to include another trigger for
PCA--from the literature review and interviews to supplement those
gathered through the first Delphi survey. We also used the literature
review and interviews to learn about trade-offs associated with
options to change the PCA framework.
We conducted the second survey from February 2011 through March 2011.
In our second survey, we asked recipients their opinion on the
positive aspects and shortcomings of PCA identified in our analysis of
the first survey. We also asked recipients to rate the potential
impact and feasibility of the options to change the PCA framework and
rank the three top options. We sent this survey to the same 44
individuals, and we sent out reminder Email messages and subsequently
e-mailed and telephoned nonrespondents to encourage a higher response
rate. We received completed surveys from 29 for a response rate of 66
percent. Of the 29 completed responses, 15 were from regulators and
supervisors, 11 were from researchers and consultants, and 3 were from
industry participants. Of the 15 nonrespondents, 3 were regulators and
supervisors and 12 were researchers and consultants. Because of the
number of nonrespondents who were from the research sector, the data
collected from these surveys may not fully represent the views of this
group.
Selecting Survey Recipients:
We used a three-step process to determine which individuals would be
invited to participate in our Delphi surveys. First, we identified the
relevant sectors or groups of banking supervision stakeholders. We
identified three sectors of stakeholders:
1. regulators and supervisors,
2. researchers and consultants, and:
3. industry participants.
Next, we identified individuals within each of these sectors, through
formal organizations when possible, including federal regulatory
agencies, state regulatory associations, and industry groups. Our
decisions to identify individuals were informed by the following
criteria:
* professional credentials,
* authorship of research on PCA,
* testimony at relevant congressional hearings,
* membership in the Shadow Financial Regulatory Committee, and:
* recommendations we received during initial interviews with industry
groups and researchers.
When possible, we also consulted with organizations to confirm that we
had identified the appropriate staff or member to include in our list
of informed stakeholders.
To help ensure that our selection was thorough, we asked respondents
in our first survey to recommend additional groups or individuals who
they felt should be included. Additional groups or individuals
identified through this process were invited to complete both surveys
based on the criteria described above. See appendix IV for a list of
survey respondents.
Although we believe that this sample was sufficient for the purposes
of identifying options that may improve PCA and for getting a sense of
the relative impact and feasibility of these options, the survey was
not a census of all informed stakeholders and was not given to a
random, generalizable sample of stakeholders. Therefore, the results
represent only the views of the individuals who responded and are not
representative of or generalizable to all informed stakeholders or all
three sectors identified above. In addition, the practical
difficulties of conducting any survey may introduce errors, commonly
referred to as nonsampling errors. For example, difficulties in
interpreting a particular question, differences in sources of
information available to respondents, or differences when analyzing
data can introduce unwanted variability into the survey results. We
took steps in developing the surveys, collecting the data, and
analyzing them to minimize such nonsampling errors. For example, we
conducted a series of pretests with several survey recipients prior to
distributing both surveys. The goals of the pretests were to help
ensure that (1) the questions were clear and unambiguous and (2)
terminology was used correctly. We made changes to the content and
format of both surveys as necessary based on the pretests.
[End of section]
Appendix II: The Resolution Process Also Can Help Minimize Losses to
the Deposit Insurance Fund:
Beyond PCA, the selection of the bank closure method serves as an
additional process for minimizing losses to the DIF. According to
section 13 of the Federal Deposit Insurance Act (FDIA), the resolution
method FDIC selects must be the alternative that is least costly to
the insurance fund, except in cases involving systemic risk where FDIC
may take other action for the purpose of winding up the insured
depository institution for which the FDIC has been appointed receiver
as necessary to avoid or mitigate such effects.[Footnote 55] To select
the least costly method, FDIC compares the estimated cost of
liquidation--basically, the amount of insured deposits FDIC must pay
minus the net realizable value of a bank's assets--with the amounts
that potential acquirers bid for the bank's assets and deposits. The
most common resolution method for failing banks is the purchase and
assumption transaction, in which a healthy bank purchases certain
assets and assumes certain liabilities of a failed bank. FDIC sells
banks through a purchase and assumption transaction unless another
approach is less costly to the DIF.
According to FDIC, their ability to influence the cost of bank
failures to the DIF is limited, but FDIC said certain resolution
methods helped minimize losses. FDIC's Division of Resolutions and
Receiverships (DRR) told us that the cost of a bank failure to the DIF
is embedded in the financial position of the failed bank. According to
FDIC DRR, factors (beyond the resolution process) that affect the cost
of a bank failure are both internal and external to the failed bank.
For instance, the stability of the bank's funding sources--that is,
the degree to which the bank has a stable base of customers rather
than "brokered" or bulk deposits from out-of-state institutional
investors--is a key internal factor. The quality of the bank's assets
(for example, the proportion of its loans that carry a high risk of
default) is a second, key internal factor. External factors such as
wider economic conditions and the risk appetite of potential buyers
also affect the cost of a bank failure.
[End of section]
FDIC DRR officials told us that although the cost of a bank failure is
largely fixed by the time of failure, the manner of resolution can
affect losses to the DIF "in the margin." In an effort to minimize
these losses, FDIC DRR customized purchase and assumption
transactions, which it used to sell 254 of the 270 banks that failed
after undergoing the PCA process, to the needs of the market. In a
purchase and assumption transaction, a healthy bank purchases certain
assets and assumes certain liabilities of a failed bank. The specific
composition of the transaction depends on the assets and liabilities
held by the failed bank as well as wider market conditions. FDIC may
offer to sell acquirers (1) the whole failed bank; (2) the whole
failed bank with a shared-loss agreement, an arrangement whereby FDIC,
with the intent of limiting losses to the deposit insurance fund,
agrees to share with the acquirer the losses on those assets; (3) less
than whole bank with a shared-loss agreement; or (4) a clean transfer
(cash, securities, and insured deposits). FDIC DRR resolved the
remaining 16 of the 270 banks that failed after being subject to PCA
through direct payout, a scenario in which FDIC pays depositors
directly and places the assets of the failed bank in a receivership.
Beyond tailoring purchase and assumption transactions to the needs of
the market, FDIC DRR pursued strategies based on the rationale that
the long-term intrinsic value of the assets of failed banks exceeded
their depressed market value. Examples are the FDIC structured
transaction program, in which FDIC acts as a receiver and partners
with a private-sector institution to dispose of assets from failed
banks. According to FDIC DRR, this program enables FDIC to take
advantage of private-sector knowledge while recouping future cash
flows from the failed bank. FDIC also sought to increase the value of
distressed assets through a loan modification program. In this
program, FDIC works with failed banks to modify rather than foreclose
on residential mortgages. This reduces the number of borrowers who
face foreclosure and rehabilitates inactive mortgages into performing
loans.
FDIC DRR told us that it used shared-loss agreements to increase the
value of distressed assets and protect the DIF. When market values
were falling, in 2008, FDIC DRR's valuations of failed banks were too
high to attract bidders. As its backlog of banks grew, FDIC DRR
adopted a loss-share approach in which it sold a pool of problem
assets to an acquirer under an agreement that FDIC would share a
portion of the losses. This structure allowed FDIC to reduce the
immediate cash outlays for the transaction. Figure 15 illustrates the
increase in shared-loss agreements from 2007 through the third quarter
of 2010. According to FDIC, these shared-loss agreements enabled FDIC
to transfer failed banks to a private-sector acquirer, an outcome that
cost the fund less than liquidation of the failed bank.
Figure 15: Trends in Use of Shared-loss Agreements, First Quarter 2006-
Third Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Year: 2007;
Percentage of bank resolutions that include a loss-share agreement:
33.3%.
Year: 2008;
Percentage of bank resolutions that include a loss-share agreement:
76.7%.
Year: 2009;
Percentage of bank resolutions that include a loss-share agreement:
70.2%.
Year: 2010;
Percentage of bank resolutions that include a loss-share agreement:
60.6%.
Source: GAO analysis of FDIC data.
[End of figure]
FDIC DRR told us that as the economy improved in 2010, it received
bids for failed banks that included no loss-share agreement. For
shared-loss agreements that FDIC did offer in this time period, it
shifted more risk to bidders. Because the losses to the DIF from these
shared-loss agreements will be realized over longer time horizons (for
example, 8-10 years), it is too early to thoroughly evaluate the
relative merits of the shared-loss agreements against other resolution
methods.
[End of section]
Appendix III: Econometric Analysis of Leading Indicators of Bank
Failure and Determinants of Losses to the Deposit Insurance Fund:
This appendix describes the methodological approach we took to
identify potential leading indicators of bank failure, generate a peer
group for the population of failed banks, and evaluate the statistical
and practical significance of potential leading indicators during the
current period of bank distress. The appendix also describes the
methodology and results for assessing potential determinants of losses
to the DIF and impact of PCA.
Methodological Approach:
In order to construct a logistic (logit) regression model of bank
failure prediction, we identified leading indicators from a previous
period of bank failures based principally on two studies.[Footnote 56]
We selected the following five financial ratios: equity
capital/assets, earnings/assets, nonperforming loans (sum of past due
loans, nonaccrual loans, and real estate owned)/assets,
securities/liabilities, and "jumbo" ($100,000 plus) certificates of
deposit/liabilities. The rationale for each of these indicators is
described in table 6 below.
Table 6: Select Leading Indicators of Bank Failure:
Indicator: Capital;
Definition: Equity capital divided by assets;
Explanation: Measure of the net worth or solvency of the institution.
Indicator: Earnings;
Definition: Net income divided by assets;
Explanation: Measure of the profitability of the institution.
Indicator: Nonperforming loans;
Definition: The sum of past due loans, nonaccrual loans, and real
estate owned divided by assets;
Explanation: Measures the quality of loans (asset quality) held by the
institution, which may include losses not yet reflected in capital.
Indicator: Securities;
Definition: Securities divided by liabilities;
Explanation: Measures the capacity of the institution to sell assets
quickly to meet obligations.
Indicator: Unstable funding;
Definition: Large ($100,000 plus) certificates of deposit divided by
liabilities;
Explanation: Measures the reliance of the institution on certain high-
cost and volatile funding sources.
Source: GAO analysis of academic studies.
Note: We relied on two widely cited studies. See Cole and Gunther,
"Separating the Likelihood and Timing of Bank Failure," and Cole and
Gunther, "Predicting Bank Failure: A Comparison of On-and Off-site
Monitoring Systems."
[End of table]
We found that the equity capital measure from the literature evolved
in a way that was quite similar to certain regulatory capital measures
(see figure 16) for banks that ultimately failed. The correlation
between the aggregate equity capital measure and the leverage ratio
was 0.99; the correlation with the tier 1 capital to risk-weighted
assets ratio was 0.97.
Figure 16: Equity Capital and Regulatory Capital at Failed Banks,
First Quarter 2006-Second Quarter 2009:
[Refer to PDF for image: multiple line graph]
2006, Q1;
Equity capital: 11.08%;
Leverage ratio: 11.21%;
Tier 1 capital to risk-weighted assets: 14.87%.
2006, Q2;
Equity capital: 11.39%;
Leverage ratio: 11.86%;
Tier 1 capital to risk-weighted assets: 15.69%.
2006, Q3;
Equity capital: 11.3%;
Leverage ratio: 11.79%;
Tier 1 capital to risk-weighted assets: 14.73%.
2006, Q4;
Equity capital: 11.35%;
Leverage ratio: 11.58%;
Tier 1 capital to risk-weighted assets: 15.01%.
2007, Q1;
Equity capital: 11.38%;
Leverage ratio: 11.39%;
Tier 1 capital to risk-weighted assets: 14.62%.
2007, Q2;
Equity capital: 10.86%;
Leverage ratio: 10.56%;
Tier 1 capital to risk-weighted assets: 12.96%.
2007, Q3;
Equity capital: 10.64%;
Leverage ratio: 10.23%;
Tier 1 capital to risk-weighted assets: 12.26%.
2007, Q4;
Equity capital: 10.09%;
Leverage ratio: 9.49%;
Tier 1 capital to risk-weighted assets: 11.36%.
2008, Q1;
Equity capital: 9.66%;
Leverage ratio: 9.07%;
Tier 1 capital to risk-weighted assets: 10.89%.
2008, Q2;
Equity capital: 8.95%;
Leverage ratio: 8.45%;
Tier 1 capital to risk-weighted assets: 10.25%.
2008, Q3;
Equity capital: 8.39%;
Leverage ratio: 7.87%;
Tier 1 capital to risk-weighted assets: 9.66%.
2008, Q4;
Equity capital: 6.89%;
Leverage ratio: 6.35%;
Tier 1 capital to risk-weighted assets: 8.05%.
2009, Q1;
Equity capital: 6.14%;
Leverage ratio: 5.54%;
Tier 1 capital to risk-weighted assets: 7.03%.
2009, Q2;
Equity capital: 5.61%;
Leverage ratio: 4.33%;
Tier 1 capital to risk-weighted assets: 5.75%.
Source: GAO analysis of FDIC and SNL Financial data.
[End of figure]
Given the attention to commercial real estate concentrations during
this crisis, we developed a more generic measure of loan concentration
as a potential leading indicator. The Bank for International
Settlements and Deutsche Bundesbank have described how a Herfindahl-
Hirschman Index (HHI) could be used to measure loan concentration.
[Footnote 57] We adopted a version based on sectors defined below.
This is an imperfect measure of concentration because it does not
account for the correlations between the various sectors and with the
overall economy. However, an HHI is a useful and straightforward
indicator of credit concentration. All else being equal, it should be
associated with greater risk and there may therefore be associated
with a greater likelihood of failure. We define two possible HHIs
based on two different sector definitions (identical except for one
distinction--in HHI 1 multifamily residential real estate is included
with one-four family residential real estate, and in HHI 2 it is
included with commercial real estate):
* HHI 1: Sector shares are defined as acquisition, development, and
construction loans (ADC) plus nonfarm nonresidential real estate
(commercial real estate, or CRE, narrowly defined), residential real
estate (including one-four family and multifamily [five or more] real
estate), consumer loans, loans to farms plus agricultural production
loans, commercial and industrial (C&I) loans, and other (a residual).
* HHI 2: Sector shares are defined as ADC loans plus nonfarm
nonresidential real estate (CRE narrowly defined) plus multifamily
residential real estate loans (these three sectors are similar to the
broad definition of CRE used in the joint CRE concentration guidance
that the federal banking regulators issued), one-four family
residential real estate loans, consumer loans, loans to farms plus
agricultural production loans, C&I loans, and other (a residual).
[Footnote 58]
We identified failed banks and dates of failure based on FDIC data. To
properly assess the predictive power of potential leading indicators
during the present bank crisis, we developed a control group of
healthy banks. We used the Uniform Bank Performance Report to identify
banks in the same general peer group and then selected two in the same
state for each failed bank. For each failed thrift, we selected two
thrifts from the same state as peers.
Econometric Results:
We estimated a variety of four-and eight-quarter ahead forecasting
models via logit using Huber-White robust standard errors.
Technically, our estimates were based on five-and nine-quarter ahead
forecasts because the Call Report data are released well after the
dated quarter. For example, we used fourth-quarter 2006 data,
available sometime during the first quarter of 2007, to determine if a
bank failed in the second, third, or fourth quarter of 2007 or the
first quarter of 2008.
We adopt in-sample measures of model and variable performance but no
traditional test of out of sample forecasting ability (e.g.,
estimating the model through 2009 and measuring forecast accuracy in
2010). However, the logistic regressions can be thought of (with the
exception of the concentration index) as an out-of-sample test of the
models and variables as they were estimated in the aforementioned
assessments of earlier waves of bank failures published 1995 and 1998.
[Footnote 59]
We first estimated a model with the five leading indicators identified
previously, at four-and eight-quarter forecasting horizons. As evident
in tables 7 and 8 below, these five indicators remain highly
significant predictors of bank failure.
Table 7: Logit Model of Bank Failure with Standard Financial Ratios,
Four-Quarter Horizon:
Indicator: Capital;
Coefficient: -36.4539;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -46.8159;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 27.9025;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -0.9936;
p-value: 0.0400.
Indicator: Unstable funding;
Coefficient: 1.0405;
p-value: 0.0103.
Indicator: McFadden's r-squared;
Coefficient: 0.47;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 8: Logit Model of Bank Failure with Standard Financial Ratios,
Eight-Quarter Horizon:
Indicator: Capital;
Coefficient: -8.0321;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -68.0782;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 42.3400;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -1.5070;
p-value: < 0.0001.
Indicator: Unstable funding;
Coefficient: 1.2953;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.22;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Next we estimated two models at a four-quarter horizon with our two
measures of sector loan concentration in addition to the five
indicators. As evident in tables 9 and 10 below, both concentration
indices are significant predictors of bank failure, though the p-value
of the coefficient estimate for HHI 2 is much smaller.
Table 9: Logit Model of Bank Failure with HHI 1, Four-Quarter Horizon:
Indicator: Capital;
Coefficient: -36.6820;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -47.0561;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 27.6294;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -0.8334;
p-value: 0.0820.
Indicator: Unstable funding;
Coefficient: 1.0163;
p-value: 0.0111.
Indicator: HHI 1;
Coefficient: 0.0001;
p-value: 0.0124.
Indicator: McFadden's r-squared;
Coefficient: 0.47;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 10: Logit Model of Bank Failure with HHI 2, Four-Quarter Horizon:
Indicator: Capital;
Coefficient: -37.2551;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -47.0610;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 27.4433;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -0.7846;
p-value: 0.0916.
Indicator: Unstable funding;
Coefficient: 0.8846;
p-value: 0.0276.
Indicator: HHI 2;
Coefficient: 0.0002;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.47;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
We estimated marginal effects of one-standard deviation changes based
on the coefficients in table 10. The magnitude or practical
significance of these indicators is also notable, with a one-standard
deviation increase in the indicator changing the probability of
failure over the next year (from about 2.8 percent at the means of the
independent variables) in the next four quarters as follows:[Footnote
60]
* capital: down 2.7 percentage points,
* earnings: down 0.7 percentage points,
* nonperforming loans: up 5.0 percentage points,
* securities: down 0.5 percentage points,
* unstable funding: up 0.3 percentage points,
* concentration index: up 0.9 percentage points.
It is possible that the concentration index is predictive of failure
because many failed banks had loan concentrations in sectors that
experienced downturns, not because the institutions were less
diversified overall. Concentration in the CRE sector in particular
could explain the predictive power of the concentration index because
of the recent downturn in CRE. As evident in tables 11 and 12 below,
while CRE is predictive of bank failure, HHI 2 remains predictive
after controlling for CRE concentration, though the coefficient is
smaller and less significant than the model in table 10.
Table 11: Logit Model of Bank Failure with CRE, Four-Quarter Horizon:
Indicator: Capital;
Coefficient: -39.0898;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -46.7415;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 26.5067;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -1.0568;
p-value: 0.0351.
Indicator: Unstable funding;
Coefficient: 0.3991;
p-value: 0.3722.
Indicator: CRE;
Coefficient: 0.0133;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.47;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 12: Logit Model of Bank Failure with CRE and HHI 2, Four-Quarter
Horizon:
Indicator: Capital;
Coefficient: -39.0078;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -46.9419;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 26.5317;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -0.8993;
p-value: 0.0672.
Indicator: Unstable funding;
Coefficient: 0.4153;
p-value: 0.3486.
Indicator: CRE;
Coefficient: 0.0099;
p-value: 0.0001.
Indicator: HHI 2;
Coefficient: 0.0001;
p-value: 0.0013.
Indicator: McFadden's r-squared;
Coefficient: 0.48;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Next we estimated a model with HHI 2 at the eight-quarter horizon. As
evident in table 13, the concentration index remained a statistically
significant predictor at the longer horizon.
Table 13: Logit Model of Bank Failure with HHI 2, Eight-Quarter
Horizon:
Indicator: Capital;
Coefficient: -9.4549;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -69.9422;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 42.5927;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -1.1304;
p-value: 0.0003.
Indicator: Unstable funding;
Coefficient: 0.9810;
p-value: 0.0001.
Indicator: HHI 2;
Coefficient: 0.0002;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.24;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Next we estimated a model with only CAMELS ratings at four-and eight-
quarter horizons, along with a model combining CAMELS ratings with the
model in table 10 (five indicators plus HHI 2) also at four-and eight-
quarter horizons. As evident in tables 14-17, CAMELS ratings on their
own are predictive of bank failure within four and eight quarters. As
a composite index meant to capture the underlying CAMELS component
factors (capital, asset quality, management, earnings, liquidity, and
sensitivity to market risk) CAMELS are similar to a predictive
regression model based on financial indicators that represent some of
those categories--in the sense that they both take into account more
than just capital. However, CAMELS ratings have less explanatory power
by themselves, as measured by McFadden's r-squared, 0.26 versus 0.47
for the logit with the financial ratios and concentration index.
Furthermore, CAMELS ratings and the financial ratios we have chosen
each contain unique information that can be helpful in anticipating
bank distress. CAMELS ratings remain a highly statistically
significant predictor of bank failure when added to a regression with
capital, earnings, nonperforming loans, securities, unstable funding,
and the concentration index, though unsurprisingly the coefficient is
somewhat less significant than on its own. Thus CAMELS ratings contain
information that is not fully accounted for by the financial
indicators we have identified and included in the regression, and vice
versa.
Table 14: Logit Model of Bank Failure with CAMELS, Four-Quarter
Horizon:
Indicator: CAMELS rating;
Coefficient: 1.5649;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.26;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 15: Logit Model of Bank Failure with CAMELS, Eight-Quarter
Horizon:
Indicator: CAMELS rating;
Coefficient: 1.0279;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.08;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 16: Logit Model of Bank Failure with CAMELS and Financial
Indicators, Four-Quarter Horizon:
Indicator: Capital;
Coefficient: -34.2274;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -44.3722;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 23.2022;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -0.7588;
p-value: 0.1072.
Indicator: Unstable funding;
Coefficient: 1.0172;
p-value: 0.0101.
Indicator: HHI 2;
Coefficient: 0.0002;
p-value: < 0.0001.
Indicator: CAMELS rating;
Coefficient: 0.4250;
p-value: < 0.0001.
Indicator: McFadden's r-squared;
Coefficient: 0.48;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Table 17: Logit Model of Bank Failure with CAMELS and Financial
Indicators, Eight-Quarter Horizon:
Indicator: Capital;
Coefficient: -10.6895;
p-value: < 0.0001.
Indicator: Earnings;
Coefficient: -57.7312;
p-value: < 0.0001.
Indicator: Nonperforming loans;
Coefficient: 40.5932;
p-value: < 0.0001.
Indicator: Securities;
Coefficient: -1.1024;
p-value: 0.0005.
Indicator: Unstable funding;
Coefficient: 0.9770;
p-value: 0.0001.
Indicator: HHI 2;
Coefficient: 0.0002;
p-value: < 0.0001.
Indicator: CAMELS rating;
Coefficient: 0.2834;
p-value: 0.0002.
Indicator: McFadden's r-squared;
Coefficient: 0.25;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
Finally, we estimated marginal effect of a one-rating increase
(deterioration) in the CAMELS rating based on the coefficients in
table 15. The magnitude or practical significance of the CAMELS rating
is also notable, with a one-rating increase changing the probability
of failure over the next year from about 2.8 percent to 4.2 percent.
[Footnote 61]
Analysis of DIF Losses:
We estimated a variety of econometric models to assess the impact of
PCA on the DIF. Our model includes all bank failures from first
quarter 2007 to third quarter 2010. In order to derive a better
estimate of PCA's impact than comparing mean or median losses, we
controlled for other factors that might affect losses to the DIF and
therefore account for some systematic differences between banks that
underwent the PCA process before failure and those that did not. We
attempted to control for factors related to the quality of the bank's
balance sheet (and therefore expected value to potential buyers) and
the size of FDIC's deposit liabilities.[Footnote 62]
Table 18: Potential Factors Affecting DIF Losses:
Control variable: Deposits;
Definition: Several measures of deposits divided by assets;
Explanation: Measures FDIC liabilities.
Control variable: Securities;
Definition: Securities divided by assets;
Explanation: Securities are generally more liquid and therefore easier
to value.
Control variable: Nonperforming loans or assets;
Definition: Nonperforming loans are the sum of past due loans,
nonaccrual loans, and real estate owned divided by assets;
nonperforming assets also include nonloan assets that are repossessed
or in nonaccrual status;
Explanation: Measures the quality of loans or assets that may have
limited value outside the depository institution, and therefore low
resale value.
Source: GAO.
[End of table]
We report on the results of several models we estimated via ordinary
least-squares (OLS) below. All models reported below were estimated
with White standard errors. Prompt corrective action is a dummy
variable equal to "1" if the failed institution underwent the PCA
process, "0" otherwise.
While PCA was not statistically significant in any of the
specifications we ran, it was consistently negative in the 1-3
percentage point range.[Footnote 63] Because institutions that
underwent PCA had on average almost $1 billion in assets, a small
effect that did not meet conventional standards for statistical
significance might in some circumstances be of practical or economic
significance.[Footnote 64]
Mean losses for PCA versus non-PCA banks are 28 percent of assets
versus 25.6 percent of assets (the difference was not statistically
significant) before controlling for other factors. After controlling
for other factors, banks that underwent the PCA process had 1-3
percentage point lower losses as a percentage of assets, though the
difference remained statistically insignificant. In total, controlling
for balance sheet quality resulted in a roughly 3-5 point change in
DIF losses and suggests a more positive role for PCA in reducing
losses to the DIF. In addition, the balance sheet factors are all
highly statistically significant.
As shown in table 19, in the model with deposits measured as the total
deposits of the bank (which may exceed the liabilities of the FDIC),
the coefficient on PCA was roughly negative 3--banks that underwent
PCA had DIF losses that were roughly 3 percentage points less as a
percentage of assets--but not statistically significant.
Table 19: Model of DIF Losses with Nonperforming Loans and Total
Deposits, First Quarter 2007-Third Quarter 2010:
Variable: Securities;
Coefficient: -0.1626;
p-value: 0.0615.
Variable: Nonperforming loans;
Coefficient: 0.3628;
p-value: 0.0001.
Variable: Deposits;
Coefficient: 0.3909;
p-value: < 0.0001.
Variable: PCA;
Coefficient: -3.1609;
p-value: 0.2397.
Variable: R-squared;
Coefficient: 0.21;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
As shown in table 20, in the model with deposits measured as the small
deposits of the bank (which may understate the liabilities of the
FDIC), the coefficient on PCA was roughly negative 1--banks that
underwent PCA had DIF losses that were roughly 1 percentage point less
as a percentage of assets--but not statistically significant.
Table 20: Model of DIF Losses with Nonperforming Loans and Small
Deposits, First Quarter 2007-Third Quarter 2010:
Variable: Securities;
Coefficient: -0.2096;
p-value: 0.0105.
Variable: Nonperforming loans;
Coefficient: 0.4653;
p-value: < 0.0001.
Variable: Small deposits;
Coefficient: 0.2707;
p-value: < 0.0001.
Variable: PCA;
Coefficient: -1.1196;
p-value: 0.6596.
Variable: R-squared;
Coefficient: 0.23;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
As shown in table 21, in the model with deposits measured as the small
deposits of the bank and nonperforming assets substituted for
nonperforming loans, in table 20, the coefficient on PCA was also
roughly negative 1--banks that underwent PCA had DIF losses that were
roughly 1 percentage point less as a percentage of assets--but not
statistically significant.
Table 21: Model of DIF Losses with Nonperforming Assets and Small
Deposits, First Quarter 2007-Third Quarter 2010:
Variable: Securities;
Coefficient: -0.2170;
p-value: 0.0077.
Variable: Nonperforming assets;
Coefficient: 0.4426;
p-value: < 0.0001.
Variable: Small deposits;
Coefficient: 0.2726;
p-value: < 0.0001.
Variable: PCA;
Coefficient: -1.1627;
p-value: 0.6480.
Variable: R-squared;
Coefficient: 0.23;
p-value: Not applicable.
Source: GAO analysis of data from FDIC and SNL Financial.
[End of table]
[End of section]
Appendix IV: PCA Survey Respondents:
We asked 44 informed stakeholders from the regulatory, research, and
industry sectors to complete our first and second surveys about prompt
corrective action. For more information on our survey and selection
methodologies, see appendix I. The following table lists the
individuals from whom we received completed responses to the first,
second, or both surveys.
Table 22: Survey Respondents:
Name: Braswell, Rob;
Primary organization: Georgia Department of Banking and Finance.
Name: Clarke, Scott;
Primary organization: Illinois Department of Financial and
Professional Regulations.
Name: Cole, Chris;
Primary organization: Independent Community Bankers of America.
Name: Corcoran, Kevin;
Primary organization: OTS.
Name: Douglas, John;
Primary organization: Davis Polk and Wardwell LLC.
Name: Duffie, Darrell;
Primary organization: Stanford University.
Name: Eisenbeis, Robert A.;
Primary organization: Cumberland Advisors.
Name: Ellis, Diane;
Primary organization: FDIC, Financial Risk Management and Research,
Division of Insurance and Research.
Name: Evanoff, Douglas D.;
Primary organization: Federal Reserve Bank of Chicago.
Name: Gerrish, Jeff;
Primary organization: Gerrish McCreary Smith Consultants and Attorneys.
Name: Grace, Ray;
Primary organization: North Carolina Commissioner of Banks.
Name: Hancock, Diana;
Primary organization: Federal Reserve, Division of Research and
Statistics.
Name: Ivie, Stan;
Primary organization: FDIC, Division of Supervision and Consumer
Protection.
Name: Kane, Edward J.;
Primary organization: Boston College.
Name: Kaufman, George;
Primary organization: Loyola University, Graduate School of Business.
Name: Kelly, Jennifer;
Primary organization: OCC, Division of Midsize/Community Bank
Supervision.
Name: Lemieux, Cathy;
Primary organization: Federal Reserve Bank of Chicago.
Name: Leuz, Christian;
Primary organization: University of Chicago.
Name: Levonian, Mark;
Primary organization: OCC.
Name: Litan, Robert E.;
Primary organization: Brookings Institution.
Name: Loving, Bill;
Primary organization: Pendleton Bank.
Name: Nieto, Maria;
Primary organization: Bank of Spain.
Name: Oakes, Nancy;
Primary organization: Federal Reserve, Enforcement.
Name: Quigley, Lori;
Primary organization: OTS.
Name: Scott, Kenneth E.;
Primary organization: Stanford University.
Name: Spoth, Christopher J.;
Primary organization: FDIC, Division of Supervision and Consumer
Protection.
Name: Stevens, Michael;
Primary organization: Conference of State Bank Supervisors.
Name: Sweeney, Maureen;
Primary organization: FDIC, Division of Insurance and Research.
Name: Tenhundfeld, Mark;
Primary organization: America Bankers Association.
Name: Thompson, Sandra L.;
Primary organization: FDIC, Division of Supervision and Consumer
Protection.
Name: Wall, Larry;
Primary organization: Federal Reserve Bank of Atlanta.
Name: Watkins, Rick;
Primary organization: Federal Reserve, Supervisory Issues and Special
Situations.
Source: GAO.
[End of table]
[End of section]
Appendix V: Responses to Questions from GAO's Second Delphi Survey on
the Prompt Corrective Action Framework:
We distributed a survey to 44 individuals from the regulatory,
research, and industry sectors to determine their views on the PCA
framework and options for modifying the PCA framework to minimize
losses to the DIF. We received completed responses from 29 of 44
individuals, for a response rate of 66 percent. Tables 23-28 and
figures 17-18 below show responses to questions from the survey. For
more information about our methodology for designing and distributing
the survey, see appendix I.
Section 1: PCA Positive Elements and Shortcomings:
Table 23: Stakeholder Views on Potential Positive Elements of the PCA
Framework:
Stakeholder views: Establishes consistent capital standards and
corresponding restrictions and requirements;
Positive element of PCA: 24;
Not a positive element of PCA: 3;
No opinion: 1;
Total: 28.
Stakeholder views: Gives institutions an incentive to avoid or resolve
capital deficiencies;
Positive element of PCA: 27;
Not a positive element of PCA: 1;
No opinion: 0;
Total: 28.
Stakeholder views: Makes institutions less likely to fail;
Positive element of PCA: 16;
Not a positive element of PCA: 10;
No opinion: 2;
Total: 28.
Stakeholder views: Helps reduce regulatory forbearance;
Positive element of PCA: 16;
Not a positive element of PCA: 9;
No opinion: 3;
Total: 28.
Stakeholder views: Helps close institutions before insolvency (i.e.,
before they develop negative net worth);
Positive element of PCA: 23;
Not a positive element of PCA: 3;
No opinion: 2;
Total: 28.
Source: GAO.
Note: Totals may not add to 29 because respondents did not all answer
every question.
[End of table]
Table 24: Stakeholder Views on Potential Shortcomings of the PCA
Framework:
Stakeholder views: Capital is a lagging indicator;
Shortcoming of PCA: 22;
Not a shortcoming of PCA: 6;
No opinion: 0;
Total: 28.
Stakeholder views: The measurement of capital is subjective (e.g.,
loan loss reserves may be insufficient, financial reporting may be
inaccurate, etc.);
Shortcoming of PCA: 23;
Not a shortcoming of PCA: 5;
No opinion: 0;
Total: 28.
Stakeholder views: The focus of PCA is too narrow (e.g., it is based
only on capital;
it applies only to institutions, not holding companies, etc.);
Shortcoming of PCA: 22;
Not a shortcoming of PCA: 5;
No opinion: 1;
Total: 28.
Stakeholder views: PCA restrictions and requirements have limited
flexibility;
Shortcoming of PCA: 13;
Not a shortcoming of PCA: 15;
No opinion: 0;
Total: 28.
Stakeholder views: During times of severe economic stress, PCA's
effectiveness is more limited;
Shortcoming of PCA: 22;
Not a shortcoming of PCA: 2;
No opinion: 4;
Total: 28.
Source: GAO.
Note: Totals may not add to 29 because all respondents did not answer
every question.
[End of table]
Section 2: Rating Options to Modify the PCA Framework:
Table 25: Stakeholder Views on Potential Impact of Each Option to Make
the PCA Framework More Effective in Minimizing Losses to the DIF:
Stakeholder views: Change accounting rules used to measure capital
levels (e.g., make greater use of market values to assess assets,
change rules for loan loss reserves, etc.);
Would diminish effectiveness: 7;
No impact: 1;
Would improve effectiveness: 14;
Unsure: 7;
Total: 29.
Stakeholder views: Eliminate the PCA framework;
Would diminish effectiveness: 22;
No impact: 2;
Would improve effectiveness: 2;
Unsure: 3;
Total: 29.
Stakeholder views: Encourage greater uniformity across regulators
(e.g., more consistency in capital definitions across state regulators
and in closure authority across federal regulators, etc.);
Would diminish effectiveness: 2;
No impact: 5;
Would improve effectiveness: 21;
Unsure: 1;
Total: 29.
Stakeholder views: Enhance restrictions and requirements at the
holding company level;
Would diminish effectiveness: 1;
No impact: 5;
Would improve effectiveness: 18;
Unsure: 5;
Total: 29.
Stakeholder views: Include another trigger for PCA (i.e., another
measure of bank soundness or performance);
Would diminish effectiveness: 1;
No impact: 2;
Would improve effectiveness: 18;
Unsure: 8;
Total: 29.
Stakeholder views: Incorporate an institution's risk profile (e.g.,
concentration exposure, etc.) into the PCA capital category thresholds;
Would diminish effectiveness: 2;
No impact: 2;
Would improve effectiveness: 21;
Unsure: 4;
Total: 29.
Stakeholder views: Make no changes to the PCA framework;
Would diminish effectiveness: 13;
No impact: 13;
Would improve effectiveness: 0;
Unsure: 3;
Total: 29.
Stakeholder views: Make PCA restrictions and requirements less
prescriptive (e.g., more flexibility in timelines, more discretion in
application of restrictions, etc.);
Would diminish effectiveness: 15;
No impact: 2;
Would improve effectiveness: 8;
Unsure: 4;
Total: 29.
Stakeholder views: Raise all capital category thresholds;
Would diminish effectiveness: 4;
No impact: 3;
Would improve effectiveness: 17;
Unsure: 5;
Total: 29.
Stakeholder views: Raise capital category thresholds for larger
institutions;
Would diminish effectiveness: 2;
No impact: 6;
Would improve effectiveness: 15;
Unsure: 5;
Total: 28.
Stakeholder views: Raise the critically undercapitalized threshold;
Would diminish effectiveness: 3;
No impact: 5;
Would improve effectiveness: 20;
Unsure: 1;
Total: 29.
Stakeholder views: Strengthen PCA restrictions and requirements (e.g.,
shorter time frames, earlier use of restrictions available under the
significantly undercapitalized category, etc.);
Would diminish effectiveness: 8;
No impact: 1;
Would improve effectiveness: 15;
Unsure: 5;
Total: 29.
Source: GAO.
Note: Totals may not add to 29 because respondents did not all answer
every question.
[End of table]
Table 26: Stakeholder Views on Potential Feasibility for Federal
Regulators to Implement Each Option:
Stakeholder views: Change accounting rules used to measure capital
levels (e.g., make greater use of market values to assess assets,
change rules for loan loss reserves, etc.);
Feasible: 13;
Not Feasible: 6;
Unsure: 10;
Total: 29.
Stakeholder views: Eliminate the PCA framework;
Feasible: 5;
Not Feasible: 14;
Unsure: 10;
Total: 29.
Stakeholder views: Encourage greater uniformity across regulators
(e.g., more consistency in capital definitions across state regulators
and in closure authority across federal regulators, etc.);
Feasible: 16;
Not Feasible: 2;
Unsure: 11;
Total: 29.
Stakeholder views: Enhance restrictions and requirements at the
holding company level;
Feasible: 19;
Not Feasible: 2;
Unsure: 8;
Total: 29.
Stakeholder views: Include another trigger for PCA (i.e., another
measure of bank soundness or performance);
Feasible: 20;
Not Feasible: 3;
Unsure: 6;
Total: 29.
Stakeholder views: Incorporate an institution's risk profile (e.g.,
concentration exposure, etc.) into the PCA capital category thresholds;
Feasible: 22;
Not Feasible: 1;
Unsure: 6;
Total: 29.
Stakeholder views: Make PCA restrictions and requirements less
prescriptive (e.g., more flexibility in timelines, more discretion in
application of restrictions, etc.);
Feasible: 16;
Not Feasible: 4;
Unsure: 9;
Total: 29.
Stakeholder views: Raise all capital category thresholds;
Feasible: 17;
Not Feasible: 6;
Unsure: 6;
Total: 29.
Stakeholder views: Raise capital category thresholds for larger
institutions;
Feasible: 18;
Not Feasible: 1;
Unsure: 9;
Total: 28.
Stakeholder views: Raise the critically undercapitalized threshold;
Feasible: 20;
Not Feasible: 4;
Unsure: 5;
Total: 29.
Stakeholder views: Strengthen PCA restrictions and requirements (e.g.,
shorter time frames, earlier use of restrictions available under the
significantly undercapitalized category, etc.);
Feasible: 16;
Not Feasible: 6;
Unsure: 7;
Total: 29.
Source: GAO.
Note: Totals may not add to 29 because respondents did not all answer
every question.
[End of table]
Section 3: Rank Ordering of Options to Modify the PCA Framework:
Table 27: Stakeholder Ranking of 12 Potential Options to Modify PCA:
Potential options: Change accounting rules used to measure capital
levels (e.g., make greater use of market values to assess assets,
change rules for loan loss reserves, etc.);
Most effective option: 3;
Second most effective option: 3;
Third most effective option: 1;
Total number of respondents selecting option among top three most
effective: 7.
Potential options: Eliminate the PCA framework;
Most effective option: 1;
Second most effective option: 0;
Third most effective option: 1;
Total number of respondents selecting option among top three most
effective: 2.
Potential options: Encourage greater uniformity across regulators
(e.g., more consistency in capital definitions across state regulators
and in closure authority across federal regulators, etc.);
Most effective option: 0;
Second most effective option: 3;
Third most effective option: 5;
Total number of respondents selecting option among top three most
effective: 8.
Potential options: Enhance restrictions and requirements at the
holding company level;
Most effective option: 3;
Second most effective option: 2;
Third most effective option: 3;
Total number of respondents selecting option among top three most
effective: 8.
Potential options: Include another trigger for PCA (i.e., another
measure of bank soundness or performance);
Most effective option: 3;
Second most effective option: 4;
Third most effective option: 5;
Total number of respondents selecting option among top three most
effective: 12.
Potential options: Incorporate an institution's risk profile (e.g.,
concentration exposure, etc.) into the PCA capital category thresholds;
Most effective option: 5;
Second most effective option: 6;
Third most effective option: 1;
Total number of respondents selecting option among top three most
effective: 12.
Potential options: Make no changes to PCA framework;
Most effective option: 0;
Second most effective option: 0;
Third most effective option: 0;
Total number of respondents selecting option among top three most
effective: 0.
Potential options: Make PCA restrictions and requirements less
prescriptive (e.g., more flexibility in timelines, more discretion in
application of restrictions, etc.);
Most effective option: 4;
Second most effective option: 1;
Third most effective option: 1;
Total number of respondents selecting option among top three most
effective: 6.
Potential options: Raise all capital category thresholds;
Most effective option: 7;
Second most effective option: 2;
Third most effective option: 1;
Total number of respondents selecting option among top three most
effective: 10.
Potential options: Raise capital category thresholds for larger
institutions;
Most effective option: 0;
Second most effective option: 3;
Third most effective option: 2;
Total number of respondents selecting option among top three most
effective: 5.
Potential options: Raise the critically undercapitalized threshold;
Most effective option: 2;
Second most effective option: 3;
Third most effective option: 3;
Total number of respondents selecting option among top three most
effective: 8.
Potential options: Strengthen PCA restrictions and requirements (e.g.,
shorter timeframes, earlier use of restrictions available under the
significantly undercapitalized category, etc.);
Most effective option: 0;
Second most effective option: 1;
Third most effective option: 2;
Total number of respondents selecting option among top three most
effective: 3.
Potential options: Total;
Most effective option: 28;
Second most effective option: 28;
Third most effective option: 25.
Source: GAO.
Note: Totals may not add to 29 because respondents did not all answer
every question.
[End of table]
Table 28: Stakeholder Views on the Potential Impact of Potential
Additional PCA Triggers:
Potential additional triggers: Asset concentration trigger;
Would diminish effectiveness of PCA: 4;
No impact: 1;
Would improve effectiveness of PCA: 20;
Unsure: 4;
Total: 29.
Potential additional triggers: Asset quality trigger (e.g.,
nonperforming assets, etc.);
Would diminish effectiveness of PCA: 1;
No impact: 0;
Would improve effectiveness of PCA: 26;
Unsure: 1;
Total: 28.
Potential additional triggers: Contingent capital trigger;
Would diminish effectiveness of PCA: 3;
No impact: 3;
Would improve effectiveness of PCA: 10;
Unsure: 13;
Total: 29.
Potential additional triggers: Forward-looking trigger (e.g., stress
test results, etc.);
Would diminish effectiveness of PCA: 2;
No impact: 1;
Would improve effectiveness of PCA: 13;
Unsure: 12;
Total: 28.
Potential additional triggers: Liquidity trigger;
Would diminish effectiveness of PCA: 4;
No impact: 2;
Would improve effectiveness of PCA: 19;
Unsure: 4;
Total: 29.
Potential additional triggers: Sources of funding trigger (e.g., level
of brokered deposits, mismatch between short-term funding and long-
term lending, etc.);
Would diminish effectiveness of PCA: 6;
No impact: 2;
Would improve effectiveness of PCA: 16;
Unsure: 5;
Total: 29.
Potential additional triggers: Subordinated debt spreads trigger;
Would diminish effectiveness of PCA: 1;
No impact: 2;
Would improve effectiveness of PCA: 14;
Unsure: 12;
Total: 29.
Potential additional triggers: Supervisory-driven trigger (e.g.,
CAMELS ratings, etc.);
Would diminish effectiveness of PCA: 5;
No impact: 3;
Would improve effectiveness of PCA: 14;
Unsure: 7;
Total: 29.
Source: GAO.
Note: Totals may not add to 29 because respondents did not all answer
every question.
[End of table]
Figure 17: Stakeholder Views on Potential Additional PCA Trigger That
Would Have the Most Positive Impact on PCA Effectiveness:
[Refer to PDF for image: vertical bar graph]
PCA trigger: Asset concentration;
Number of stakeholders: 6.
PCA trigger: Asset quality;
Number of stakeholders: 4.
PCA trigger: Contingent capital;
Number of stakeholders: 2.
PCA trigger: Forward-looking;
Number of stakeholders: 3.
PCA trigger: Liquidity;
Number of stakeholders: 2.
PCA trigger: Subordinated debt spreads;
Number of stakeholders: 4.
PCA trigger: Supervisory-driven;
Number of stakeholders: 2.
PCA trigger: Other;
Number of stakeholders: 4.
Source: GAO analysis of FDIC data.
Note: Total may not add to 29 because respondents did not all answer
every question.
[End of figure]
Figure 18: Stakeholder Overall Opinion of the PCA Framework:
[Refer to PDF for image: vertical bar graph]
Opinion: Should not be changed;
Number of stakeholders: 1.
Opinion: Should be modified with one or more of the listed options;
Number of stakeholders: 23.
Opinion: Should be modified with an option that was not included on
this survey;
Number of stakeholders: 0.
Opinion: Should be supplemented by a different framework;
Number of stakeholders: 2.
Opinion: Should be completely replaced by a different framework;
Number of stakeholders: 2.
Opinion: Should be eliminated and not replaced;
Number of stakeholders: 1.
Opinion: Should be eliminated and not replaced;
Number of stakeholders: 1.
Opinion: Should be eliminated and not replaced;
Number of stakeholders: 1.
Opinion: Should be eliminated and not replaced;
Number of stakeholders: 1.
Source: GAO analysis of FDIC data.
Note: Total may not add to 29 because respondents did not all answer
every question.
[End of figure]
[End of section]
Appendix VI: Comments from the Federal Deposit Insurance Corporation:
FDIC:
Federal Deposit Insurance Corporation:
Division of Risk Management Supervision:
550 17th Street NW:
Washington, D.C. 20429-9990:
June 10, 2011:
Orice Williams Brown:
Managing Director, Financial Markets and Community Investment:
United States Government Accountability Office:
411 G Street N.W., Room 2A16:
Washington, D.C. 20548:
Dear Ms. Brown:
The Federal Deposit Insurance Corporation (FDIC) reviewed the GAO
report Banking Regulation: Modified Prompt Corrective Action Framework
Would Improve Effectiveness (Report) (GA0-11-612). The Report stated
that while Prompt Corrective Action (PCA) is a mechanism for
addressing financial deterioration, it has not prevented widespread
losses to the Deposit Insurance Fund (DIF). The FDIC agrees with the
Report's recommendation that enhancements to PCA triggers should be
considered.
The existing PCA capital triggers, along with the accompanying capital
definitions, form the core of the federal banking agencies' (agencies)
regulatory capital framework for depository institutions. The
consensus of lessons-learned studies undertaken after the recent
financial crisis is capital requirements need to be strengthened. The
FDIC anticipates the agencies will seek comment later this year on a
Notice of Proposed Rulemaking (NPR) to implement the Basel 111
standards recently published by the Basel Committee on Banking
Supervision. That proposal should address whether the PCA capital
triggers should be strengthened. Accordingly, the FDIC and other
agencies will consider jointly the GAO's recommendation of possible
modifications to the capital tripwires in the context of the comments
received on that rulemaking.
The Report recommends the agencies consider adding tripwires other
than capital to the PCA framework. We would emphasize the FDIC's
supervisory and enforcement framework is not based solely on
institutions' capital levels. However, for purposes of PCA's automatic
enforcement tripwires, a focus on capital levels has advantages,
particularly in a banking environment as diverse as that of the United
States. Capital requirements are a universally applicable construct
for banks of all sizes that directly affect their ability to absorb
losses.
Other triggers mentioned in the Report, such as those measuring
concentrations, liquidity, management, or overall risk profile, appear
to have greater risk of unintended consequences for the structure of
the banking industry, its activities or its stability in times of
stress. We believe any such additions to the PCA tripwires should be
preceded by substantial further study and consideration of the
possible unintended consequences of these changes. We believe the wide
diversity of views about potential changes to the triggers, expressed
in the Report by respondents of the GAO's survey of stakeholders,
reflects the practical difficulties and uncertain results of
substantial changes to the triggers.
The Report questioned the ability of PCA to help turn around troubled
financial institutions, which would thereby reduce losses to the DIF.
It is difficult to assess what the magnitude of losses to the DIF
would have been during the worst financial and real-estate crisis
since the Great Depression had the PCA framework not been in place.
The FDIC believes the PCA framework had considerable value in
providing a timely, objective framework for addressing problems that
are evidenced by realized or impending capital deterioration. The very
public and objective nature of its tripwires, which are fully known by
banks and market participants, provide a disciplining effect that
bolsters the efforts of supervisors in obtaining corrective action in
addressing deteriorating bank conditions. In short, we believe the
conceptual framework of PCA is well-founded.
In the FDIC's experience, PCA, as currently structured, has been a
valuable addition to enforcement tools available to the federal
banking agencies. We do not view the PCA framework alone as the
primary driver of a problem bank turnaround, but as a backstop to the
enforcement framework when capital ratios (a lagging indicator, as
noted in the Report) deteriorate. Most of the PCA provisions require
an institution to retain capital, restore capital, or sell additional
capital, thus attempting to limit the loss to the deposit insurance
fund. The regulators use a variety of other enforcement powers to
directly address the practices and conditions that contributed to the
institutions' problems. We note that for the state nonmember banks the
FDIC supervises, we took many formal supervisory directives, PCA and
otherwise, in response to the problems we identified.
The Report stated the supervisory response to problems in the U.S.
banking industry was in many cases not sufficiently forceful or
timely. The FDIC takes such issues very seriously and strived to
improve its supervisory processes in response to identified lessons
learned, such as those contained in Material Loss Reviews. The Report
acknowledged the regulators incorporated lessons learned into their
supervisory and enforcement programs during the crisis that improved
the accuracy of CAMELS ratings and the timeliness of enforcement
actions.
It is also important to note that many of the GAO's findings with
respect to PCA's effectiveness, as well as peripheral findings
throughout the Report regarding the regulators' supervisory and
enforcement programs, are heavily influenced by the timing of the
evaluation period. The industry experienced an unprecedented,
precipitous decline beginning in 2008 that continued well into 2010.
Although the severity of deterioration has abated, the industry has
not yet recovered. As of March 31, 888 insured depository institutions
reside on the FDIC's Problem Bank List. However, most of these
institutions will survive and are expected to remain above the
Undercapitalized PCA thresholds. As such, the results of this Report
did not measure the effectiveness of PCA or other supervisory tools
through the entirety of the current cycle.
Implementing changes to PCA or other aspects of the supervisory
framework based on this incomplete chapter in history would increase
the risk of imposing unintended consequences on both the industry and
the regulatory framework. In light of the foregoing, we believe
caution and substantial further study is warranted before concluding
that far-reaching changes in, or additions to, the PCA triggers are
appropriate.
Thank you for the opportunity to review the Report.
Sincerely,
Signed by:
Sandra L. Thompson:
Director:
[End of section]
Appendix VII: Comments from the Board of Governors of the Federal
Reserve System:
Board of Governors of the Federal Reserve System:
Division of Banking Supervision and Regulation:
Washington, D.C. 20551:
June 8, 2011:
Ms. A. Nicole Clowers:
Acting Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Clowers:
The Federal Reserve Board (FRB) has reviewed your draft report
entitled Bank Regulation, Modified Prompt Corrective Action Framework
Would Improve Effectiveness. This response summarizes the FRB's
overall reaction to the draft report. Additional technical comments
have been provided separately by FRB staff to your staff.
In the draft report. the GAO observes that although the Prompt
Corrective Action (PCA) framework provided a mechanism to address
financial deterioration in banks. PCA did not prevent widespread
losses to the Deposit insurance Fund (DIF). The draft report notes
that it has been well understood since the 1990s that the
effectiveness of PCA is limited because of its reliance on capital,
which can lag behind other indicators of hank health. By the time a
hank falls into the undercapitalized or lower PCA capital categories
it may not be able to recover regardless of the regulatory action
imposed. Along that line, the draft report concludes that most banks
that underwent PCA during the GAO's sample period of 2006 through the
third quarter of 2010 either failed or remained troubled. Moreover,
the report concludes that the lagging character of PCA triggers limit
regulators' ability to promptly address bank problems, and the report
offers three suggestions for regulators to consider to make PCA more
effective.
The FRB agrees the PCA capital triggers are not timely indicators of
problems or weaknesses and typically are activated only after
weaknesses are manifested through capital erosion and, therefore, PCA
is not effective in preventing cost to DIF. Nonetheless, the FRB still
views PCA as a useful supervisory tool that empowers bank regulators
to take actions on significantly nonviable banks in a consistent
manner and provides a mechanism for ensuring such banks are closed or
otherwise resolved within prompt timelines (i.e., an orderly
resolution process), which contributes to a healthy banking system and
serves to limit cost to the DIF in the long run.
Although, as the report concludes. most banks that underwent PCA
either failed or remained troubled during the-GAO's sample period (a
period of intense decline in banking conditions), that is largely
attributed to limited access to capital more than to the
ineffectiveness of PCA. As conditions stabilized later in the cycle
and through the current period, an increasing number of troubled
institutions have been successful at raising capital or merging with
other banks. The FRB believes that the requirements of PCA on troubled
banks are useful in containing risk and can lead to correction of
troubled institutions as long as opportunities for capital raises or
merger are available. For troubled banks that arc unable to raise
capital, or otherwise resolve problems, PCA serves to limit cost to
the DIP through a timely and orderly resolution process. Without PCA,
failures and resolutions could he less orderly and, consequently, more
costly.
A point covered in the GAO's survey questions but not elaborated on in
the report is whether a change in accounting rules used to measure
capital levels should be considered. The FRB views this as one of the
more promising options identified in the report to improve the
effectiveness of PCA. The survey question may be aimed at changing the
accounting rules to recognize credit losses earlier which would
improve the effectiveness of PCA during declining credit cycles. The
Financial .Accounting Standards Board and the International Accounting
Standards Board have been working on impairment accounting to move
from an incurred loss to an expected loss model. The FRB, along with
the other banking agencies, supports this effort and is actively
monitoring this effort.
As the draft report states, most stakeholders, including the FRB,
agreed that PCA should he modified and made more effective. The GAO
survey results suggest incorporating an institution's risk profile,
increasing minimum PCA capital ratios for each capital category, and
including another trigger for PCA, such as an asset quality or
concentration trigger; as broad options for making PCA more effective.
Although it is early in the process, most of the existing capital
trigger levels will likely need revision to reflect regulatory capital
requirement changes resulting from the Dodd-Frank Act and Basel Ill
rules, and work has begun to determine what changes should be
developed. That said. there are challenges in making revisions, and
some revisions suggested in the report could have undesirable
consequences. such as potentially over-restricting bank lending. The
FRB generally agrees with the advantages and disadvantages on each of
the three suggestions noted in the report and will keep these issues
in mind as work progresses.
In addition to recommendations to modify PCA, the FRB will consider
all the recommendations it the report as part of an ongoing process to
modify and update supervisory processes. As the report mentions, early
warning signs in earnings, asset quality, liquidity, and concentration
levels, as well as risk management deficiencies that could contribute
to unsafe and unsound banking conditions are already monitored as part
of the FRB's (and other banking agencies) supervisory processes.
Offsite surveillance and statistical models used by the FRB as well as
onsite supervisory activities have been the FRB's most useful tools in
identifying early warnings signs of developing or potential financial
distress. Despite that, the FRB recognizes that over the past few
years of this banking cycle, early warning signs did not always result
in appropriate and timely supervisory actions. The FRB Office of the
Inspector General concluded in Material Loss Reviews on a number of
banks that failed from 2008 through 2010 that there were opportunities
for the FRB to take more forceful supervisory actions to address
safety and soundness examination findings early on. Cognizant of the
need for more prompt remediation of supervisory concerns, FRB staff
has developed an examination issues tracking process that identifies
and centrally monitors supervisory issues for each affected
institution. Depending on the degree of concerns and responsiveness of
bank management, institutions with uncorrected deficiencies or repeat
deficiencies are subject to increasing supervisory actions until
deficiencies are corrected. FRB staff believes effective
implementation of this process will minimize uncorrected safety and
soundness weaknesses, which should lead to fewer significantly
troubled banks and should ultimately minimize future losses to the DIF.
Contrary to a generalized finding in the GAO's draft report, the FRB
does not find that it has been inconsistent in the use of supervisory
enforcement actions and PCA for banks under its supervision. The FRB
has a policy and practice of placing formal supervisory actions on its
supervised banks that exhibit significant supervisory concerns.
Moreover, the FRB has been diligent in following specific requirements
of PCA for any bank that is less than adequately capitalized as
defined under PCA.
We appreciate the professionalism of the GAO review team that prepared
the report. Thank you for the opportunity to comment.
Sincerely,
Signed by:
Patrick Parkinson:
Director:
[End of section]
Appendix VIII: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC 20219:
June 6, 2011:
Ms. A. Nicole Clowers:
Acting Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Clowers:
We have received and reviewed your draft report titled "Bank
Regulation: Modified Prompt Corrective Action Framework Would Improve
Effectiveness?' Your report was mandated by Section 202(g) of the Dodd-
Frank Wall Street Reform and Consumer Protection Act to study the
federal regulators' use of prompt corrective action (PCA) and report
your findings to the Financial Stability Oversight Council (FSOC).
You found that: (1) PCA did not-prevent widespread losses to the
deposit insurance fund; (2) other indicators provide early warning of
deterioration, and although regulators identified conditions early,
responses were inconsistent; and (3) while most stakeholders favored
modifying PCA, their preferred options involve some tradeoffs.
You recommend that the federal banking regulators consider: (1)
additional triggers that would require early and forceful regulatory
actions tied to specific unsafe banking practices; (2) incorporating
an institution's risk profile into the PCA capital category
thresholds; and (3) raising all the PCA capital category thresholds.
You also recommend that regulators work through the FSOC to make
recommendations to Congress on how PCA should be modified.
We agree to consider the actions you recommend. The banking regulators
are continuously engaged in dialog about early warning indicators and
early intervention, though, as your report points out, a uniform
approach is not always the result. The OCC, for example, takes formal
enforcement action earlier than the other agencies--when a bank's
safety and soundness composite rating drops to a three. Consistent
with your second consideration above, the OCC imposes higher minimum
capital standards for national banks whose risk profile warrants it.
We also recognize that future enhancements to regulatory capital
requirements will interplay with PCA capital category thresholds and
may effectively raise them.
We expect the dialog with the other federal banking agencies to
continue as we continue to avail ourselves of the flexibility to use
the above mentioned tools. Should We find that a statutory change is
needed to PCA to increase its effectiveness, we agree to inform the
FSOC of our views on this issue.
We appreciate the opportunity to comment on the draft report.
Sincerely,
Signed by:
John Walsh:
Acting Comptroller of the Currency:
[End of section]
Appendix IX: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
A. Nicole Clowers, (202) 512-8678 or Clowersa@gao.gov Thomas J.
McCool, (202) 512-2642 or Mccoolt@gao.gov:
Staff Acknowledgments:
In addition to the contacts above, Kay Kuhlman (Assistant Director),
JoAnna Berry, Gary Chupka, Bill Cordrey, Andrea Dawson, Michael
Hoffman, Barry Kirby, Joanie Lofgren, Grant Mallie, Marc Molino, Tim
Mooney, Steven Putansu, Ellen Ramachandran, Linda Rego, Barbara
Roesmann, and Andrew Stavinsky made key contributions to this report.
[End of section]
Footnotes:
[1] The DIF was created in 2006, when the Federal Deposit Insurance
Reform Act of 2005 provided for the merging of the Bank Insurance Fund
and the Saving Association Insurance Fund. Pub. L. No. 109-171, title
II, subtitle B, § 2102, 120 Stat. 4 (2006). The Federal Deposit
Insurance Corporation (FDIC) administers the DIF, the goal of which is
to (1) insure the deposits and protect the depositors of DIF-insured
institutions, and (2) upon appointment of FDIC as receiver, resolve
failed DIF-insured institutions at the least possible cost to the DIF
(unless a systemic risk determination is made). The DIF is primarily
funded from deposit insurance assessments.
[2] Pub. L. No. 102-242, 105 Stat. 2236 (1991); Ch. 967, §§ 1,2, 64
Stat. 873 (1950).
[3] 12 U.S.C. § 1831o.
[4] 12 U.S.C. § 1831p-1.
[5] See GAO, Troubled Asset Relief Program: Additional Actions Needed
to Better Ensure Integrity, Accountability, and Transparency,
[hyperlink, http://www.gao.gov/products/GAO-09-161] (Washington D.C.:
Dec. 2, 2008).
[6] See GAO, Federal Deposit Insurance Act: Regulators' Use of
Systemic Risk Exception Raises Moral Hazard Concerns and Opportunities
Exist to Clarify the Provision, [hyperlink,
http://www.gao.gov/products/GAO-10-100] (Washington, D.C.: Apr. 15,
2010).
[7] 12 U.S.C. § 5382(g). The Financial Stability Oversight Council
(FSOC) was created by the Dodd-Frank Act to provide comprehensive
monitoring to ensure the stability of the nation's financial system
and has responsibilities to facilitate coordination among the member
agencies, recommend stricter standards if necessary, and make
recommendations to Congress in closing specific regulatory gaps.
Voting members include, among others, the Secretary of the Treasury,
who serves as the Chairperson of FSOC; the Chairman of the Board of
Governors of the Federal Reserve System; the Comptroller of the
Currency; and the Chairperson of FDIC. 12 U.S.C. § 5321.
[8] This report uses the phrase "banks that underwent the PCA process"
to describe banks that fell into one of the three lowest PCA capital
thresholds--undercapitalized, significantly undercapitalized, or
critically undercapitalized--during any quarter in our period of
analysis.
[9] We reported in March 2011 that FDIC maintained effective internal
control over financial statements for the DIF. GAO, Financial Audit:
Federal Deposit Insurance Corporation Funds' 2010 and 2009 Financial
Statements, [hyperlink, http://www.gao.gov/products/GAO-11-412]
(Washington, D.C.: Mar. 18, 2011).
[10] Section 313 of the Dodd-Frank Act abolishes OTS and section 312
distributes its regulatory functions among the Federal Reserve, FDIC,
and OCC. OTS will cease to exist 90 days after the transfer date,
which is July 21, 2011, unless it is extended to another date that is
within 18 months of July 21, 2010. See 12 U.S.C. §§ 5411-13.
[11] In October 2008, the standard maximum insurance amount of
$100,000 was temporarily raised to $250,000, effective through
December 31, 2013. See 12 U.S.C. § 5241. Section 335(a)(1) of the Dodd-
Frank Act, signed into law on July 21, 2010, made this increase
permanent. See 12 U.S.C. 1821(a)(1)(E).
[12] 12 U.S.C. § 1818.
[13] 12 U.S.C. § 1831o(c).
[14] Section 38 allows an exception to the 90-day closure rule if both
the primary regulator and FDIC concur and document why some other
action would better achieve the purpose of section 38--resolving the
problems of institutions at the least possible long-term cost to the
DIF.
[15] A bank can be reclassified or downgraded to critically
undercapitalized only based on its failure to maintain a tangible
equity to total assets ratio of at least 2 percent.
[16] See GAO, Deposit Insurance: Assessment of Regulators' Use of
Prompt Corrective Action Provisions and FDIC's New Deposit Insurance
System, [hyperlink, http://www.gao.gov/products/GAO-07-242]
(Washington, D.C.: Feb. 15, 2007).
[17] Capital levels, reported by institutions through Call and Thrift
Financial Reports, may drop precipitously from previously reported
levels, including conditions prompting liquidity issues, necessitating
the closing of a bank without an opportunity to pursue PCA measures
prior to failure.
[18] Many of these banks were merged into an acquiring bank without
financial assistance from the government, although some were merged
with governmental assistance or were dissolved through a voluntary
liquidation that did not result in a new institution. These 46
dissolved banks are now classified as inactive by FDIC, although
components of these banks may operate under the certification number
of an acquiring bank. We did not count as dissolved 253 banks that
continued to operate under their original unique certification number
and were classified as active by FDIC, regardless of whether another
entity had gained a large or controlling stake in their operations.
[19] Expressed as means, the average loss was 28.0 percent of assets
for banks that underwent the PCA process; for banks that did not, the
average loss was 25.6 percent. This report frequently uses medians
when calculating averages so that the results are less sensitive to
values at the extremes of the sample. For example, median losses
divide banks into equal groups, half with losses above that amount,
and half with losses below it.
[20] Statistical significance refers to the likelihood of an observed
difference being due to chance. We controlled for factors affecting
the quality of the balance sheet and the size of deposit liabilities.
Banks with more securities had lower losses, and banks with more
nonperforming loans and deposits had higher losses. See appendix III
for more information.
[21] Expressed as means, the average size of the 25 banks that did not
undergo the PCA process before failure was $14.8 billion, versus $956
million for those banks that first underwent the PCA process. If we
exclude Washington Mutual Bank, or WaMu--the nation's largest savings
and loan association before its failure--the mean size of banks that
did not undergo the PCA process before failure drops from $14.8
billion to $2.6 billion.
[22] In this report, we use the term "forbearance" to refer to
granting banks temporary relief from compliance with regulatory
requirements.
[23] See 12 C.F.R. § 337.6.
[24] For example, some large institutions did not fail but received
other assistance authorized under systemic risk determinations related
to (1) the banking system as a whole through the Temporary Liquidity
Guarantee Facility; and (2) Citigroup and its insured institution
subsidiaries. See GAO-10-100 for further information on the use of
systemic risk determinations.
[25] Joe Peek and Eric Rosengren, "The Use of Capital Ratios to
Trigger Interventions in Problem Banks: Too Little, Too Late," New
England Economic Review, September/October issue (1996).
[26] David S. Jones and Kathleen Kuester King, "The Implementation of
Prompt Corrective Action: An Assessment," Journal of Banking and
Finance, vol.19 (1995).
[27] GAO, Bank Supervision: Prompt and Forceful Regulatory Actions
Needed, [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69]
(Washington, D.C.: April 1991).
[28] A composite indicator is an indicator that integrates information
from a number of distinct indicators.
[29] We relied on two widely cited studies. See Rebel A. Cole and
Jeffrey W. Gunther, "Separating the Likelihood and Timing of Bank
Failure," Journal of Banking and Finance, vol.19 (1995) and Rebel A.
Cole and Jeffrey W. Gunther, "Predicting Bank Failure: A Comparison of
On-and Off-site Monitoring Systems," Journal of Financial Services
Research, vol.13, no.2 (1998).
[30] In contrast to statistical significance, which refers to the
likelihood of an observed difference being due to chance, practical
significance refers to the magnitude of an observed difference.
[31] See Basel Committee on Banking Supervision, Basel III:
International Framework for Liquidity Risk Measurement, Standards, and
Monitoring. December 2010. Basel, Switzerland.
[32] We measure sector loan concentration as a Herfindahl-Hirschman
Index (HHI) where the "market shares" are the proportion of loans in
each sector. See appendix III for more information.
[33] John O'Keefe and James A. Wilcox, "How Has Bank Supervision
Performed and How Might It Be Improved?" Paper presented at Federal
Reserve Bank of Boston's 54TH Economic Conference "After the Fall: Re-
Evaluating Supervisory, Regulatory, and Monetary Policy" (2009).
[34] FDIC's Statistical CAMELS Off-site Rating (SCOR) system was
designed to help the agency identify institutions that have
experienced noticeable financial deterioration. The model helps
predict 1-and 2-rated institutions in danger of being downgraded to 3
or worse. The Federal Reserve uses the Supervision and Regulation
Statistical Assessment of Bank Risk model (SR-SABR) as its primary off-
site monitoring tool.
[35] To assess the prevalence of failed banks that previously had been
identified on the regulators' watch or review lists, we assessed 252
banks regulated by FDIC, the Federal Reserve, and OCC that failed from
the first quarter of 2008 through the third quarter of 2010. We
identified when the banks were included on the regulators' watch or
review lists within 2 years of their failure. OTS also conducts off-
site monitoring to identify institutions that warrant further scrutiny
that are captured in a high risk profile list. Because of some
complications in collecting these data for the entire time period of
our analysis, we did not include OTS institutions in this analysis.
[36] Uniform Financial Institution Rating System, 62 Fed. Reg. 752
(Jan. 6, 1997).
[37]
[38] We reviewed CAMELS ratings over a 2-year period prior to bank
failure for 292 banks that failed from the first quarter of 2008
through the third quarter of 2010.
[39] Through a systematic review of material loss reviews or other
evaluations performed on 136 institutions that failed between in 2008,
2009, and 2010, we identified the first enforcement action relevant to
the regulator's efforts to address deteriorating conditions in banks
in the 2-year period before failure.
[40] GAO, Deposit Insurance: A Strategy for Reform, [hyperlink,
http://www.gao.gov/products/GAO/GGD-91-26] (Washington, D.C.: March
1991), and [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69].
[41] A de novo bank is a newly chartered bank that has been open for
less than 3 years.
[42] Of the remaining six respondents, two said PCA should be
supplemented by a different framework, two said PCA should be
completely replaced by a different framework, one told us PCA should
be eliminated and not replaced, and one stakeholder told us the PCA
framework should not be changed.
[43] Of the remaining eight, two survey respondents said incorporating
an institution's risk profile into the PCA capital category thresholds
would have no impact, two told us it would diminish the effectiveness
of PCA, and four were unsure.
[44] To categorize institutions into the five PCA capital categories,
two capital measures (total risk-based capital ratio and Tier 1 risk-
based capital ratio) divide the amount of capital by risk-weighted
assets.
[45] Of the remaining 12, 3 told us raising all capital category
thresholds would have no impact, 4 said it would diminish PCA
effectiveness, and 5 respondents were unsure.
[46] See 57 Fed. Reg. 44866 (Sept. 29, 1992).
[47] GAO, Risk-Based Capital: Bank Regulators Need to Improve
Transparency and Overcome Impediments to Finalizing the Proposed Basel
II Framework, [hyperlink, http://www.gao.gov/products/GAO-07-253]
(Washington, D.C.: Feb. 15, 2007); Congressional Research Service, Who
Regulates Whom? An Overview of U.S. Fiscal Supervision, R40249
(Washington, D.C.: Dec. 8, 2010).
[48] See Who Regulates Whom; [hyperlink,
http://www.gao.gov/products/GAO-07-253]; Douglass Elliott, "A Primer
on Bank Capital" The Brookings Institution. (Washington, D.C.: Jan.
28, 2010).
[49] Of the remaining 11, 1 said adding another PCA trigger would
diminish PCA effectiveness, 2 told us it would have no impact, and 8
were unsure.
[50] One survey respondent did not answer this question; therefore,
the total number of respondents in this case is 28.
[51] Pub. L. No. 103-325, § 318, 18 Stat. 2160, 2223-2224 (1994)
(providing for the standards to be issued either by regulation [as
originally specified in FDICIA] or by guideline and eliminating the
requirement to establish quantitative standards for asset quality and
earnings).
[52] GAO, Bank and Thrift Regulation: Implementation of FDICIA's
Prompt Regulatory Action Provisions, GAO/GGD-97-18 (Washington, D.C.:
Nov. 21, 1996).
[53] [hyperlink, http://www.gao.gov/products/GAO-07-242].
[54] [hyperlink, http://www.gao.gov/products/GAO-07-242], [hyperlink,
http://www.gao.gov/products/GAO/GGD-97-18], and [hyperlink,
http://www.gao.gov/products/GAO/GGD-91-69].
[55] [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69] and
[hyperlink, http://www.gao.gov/products/GAO/GGD-91-26].
[56] 12 U.S.C. § 1823(c)(4).
[57] Cole and Gunther, "Separating the Likelihood and Timing of Bank
Failure," and Cole and Gunther, "Predicting Bank Failure: A Comparison
of On-and Off-site Monitoring Systems."
[58] Basel Committee on Banking Supervision, Studies on Credit Risk
Concentration. Working Paper No. 15, November, 2006. Basel,
Switzerland. Deutsche Bundesbank, Concentration Risk in Credit
Portfolios. Monthly Report, June 2006. Frankfurt, Germany.
[59] Office of the Comptroller of the Currency, Board of Governors of
the Federal Reserve System, Federal Deposit Insurance Corporation,
Concentrations in Commercial Real Estate Lending, Sound Risk
Management Practices, December, 2006.
[60] Cole and Gunther, "Separating the Likelihood and Timing of Bank
Failure," and Cole and Gunther, "Predicting Bank Failure: A Comparison
of On-and Off-site Monitoring Systems."
[61] The marginal effect is calculated at the means of the independent
variables in the first quarter of 2008.
[62] As above, the marginal effect is calculated at the means of the
independent variables in the first quarter of 2008. For comparison
purposes, a one standard deviation (0.7) increase in the CAMELS rating
raises the probability of failure by 0.9 percentage points, to 3.7
percent.
[63] A similar approach that is not focused on the effect of PCA is
Kathleen McDill, "Resolution Costs and the Business Cycle," FDIC
Working Paper 2004-01 (2004).
[64] While in theory DIF losses are a random variable that could take
on positive or negative (if the FDIC turned a profit on the sale of a
failed bank) values, the FDIC has not earned profits over its deposit
liabilities on any bank resolution. Therefore, one might consider the
dependent variable to be censored and a regression approach such as a
Tobit might be appropriate. For each of the OLS regressions reported
below we performed the regressions again as a Tobit to see if our
results were sensitive to this specification. We did not find any
substantive changes as the coefficient on PCA remained statistically
insignificant and in the negative 1-3 range.
[65] See, e.g., Deirdre N. McCloskey and Stephen T. Ziliak, "The
Standard Error of Regressions," Journal of Economic Literature (1996).
[End of section]
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