Introduction

In the 1980s and early 1990s, the solvency of the federal depository insurance funds was threatened when hundreds of thrifts and banks failed. Taxpayers were forced to bailout the insurance fund for thrifts, and the insurance fund for banks had a negative balance for the first time in its history. This situation prompted concern and considerable debate about the need to reform federal deposit insurance and regulatory oversight. In response, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) to, among other things, improve the supervision and examination of depository institutions and to protect the federal deposit insurance funds from further losses. Among its various provisions, FDICIA added two new sections to the Federal Deposit Insurance Act of 1950—sections 38 and 39—referred to as the Prompt Regulatory Action provisions. The Prompt Regulatory Action provisions required federal regulators to institute a two-part system of regulatory actions that would be triggered when an institution fails to meet minimum capital levels or safety-and-soundness standards. Enactment of this two-part system was intended to increase the likelihood that regulators would respond promptly and forcefully to prevent or minimize losses to the deposit insurance funds from failures.

		Background

The Federal Deposit Insurance Corporation (FDIC), Federal Reserve System (FRS), and two agencies within the Department of the Treasury—the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS)—share responsibility for regulating and supervising federally insured banks and thrifts in the United States. FDIC regulates state-chartered banks that are not members of FRS; FRS regulates state-chartered, member banks; OCC regulates nationally chartered banks; and OTS regulates all federally insured thrifts, regardless of charter type. The regulators carry out their oversight responsibilities primarily through monitoring data filed by institutions, conducting periodic on-site examinations, and taking actions to enforce federal safety-and-soundness laws and regulations.

			Problems of Thrifts and Banks From 1980 to 1990

From 1980 to 1990, record losses absorbed by the federal deposit insurance funds highlighted the need for a new approach in federal regulatory oversight. Sharply mounting thrift losses over the decade bankrupted the Federal Savings and Loan Insurance Corporation (FSLIC), which was the agency responsible for insuring thrifts until 1989, despite a doubling of premiums and a special $10.8 billion recapitalization program. During this period, a record 1,020 thrifts failed at a cost of about $100 billion to the deposit insurance funds for thrifts. Banks also failed at record rates. From 1980 to 1990, a total of 1,256 federally insured banks were closed or received FDIC financial assistance. Estimated losses to the bank insurance fund for resolving these banks was about $25 billion. These losses resulted in the bank insurance fund’s incurring annual net losses in 1988, 1989, and 1990 that jeopardized the fund’s solvency for the first time since FDIC’s inception.
Industry analysts have recognized many factors as contributing to the high level of thrift failures from 1980 to 1990. For example, thrifts faced increased competition from nondepository institutions, such as money-market funds and mortgage banks, as well as periods of inflation, recession, and fluctuating interest rates during that period. High interest rates and increased competition for deposits during the decade also created a mismatch between interest revenues from the fixed rate mortgages that constituted the bulk of the thrift industry’s assets and the cost of borrowing funds in the marketplace. Increased powers granted to thrifts in a period during which supervision did not keep pace has also been cited by some analysts, including us, as contributing to the problems of the industry.
Regulators and industry analysts have associated a number of factors with the problems of banks during the 1980s. First, banks suffered losses resulting from credit risk—risk of default on loans—in an environment of prolonged economic expansion and increasingly volatile interest rates. The decade began with crises in agricultural loans and loans to developing nations. Next, unrepaid energy loans took a toll and led to the downfall of several major banks, including Continental Illinois in Chicago and First RepublicBank in Texas. As the decade came to a close, highly leveraged transactions and the collapse of commercial real estate markets, in which banks had been heavy lenders, depleted the capital structures of some major East Coast and West Coast banks and led to their failures.
One factor we and others cited as contributing to the problems of both thrifts and banks during this period was excessive forbearance by federal regulators. Regulators had wide discretion in choosing the severity and timing of enforcement actions that they took against depository institutions with unsafe and unsound practices. In addition, regulators had a common philosophy of trying to work informally and cooperatively with troubled institutions. In a 1991 report, we found that this approach, in combination with regulators’ wide discretion in the oversight of financial institutions, had resulted in enforcement actions that were neither timely nor forceful enough to (1) correct unsafe and unsound banking practices or (2) prevent or minimize losses to the insurance funds. Regulators themselves recognized that their supervisory practices in the 1980s failed to adequately control risky practices that led to the numerous thrift and bank failures.

			Legislative Response to the Thrift and Bank Crisis of the 1980s

Congress passed two major laws to address the thrift and bank crisis of the 1980s. The first, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), was enacted primarily in response to the immediate problems surrounding FSLIC’s bankruptcy and troubles in the thrift industry. FIRREA created a new regulator for the thrift industry, OTS, and a new insurance fund, the Savings Association Insurance Fund (SAIF), to replace the bankrupt FSLIC. In addition, FIRREA increased the enforcement authority of both bank and thrift regulators. For example, FIRREA expanded the circumstances under which regulators could assess civil money penalties and increased the maximum penalty to $1 million per day. FIRREA also authorized FDIC to terminate a bank’s or thrift’s deposit insurance on the basis of unsafe and unsound conditions.
The second major piece of legislation, FDICIA, contains several provisions that were intended to collectively improve the supervision of federally insured depository institutions. Specifically, FDICIA requires a number of corporate governance and accounting reforms to (1) strengthen the corporate governance of depository institutions, (2) improve the financial reporting of depository institutions, and (3) help in the early identification of emerging safety-and-soundness problems in depository institutions. In addition, FDICIA contains provisions that were intended to improve how regulators supervise depository institutions.
Among the corporate governance and accounting reforms, FDICIA establishes generally accepted accounting principles as the standard for all reports and statements filed with the regulators. FDICIA also requires the management and auditors of depository institutions to annually report on their financial condition and management. The report is to include management’s assessment of (1) the effectiveness of the institution’s internal controls and (2) the institution’s compliance with designated laws and regulations. In addition, FDICIA requires the institution’s external auditors to report separately on management’s assertions. Furthermore, FDICIA requires the institutions to have an independent audit committee composed of outside independent directors.
Among the supervision provisions, FDICIA requires regulators to perform annual on-site examinations of insured banks and thrifts (an 18-month cycle was allowed for qualified smaller institutions with assets of less than $100 million). FDICIA’s sections 131 and 132 added two new sections to the Federal Deposit Insurance Act (sections 38 and 39) that require the implementation of a “trip wire” approach to increase the likelihood that regulators will address the problems of troubled institutions at an early stage to prevent or minimize loss to the insurance funds.

				Section 38 Provisions

Section 38 creates a capital-based framework for bank and thrift oversight that is based on the placement of financial institutions into one of five capital categories. Capital was made the centerpiece of the framework because it represents funds invested by an institution’s owners, such as common and preferred stock, that can be used to absorb unexpected losses before the institution becomes insolvent. Thus, capital was seen as serving a vital role as a buffer between bank losses and the deposit insurance system. Although section 38 does not in any way limit regulators’ ability to take additional supervisory action, it requires federal regulators to take specific actions against banks and thrifts that have capital levels below minimum standards. The specified regulatory actions are made increasingly severe as an institution’s capital drops to lower levels.
Section 38 requires regulators to establish criteria for classifying depository institutions into the following five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The section does not place restrictions on institutions that meet or exceed the minimum capital standards—that is, those that are well- or adequately capitalized—other than prohibiting the institutions from paying dividends or management fees that would drop them into the undercapitalized category.
A depository institution that fails to meet minimum capital levels faces several mandatory restrictions or actions under section 38. The mandatory actions are intended to ensure a swift regulatory response that would prevent further erosion of an institution’s capital. Specifically, section 38 requires an undercapitalized institution to submit a capital restoration plan detailing, among other things, how the institution is going to become adequately capitalized; restrict its asset growth during any quarter so that its average total assets for the quarter do not exceed the preceding quarter’s average total assets, unless certain conditions are met; and receive prior regulatory approval for acquisitions, branching, and new lines of business.
Section 38 allows regulators to take additional actions against an undercapitalized institution, if deemed necessary. It also requires regulators to closely monitor the institution’s condition and its compliance with section 38’s requirements.
Section 38 requires regulators to take more forceful corrective measures when institutions become significantly undercapitalized. Regulators must take 1 or more of 10 specified actions, including (1) requiring the sale of equity or debt or, under certain circumstances, requiring institutions to be acquired by or merged with another institution; (2) restricting otherwise allowable transactions with affiliates; and (3) restricting the interest rates paid on deposits by the institution. Each of these three steps is to be mandatory unless the regulator determines that taking such steps would not further the purpose of section 38, which is to resolve the problems of insured depository institutions at the least possible long-term loss to the insurance fund. Other specific actions available to the regulators include imposing more stringent asset growth limitations than required for undercapitalized institutions or requiring the institution to reduce its total assets; requiring the institution, or its subsidiaries, to alter, reduce, or terminate an activity that the regulator determines poses excessive risk to the institution; improving management by (1) ordering a new election for the institution’s board of directors, (2) dismissing directors or senior executive officers, and/or (3) requiring an institution to employ qualified senior executive officers; prohibiting the acceptance, including renewal and rollover, of deposits requiring prior approval for capital distributions from holding companies having control of the institution; and requiring divestiture by (1) the institution of any subsidiary that the regulator determines poses a significant risk to the institution, (2) the parent company of any nondepository affiliate that regulators determine poses a significant risk to the institution, and/or (3) any controlling company of the institution if the regulator determines that divestiture would improve the institution’s financial condition and future prospects.
Regulators can also require any other action that they determine would better resolve the problems of the institution with the least possible long-term loss to the insurance funds. Finally, section 38 prohibits significantly undercapitalized institutions from paying bonuses to or increasing the compensation of senior executive officers without prior regulatory approval.
Section 38 requires more stringent action to be taken against critically undercapitalized institutions. After an institution becomes critically undercapitalized, regulators have a 90-day period in which they must either place the institution into receivership or conservatorship or take other action that would better prevent or minimize long-term losses to the insurance fund. In either case, regulators must obtain FDIC concurrence with their actions. Section 38 also prohibits critically undercapitalized depository institutions from doing any of the following without FDIC’s prior written approval: entering into any material transaction (such as investments, expansions, acquisitions, and asset sales), other than in the usual course of business; extending credit for any highly leveraged transaction; amending the institution’s charter or bylaws, except to the extent necessary to carry out any other requirement of any law, regulation, or order; making any material change in accounting methods; engaging in any covered transaction; paying excessive compensation or bonuses; or paying interest on new or renewed liabilities at a rate that would increase the institution’s weighted average cost of funds to a level significantly exceeding the prevailing rates of interest on insured deposits in the institution’s normal market area.
In addition, section 38 prohibits a critically undercapitalized institution from making any payment of principal or interest on the institution’s subordinated debt beginning 60 days after becoming critically undercapitalized.
Finally, section 38 permits regulators to, in effect, downgrade an institution by one capital level if regulators determine that the institution is in an unsafe and unsound condition or that it is engaging in an unsafe and unsound practice. For example, regulators can treat an adequately capitalized institution as undercapitalized if the institution received a less than satisfactory rating in its most recent examination report for asset quality, management, earnings, or liquidity. This downgrading would then allow regulators to require the institution’s compliance with those restrictions applicable to undercapitalized institutions, such as limits on the institution’s growth. Thus, section 38 allows regulators to take enforcement actions against an institution that presents a danger to the insurance fund by virtue of a factor other than its capital level. In addition to the specific provisions of section 38, another section of FDICIA provides FDIC with the authority to appoint a conservator or receiver for undercapitalized institutions that meet certain criteria.

				Section 39 Provisions

To limit deposit insurance losses caused by factors other than inadequate capital, section 39 directs each regulator to establish standards defining safety and soundness in three overall areas: (1) operations and management; (2) asset quality, earnings, and stock valuation; and (3) compensation. Section 39 originally made the safety-and-soundness standards applicable to both insured depository institutions and their holding companies, but the reference to holding companies was deleted in 1994.
The section originally required regulators to prescribe safety-and-soundness standards through the use of regulations. For the operations and management standards, section 39 did not provide specific requirements other than requiring regulators to prescribe standards on internal controls, internal audit systems, loan documentation, credit underwriting, interest rate exposure, and asset growth. For asset quality, earnings, and—to the extent feasible—stock valuation, the section initially required regulators to establish quantitative standards. (See the next section for a discussion of amendments made to section 39’s original provisions.) Under compensation standards, regulators were to prescribe, among other things, standards specifying when compensation, fees, or benefits to executive officers, employees, directors, or principal shareholders would be considered excessive or could lead to material financial loss.
Section 39 initially contained a number of provisions concerning the failure to meet the regulators’ prescribed safety-and-soundness standards. One key provision of the section directed regulators to require a corrective action plan from institutions or holding companies that fail to meet any of the standards. Such plans were to specify the steps an institution or a holding company was taking or intended to take to correct the deficiency. Section 39 directed the regulators to establish specific deadlines for submission and review of the plans. If an institution or a holding company failed to submit or implement the plan, regulators were mandated to issue an order requiring the institution or holding company to correct the deficiency and to take one or more of the following remedial actions as considered appropriate: restrict the institution’s or holding company’s asset growth, require the institution or holding company to increase its ratio of tangible restrict interest rates paid on deposits, and/or require the institution or holding company to take any other action that the regulator determines would prevent or minimize losses to the insurance fund.
Section 39 also initially required regulators to take at least one of the first three previously mentioned remedial actions against institutions that (1) fail to meet any of the operational and/or asset quality standards listed in FDICIA, (2) have not corrected the deficiency, and (3) either commenced operations or experienced a change in control within the preceding 24 months or experienced extraordinary growth during the prior 18 months of failing to meet the standards.

				Riegle Community Development and Regulatory Improvement Act of 1994 Amended Section 39’s Provisions

The Riegle Community Development and Regulatory Improvement Act of 1994 (CDRI) was passed on September 23, 1994, and contains more than 50 provisions that were intended to reduce bank regulatory burden and paperwork requirements. Among its provisions, CDRI amended some of section 39’s requirements to provide regulators with greater flexibility and to respond to concerns that section 39 would subject depository institutions to undue “micromanagement” by the regulators. The CDRI amendments allow regulators to issue the standards in the form of guidelines instead of regulations. If guidelines are used, the amendments give the regulators the discretion to decide whether a corrective action plan will be required from institutions that are found not to be in compliance with the standards. Finally, the amendments eliminate the requirement that regulators issue quantitative standards for asset quality and earnings and exclude holding companies from the scope of the standards.
CDRI did not change section 39’s original provisions regarding the content and review of any plan required as a result of noncompliance with section 39’s safety-and-soundness standards. Thus, regulators still are required to issue regulations governing the contents of the plan, time frames for the submission and review of the plans, and enforcement actions applicable to the failure to submit or implement a required plan.

			Condition of the Bank and Thrift Industries Has Improved

Since the passage of FDICIA in 1991, the financial condition of the bank and thrift industries has improved substantially. As shown in table 1.1, the net income of banks more than doubled between 1991 and 1995, reaching a record high of $48.8 billion in 1995.
Table 1.1 also shows that the net income of thrifts grew dramatically in 1992 from the 1991 level, decreased slightly in 1993 and 1994, and grew to a record $7.6 billion in 1995. In the period from 1992 through 1995, the number of bank and thrift failures declined from their 1980 to 1990 levels. For example, 6 banks failed in 1995, compared with 169 bank failures in 1990.
The low number of bank failures in recent years has allowed the bank insurance fund to rebuild its reserve level. After falling to a record low of negative $7 billion in 1991, the fund grew to over $25 billion in 1995. The recapitalization of the bank insurance fund allowed FDIC to reduce the deposit insurance assessment rate paid by commercial banks twice in the latter part of 1995. As a result, commercial banks are paying the lowest average assessment rate in history.
Despite the improved performance of the thrift industry, the thrift insurance fund remained undercapitalized as of December 1995. FDICIA required FDIC to increase the bank and thrift insurance funds’ reserve balances to at least 1.25 percent of the estimated insured deposits of insured institutions within 15 years of enactment of a recapitalization schedule. FDIC achieved this reserve ratio for the bank insurance fund on May 31, 1995. However, SAIF is not expected to achieve its required reserve ratio until 2002, according to FDIC. Thus, insurance fund premiums paid by thrifts remain significantly higher than those paid by commercial banks.

		Objectives, Scope, and Methodology

The principal objective of this review was to assess the progress and results of the federal regulators’ implementation of FDICIA’s Prompt Regulatory Action provisions. Specifically, we assessed (1) the efforts of federal regulators to implement sections 38 and 39 and (2) the impact of sections 38 and 39 on federal oversight of the bank and thrift industries.
To assess the federal regulators’ efforts to implement sections 38 and 39, we compared the legislative provisions with the implementing regulations and guidelines developed and issued by the regulators. In addition, we asked for and reviewed additional guidance developed by OCC and FRS. We concentrated our assessment on OCC and FRS because the FDIC and Treasury Offices of the Inspector General (OIG), respectively, had performed similar reviews of FDIC’s and OTS’ implementation of section 38. To the extent possible, we used the results of the FDIC OIG effort to compare and contrast with the results of our review of OCC’s and FRS’ implementation of section 38. We did not include the Treasury OIG’s results because the OIG was in the process of finalizing its evaluation. However, the OIG reviews did not assess FDIC’s or OTS’ implementation of section 39.
We also assessed OCC’s and FRS’ implementation of section 38 by analyzing the supervisory actions used on the 61 banks that were undercapitalized (including those that were significantly and critically undercapitalized) for section 38 purposes. We identified the 61 banks using financial data (call reports) obtained from FDIC for the quarters ending December 1992 through December 1994. In the case of OCC, we looked at all of the 52 undercapitalized banks that were located in OCC’s Western, Southwest, and Northeast districts. These data provided us with coverage of 68 percent of all OCC-regulated banks that were undercapitalized during that period. For FRS, we looked at all nine undercapitalized banks under the jurisdiction of FRS’ Atlanta, Dallas, and San Francisco district banks. Doing so resulted in a coverage of 56 percent of all FRS-regulated banks that were undercapitalized during that period. While our results are not projectable to all undercapitalized banks under OCC’s and FRS’ jurisdiction, our results are representative of the OCC and FRS locations that we visited.
As part of our assessment of (1) OCC’s and FRS’ efforts to implement sections 38 and 39 and (2) the impact of the sections on regulatory oversight, we interviewed OCC and FRS officials in the previously mentioned locations as well as in Washington, D.C. We obtained the officials’ views on the legislative intent underlying sections 38 and 39 and the evolution of the final regulations and guidelines. We also had discussions with the officials about regulatory actions, both under their traditional enforcement and section 38 authority, taken against the 61 banks that we reviewed. Additionally, we interviewed FDIC and OTS officials to obtain information on the interagency process used to develop the safety-and-soundness standards required to implement section 39.
To assess the impact of sections 38 and 39 on the regulatory oversight of banks and thrifts, we used the 61 banks that we determined were undercapitalized for section 38 purposes to evaluate OCC’s and FRS’ use of their section 38 authority (reclassification and directives) versus the use of traditional enforcement tools. In addition, we reviewed OCC’s and FRS’ internal guidance and policies regarding the use of section 38 versus their other enforcement tools. We also obtained and analyzed information on the number of banks that the regulators had determined were undercapitalized for section 38 purposes versus the number of banks they had identified as being “problem” banks. We analyzed various articles and economic literature issued on (1) the impact of sections 38 and 39 on the regulatory process and (2) the implications of a capital-based regulatory approach in general. Additionally, we used OIG and our prior report results and recommendations to assess the content of the implementing regulations and guidelines as well as the likely impact of section 38 on the regulatory process.
We did our work from November 1994 to September 1996 in accordance with generally accepted government auditing standards. We provided a draft of this report to the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision for their review and comment. A summary of the agencies’ comments and our evaluation are included at the end of chapter 3. The agencies’ comment letters are reprinted in appendixes III to VI. Staff of OCC and FDIC also provided additional technical comments on the draft report, which were incorporated as appropriate.

	Few Institutions Have Been Subject to Enforcement Actions Under Sections 38 and 39

Regulators have taken steps to implement FDICIA’s Prompt Regulatory Action provisions. However, the financial condition of banks and thrifts has improved since the passage of FDICIA in 1991 because relatively few institutions have been considered undercapitalized under section 38 as of September 1996. Our review of a sample of 61 undercapitalized banks found that OCC and FRS have generally met section 38 requirements regarding the identification of undercapitalized institutions, the receipt and review of capital restoration plans, and the closure of critically undercapitalized institutions. Our finding was consistent with the FDIC OIG’s conclusions regarding FDIC’s implementation of section 38. All three regulators (OCC, FRS, and FDIC) had virtually no experience in using their section 38 reclassification authority and had used their section 38 authority to take enforcement actions on a relatively small number of institutions.
As of September 1996, none of the regulators had used section 39 enforcement powers. All but two of the safety-and-soundness standards required for the implementation of section 39 became effective in August 1995. The remaining two standards—asset quality and earnings—became effective on October 1, 1996, allowing for the full implementation of section 39. The regulators explained that they missed the December 1993 statutory deadline for the implementation of section 39 due to (1) the complication of developing standards on an interagency basis, (2) the concern of ensuring that the standards did not unnecessarily add to the existing regulatory burden of depository institutions, and (3) the knowledge that Congress was considering amending section 39’s requirements governing the standards.

		Few Financial Institutions Have Been Undercapitalized Under Section 38

Regulations issued by the four regulators to implement section 38 requirements are intended to ensure that prompt regulatory action is taken whenever an institution’s capital condition poses a threat to federal deposit insurance funds. Banks and thrifts have increased their capital levels since the passage of FDICIA so that relatively few financial institutions have been subject to section 38 regulatory actions in the 3 years that the regulations were in effect. Between December 1992—the effective date of the regulations—and December 1995, the number and total assets of institutions that were undercapitalized had decreased from about 2 percent in 1992 to less than one-quarter of 1 percent of all banks and thrifts by 1995.
The regulators jointly developed the implementing regulations for section 38 and based the criteria for the five capital categories on international capital standards and section 38 provisions. The four regulators specifically based the benchmarks for an adequately capitalized institution on the Basle Committee requirement, which stipulates that an adequately capitalized international bank must have at least 8 percent total risk-based capital and 4 percent tier 1 capital. For the definition of a critically undercapitalized institution, the regulators adopted section 38’s requirement of a tangible equity ratio of at least 2 percent of total assets. The regulators based the criteria for the remaining three capital categories on these two benchmarks.
As shown in table 2.1, three capital ratios are used to determine if an institution is well-capitalized, adequately capitalized, undercapitalized, or significantly undercapitalized. A well-capitalized or adequately capitalized institution must meet or exceed all three capital ratios for its capital category. To be deemed undercapitalized or significantly undercapitalized, an institution need only fall below one of the ratios listed for its capital category. Although not shown in the table, a fourth ratio—tangible equity—is used to categorize an institution as critically undercapitalized. Any institution that has a 2-percent or less tangible equity ratio is considered critically undercapitalized, regardless of its other capital ratios.
So far, relatively few financial institutions have been categorized as undercapitalized and, thus, subject to section 38 regulatory actions. This situation was due, in part, to the improved financial condition of the bank and thrift industries. The implementation of section 38 also provided institutions with strong incentives to increase their capital levels to avoid the mandatory restrictions and supervisory actions associated with being undercapitalized. As shown in table 2.2, the number of financial institutions whose reported financial data indicated undercapitalization, based on section 38 implementing regulations, steadily declined between December 1992 and December 1995. The beginning of the decline coincided with the December 1992 implementation of section 38.
Data reported by financial institutions indicated that 252 banks and thrifts, or about 2 percent of those institutions, were undercapitalized in December 1992, including those that were significantly and critically undercapitalized. As of December 1995, only 29 banks and thrifts, or about one-quarter of 1 percent of all banks and thrifts, fell into the undercapitalized categories.

		Regulators Complied With the Basic Requirements of Section 38

Our review of regulatory actions at 61 sample banks indicated that OCC and FRS complied with the basic requirements of section 38 and its implementing regulations. Specifically, OCC and FRS categorized the banks in accordance with section 38 criteria and notified undercapitalized banks of the restrictions and regulatory actions associated with their capital category. In addition, OCC and FRS typically obtained and reviewed the required capital restoration plans within the time frames specified by section 38. Moreover, the two regulators generally took action to close the critically undercapitalized banks as required by section 38. Both regulators had limited experience with issuing section 38 directives or using their reclassification authority. The FDIC OIG reported similar results regarding FDIC’s implementation of section 38.

			OCC and FRS Classified Banks in Accordance With Section 38 Requirements

OCC and FRS correctly identified and categorized the 61 sampled banks using criteria specified in section 38 legislation and implementing regulations. While primarily relying on call reports, they also used the on-site examination process to identify undercapitalized banks. The regulators then sent notices to those banks to inform the banks of their undercapitalized status and the associated section 38 mandatory restrictions, requirements, and regulatory responses.
In the jurisdictions of the offices that we visited, OCC and FRS identified a total of 61 banks as being undercapitalized at some point from December 1992 through December 1994. The two regulators identified 60 banks as undercapitalized on the basis of the call report data reported to the regulators on a quarterly basis. FRS identified an additional bank as being undercapitalized on the basis of the results of an on-site safety-and-soundness examination. Table 2.3 shows the distribution of the banks in our sample by regulator and section 38 capital category.
OCC and FRS sent the required notices to the management of the 61 banks in our sample informing them of their banks’ undercapitalized status. The notification letters advised the banks of the mandatory requirements and restrictions associated with their section 38 capital category. For significantly and critically undercapitalized banks, the notification letters also pointed out the additional mandatory and discretionary regulatory responses or actions associated with their section 38 capital categorization.

			Capital Restoration Plan Requirements Were Generally Met

OCC and FRS generally met section 38 requirements governing capital restoration plans (CRP). Section 38 requires banks to prepare a CRP within 45 days of becoming undercapitalized and allows regulators 60 days to review the CRP. For the 61 banks that we reviewed, OCC and FRS were generally successful in getting banks to submit the plans on time and in meeting the required time frames for reviewing and approving or rejecting the plans.
Section 38 provisions require that CRPs prepared by undercapitalized institutions contain certain elements. Specifically, the section requires that CRPs specify the steps that the institution will take to become adequately capitalized, the levels of capital the institution will attain during each year the plan will be in effect, how the institution will comply with the restrictions or requirements applicable to its undercapitalization capital category, and the types and levels of activities in which the institution will engage.
Section 38 prohibits regulators from accepting a CRP unless it (1) contains the previously mentioned required elements, (2) is based on realistic assumptions and is otherwise likely to succeed, and (3) would not appreciably increase the institution’s riskiness. Holding companies are required to guarantee the institution’s compliance with the CRP and to provide adequate assurance of performance.
Although the notification letters sent to the 61 undercapitalized banks in our review indicated that a CRP was required, only 44 banks submitted a CRP. Of the 17 banks that did not submit CRPs, 15 experienced conditions within the first few months of becoming undercapitalized that, according to the regulator, precluded the need for a CRP. Specifically, nine failed, two merged with other banks, one was voluntarily liquidated, and three became adequately capitalized.
OCC chose not to pursue obtaining CRPs from the remaining two banks. In one case, OCC deferred its enforcement efforts pending the results of an ongoing investigation by the Federal Bureau of Investigation and local enforcement authorities into potential criminal activity by the bank’s management. In the second case, OCC issued a section 38 directive instead of formally enforcing the requirement that the bank submit a CRP to achieve corrective action in a more timely fashion.
OCC and FRS were generally successful in getting the 44 institutions that submitted CRPs to meet the 45-day requirement. As shown in table 2.4, 10 banks exceeded the 45-day requirement, but most had submitted CRPs within 55 days.
OCC and FRS were typically successful in meeting the 60-day time frame for reviewing the 44 CRPs submitted by the banks in our sample. As shown in table 2.5, the regulators met the 60-day requirement on all but one applicable case where data were available to make a determination.
Of the 44 CRPs submitted by the banks that we looked at, OCC and FRS rejected 30 of the CRPs as inadequate and required those banks to revise and resubmit them. The regulators used the criteria specified in section 38 legislation to determine whether a CRP was acceptable. Ultimately, the regulators approved 29 of the CRPs submitted by the undercapitalized banks that we reviewed. Of the 15 banks whose CRPs were not approved, 10 ultimately failed. One of the 15 banks merged with another bank, and the remaining 4 banks obtained enough capital to eliminate the need for a CRP.

			OCC and FRS Closed Critically Undercapitalized Banks Within the Required Time Frame

As required by section 38, OCC and FRS have generally taken action to close critically undercapitalized banks within a specified time frame. Under section 38, regulators are required to close critically undercapitalized institutions within 90 days of the institutions’ becoming critically undercapitalized unless the regulator and FDIC concur that other actions would better protect the insurance funds from losses.
As previously shown in table 2.3, there were 25 critically undercapitalized banks in our sample. OCC and FRS closed 17 of these banks because they were critically undercapitalized. Fifteen of the 17 banks were closed within the prescribed 90-day period. In the case of the two banks that were closed after the 90-day deadline had expired, regulators approved the delay to allow FDIC more preparation time for the orderly closure of the banks. For the remaining 8 critically undercapitalized banks in our sample, 1 merged and the other 7 improved their capital position above the critically undercapitalized level before the end of the 90-day period.

			Few Institutions Were Subject to Section 38 Enforcement Actions

From December 1992 to September 1996, OCC and FRS used their section 38 authority to initiate directives against 8 of the 61 banks in our sample. Section 38 requires regulators to take specific regulatory actions against significantly undercapitalized institutions and to make the use of these actions discretionary for other undercapitalized institutions. In those instances in which section 38 directives were used, both OCC and FRS complied with the governing requirements of section 38 legislation and implementing regulations.
As previously discussed in chapter 1, section 38 mandates regulators to take at least 1 of 10 specified actions against significantly undercapitalized institutions. The section also provides regulators with discretionary authority to take any of the 10 specified actions that they consider appropriate against undercapitalized institutions.
OCC used directives against a relatively small number of the banks in our sample. Of the 52 OCC-regulated banks we reviewed, 16 were significantly undercapitalized at some time between December 1992 and December 1994, according to their call report data. Thus, unless the status of the banks changed, OCC would have been expected to have initiated a directive against the 16 banks to take the enforcement actions mandated by section 38. However, OCC only initiated directives against five of these banks. Seven of the remaining 11 banks either failed, merged, or improved their capital status within 90 days of becoming significantly undercapitalized, thus eliminating the need for OCC to issue a directive. OCC officials told us that directives were not initiated against the remaining four significantly undercapitalized banks because they were already subject to formal enforcement actions that OCC believed were similar to those that would be covered by directives. Thus, initiating a directive would have duplicated the existing, ongoing enforcement actions.
FRS initiated directives against three of the seven FRS-regulated banks in our sample that were categorized as significantly undercapitalized at some point between December 1992 and December 1994. According to FRS, the need for it to issue directives was precluded for three significantly undercapitalized banks because they improved their capital status, merged with another institution, or were voluntarily liquidated shortly after becoming significantly undercapitalized. FRS did not initiate a directive against the remaining significantly undercapitalized bank because the applicable corrective actions were already under way in connection with existing federal and state enforcement actions and in connection with the bank’s CRP.

			OCC and FRS Reclassified Two Banks

From December 1992 to September 1996, OCC and FRS used their reclassification authority in two instances. Section 38 authorizes bank regulators under certain circumstances to downgrade, or treat as if downgraded, an institution’s capital category if (1) it is in an unsafe or unsound condition or (2) it is deemed by the regulator to be engaging in an unsafe or unsound practice. Reclassifying an institution to the next lower capital category allows regulators to subject the institution to more stringent restrictions and sanctions.
According to OCC officials, OCC would use its section 38 reclassification authority only if its traditional enforcement actions had not been successful in correcting a bank’s problems. OCC officials told us that they prefer to use their traditional enforcement authority for several reasons. One reason was the broader range of options that OCC’s traditional enforcement actions provide both in the areas covered by the enforcement action as well as in the degree of severity of the action. Another reason that OCC prefers to use its traditional enforcement actions is the bilateral nature of these actions. According to OCC officials, traditional enforcement actions, such as a formal written agreement between the regulator and an institution, may achieve greater acceptance by the institution for taking corrective action than the unilateral nature of section 38 reclassifications and/or directives. However, OCC officials said that reclassification under section 38 can sometimes allow them to initiate certain actions faster (i.e., through directives) than would be possible using their traditional enforcement actions.
In the one case involving OCC reclassification, the agency reclassified a bank from adequately capitalized to undercapitalized because (1) OCC believed the bank was operating in an unsafe and unsound condition that would impair its capital levels and (2) the bank had not complied with earlier OCC enforcement actions. The reclassification allowed OCC to initiate a directive that, among other requirements, mandated the dismissal of a senior bank official and a director who OCC believed were responsible for the bank’s deteriorated condition. Despite OCC’s use of its reclassification authority and a section 38 directive, the bank’s condition deteriorated further until it failed 8 months later.
FRS has an internal policy that requires all problem banks, which it defined as banks with a composite rating of 4 or 5, to be considered operating in an unsafe and unsound condition and, thus, candidates for reclassification. Between December 1992 and December 1994, 58 banks had a FRS-assigned composite rating of 4 or 5. In its only use of its reclassification authority, FRS reclassified a well-capitalized bank to adequately capitalized because of continuous deterioration in the bank’s asset quality, earnings, and liquidity. This bank’s capital levels subsequently deteriorated to the point where it was considered significantly undercapitalized. The bank has since improved its capital to the well-capitalized category and is no longer considered to be a problem institution by FRS.

			OIG Reported Similar Section 38 Compliance by FDIC

In September 1994, the FDIC OIG reported that FDIC had generally complied with the provisions of section 38 and its implementing regulations. Table 2.6 compares the three regulators’ implementation of specific section 38 provisions.

		Regulators Had Not Used Their Section 39 Enforcement Authority

As of September 1996, regulators had not used their section 39 enforcement authority against an institution. In July 1995, regulators issued final guidelines and regulations to implement parts of section 39. Specifically, the regulators issued standards governing operations and management and compensation. They also issued requirements for submission and review of compliance plans. The regulators issued the remaining standards required for the full implementation of section 39—asset quality and earnings—in August 1996.
FDICIA had established a deadline of December 1, 1993, for the implementation of section 39. Regulators said they were unable to meet that deadline because of (1) the difficulty of jointly developing the standards, (2) the concerns of regulators and financial institutions that the implementation of section 39 could increase existing regulatory burden for banks and thrifts, and (3) the knowledge that Congress was considering amending the section 39 requirements to provide regulators with greater flexibility and discretion in their implementation of the section.

			Interagency Process and Concerns About Regulatory Burden Complicated the Development of Required Standards

According to the regulators, developing and issuing safety-and-soundness standards was complicated by the interagency process and by concerns about the potential regulatory burden associated with the standards. Unlike the process for promulgating capital standards under section 38, which used the Basle Accord as a reference point, the regulators had no generally accepted standards to use as the basis for the safety-and-soundness standards. In addition, the regulators told us that the legislative history for section 39 did not provide specific guidance on the standards envisioned by Congress. Furthermore, the regulators wanted to ensure that the section 39 standards did not increase the bank and thrift industries’ regulatory burden without a corresponding benefit to the federal deposit insurance funds and taxpayers.
OCC and FRS officials said that the lack of generally agreed upon standards for the areas covered by section 39 contributed to delays in developing and issuing the section’s standards. They explained that regulators consider numerous variables in assessing an institution’s safety and soundness. As a result, developing standards on an interagency basis for areas such as internal controls and interest rate exposure was difficult. According to the officials, the various regulators had different viewpoints as to how specific or general the standards should be.
On July 15, 1992, the regulators issued a joint solicitation of comments on the section 39 safety-and-soundness standards. In soliciting the views of the banking industry on the form and content of the standards, the regulators said that they were concerned with “establishing unrealistic and overly burdensome standards that unnecessarily raise costs within the regulated community.” The four regulators collectively received over 400 comment letters, primarily from banks and thrifts. According to the regulators, the comments strongly favored adopting general standards, rather than specific standards, to avoid regulatory “micromanagement.”
The regulators considered the public comments in developing the proposed standards that were published on November 18, 1993. The regulators proposed standards for the following three areas required by section 39: (1) operations and management, (2) asset quality and earnings, and (3) compensation. According to the notice of proposed rulemaking, regulators proposed general standards, rather than detailed or quantitative standards, to “avoid dictating how institutions are to be managed and operated.”
However, as required by section 39 before its amendment in 1994, the regulators proposed two quantitative standards—a maximum ratio of classified assets-to-capital and a formula to determine minimum earnings sufficient to absorb losses without impairing capital. Section 39 also required the regulators to set, if feasible, a minimum ratio of market-to-book value for publicly traded shares of insured institutions as a third quantitative standard. The regulators determined that issuing such a standard was technically feasible, but they concluded that it was not a reasonable means of achieving the objectives of the Prompt Regulatory Action provisions. The regulators explained that an institution’s stock value can be affected by factors that are not necessarily indicative of an institution’s condition, such as the performance of the general stock market and industry conditions. As a result, the regulators believed that a market-to-book value ratio would not be an operationally reliable indicator of safety and soundness. Therefore, the regulators ultimately decided against proposing a market-to-book value ratio as a third quantitative standard.
The proposed regulations also described procedures for supervisory actions that were consistent with those contained in the section 39 legislation for institutions failing to comply with standards. Specifically, the proposed regulations required institutions to prepare and submit a compliance plan within 30 days of being notified by the regulator of their noncompliance. The plan was to include a description of the steps the institution intended to take to correct the deficiency. Regulators would then have 30 days to review the plan. In addition, the proposed regulations specified enforcement actions regulators would take if an institution failed to submit an acceptable compliance plan or failed to implement the plan.
The regulators collectively received 133 comment letters, primarily from financial institutions, in response to the November 18, 1993, notice of proposed rulemaking. According to the four regulators, those who commented generally found the agencies’ proposed standards, including the two quantitative standards, acceptable. However, some of those who commented criticized the proposed quantitative standards as inflexible and overly simplistic.

			Consideration of Legislative Amendments to Section 39 Contributed to Additional Delays in Its Implementation

OCC and FRS officials attributed further delays in implementing section 39 to their knowledge that in the period from late 1993 to mid-1994, Congress was considering legislation that would amend section 39’s requirements. Congress was considering amending section 39 to reduce the administrative requirements for insured depository institutions consistent with safe-and-sound banking practices. After CDRI was passed in September 1994, regulators needed additional time to revise the standards they proposed in November 1993 to take advantage of the additional flexibility provided by the section 39 amendments.
On July 10, 1995, the regulators published final and proposed guidelines and regulations to implement section 39, as amended. The final guidelines covered operational and managerial standards, including internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, and asset growth, and compensation standards.
The final guidelines were effective in August 1995. Along with the final guidelines, regulators proposed new standards for asset quality and earnings. The final standards for asset quality and earnings were issued on August 27, 1996, with an effective date of October 1, 1996.
The final standards contained in the guidelines are less prescriptive on the institutions than those proposed in November 1993. For example, under internal controls and information systems, the guidelines specified that the “institution should  have internal controls and information systems, that are appropriate to the size of the bank and the nature and scope of its activities.”  In addition, the regulators used the additional flexibility provided by CDRI to eliminate the two previously proposed quantitative standards for classified assets and earnings. According to the regulators, the use of general rather than specific standards was supported by the overwhelming number of commenters responding to the regulators’ request for comments on the section 39 safety-and-soundness standards. Moreover, the use of guidelines instead of regulations gives the regulators flexibility in deciding whether to require a compliance plan from an institution found to be in noncompliance with the standards.
The regulators issued regulations addressing the (1) required content of compliance plans, (2) time frames governing the preparation and review of a plan, and (3) regulatory actions applicable to the failure to submit or comply with a plan. The compliance plan regulations were issued jointly on July 10, 1995, with the section 39 guidelines governing the operational, managerial, and compensation standards. Both the guidelines and regulations became effective in August 1995.

	The Effectiveness of Sections 38 and 39 Is Yet to Be Determined

FDICIA’s Prompt Regulatory Action provisions granted additional enforcement tools to regulators and provided more consistency in the treatment of capital-deficient institutions. However, sections 38 and 39, as implemented, raise questions about whether regulators will act early and forcefully enough to prevent or minimize losses to the insurance funds. Section 38 does not require regulators to take action until an institution’s capital drops below the adequately capitalized level. However, depository institutions typically experience problems in other areas, such as asset quality and management, long before these problems result in impaired capital levels. Moreover, regulators have wide discretion governing the application of section 39 because the guidelines and regulations implementing section 39, as amended, do not (1) establish clear and specific definitions of unsound conditions and practices or (2) link such conditions or practices to specific mandatory regulatory actions.
Other initiatives that have been undertaken as a result of FDICIA, as well as the regulators’ recognition of the need to be more proactive in preventing unsafe and unsound practices, may help increase the likelihood that sections 38 and 39 will be used to provide prompt and corrective regulatory action. FDICIA’s corporate governance and accounting reform provisions were designed to improve management accountability and facilitate early warning of safety-and-soundness problems. In addition, FDICIA requires regulators to revise the risk-based capital standards to ensure that reported capital accurately reflected the institution’s risk of operations. Regulators have also announced new initiatives to improve monitoring and control of bank risk-taking, but these initiatives have not been fully implemented or tested. The success of these initiatives, coupled with the regulators’ willingness to use their various enforcement authorities, including sections 38 and 39, will be instrumental in determining whether losses to the insurance funds are prevented or minimized in the future.

		Section 38 Appears to Have Produced Some Benefits

Available evidence suggests that the implementation of the section 38 capital standards between 1992 and 1995, along with other factors, has benefited the bank and thrift industries and may have helped improve federal oversight. Specifically, the section 38 standards (1) provide financial institutions with incentives to raise equity capital, (2) should help regulators prevent seriously troubled institutions from taking actions that could compound their losses, and (3) should help ensure more timely closure of near-insolvent institutions. In addition, regulatory officials have stated that section 38 serves as an important supplemental enforcement tool.
According to the regulators and banking industry analysts, section 38 provides depository institutions with strong incentives to raise additional equity capital. These officials explained that financial institutions were concerned about the potential ramifications of becoming undercapitalized, and the institutions raised additional equity capital to avoid potential sanctions. Once the implementing regulations were issued, depository institutions had clear benchmarks as to the levels of capital they needed to achieve to avoid mandatory regulatory intervention. Since the implementation of section 38, thanks in part to record industry profits, the capital levels of banks and thrifts have reached their highest levels since the 1960s.
Another benefit of the section 38 capital standards is that they should help prevent certain practices and conditions that rapidly eroded the capital of troubled institutions from 1980 to 1990 and contributed to deposit insurance fund losses. For example, section 38 standards impose growth restrictions to prevent undercapitalized and significantly undercapitalized institutions from trying to “grow” their way out of financial difficulty. As a result, it should be more difficult for these institutions to rapidly expand their asset portfolios and increase potential insurance fund losses, as many thrifts did during the 1980s. Section 38 also requires regulators to prohibit undercapitalized institutions from depleting their remaining capital by paying dividends.
OCC and FRS officials told us that another benefit of section 38 is the mandatory closure rule for critically undercapitalized institutions. These officials explained that before the implementation of section 38, regulators typically waited until an institution had 0-percent equity capital before closing it as insolvent. The officials also said that under section 38, they now have a clear legal mandate for closing problem institutions at 2-percent tangible equity capital, which should provide the insurance funds with a greater cushion against losses.
Regulatory officials we contacted also said that section 38 serves as a useful supplement to their traditional enforcement authority. For example, OCC officials said that section 38 directives allow for the prompt removal of bank officials when the agency believes such officials are responsible for the bank’s financial and operational deterioration. OCC officials said that before FDICIA, removing such individuals took longer, sometimes up to several months.

		Section 38’s Capital-Based Regulatory Approach Has Inherent Limitations

Although the capital-based regulatory approach strengthens federal oversight in several ways, by itself it has significant limitations as a mechanism to provide early intervention to safeguard the insurance funds. Capital is a lagging indicator of a financial institution’s deterioration. Troubled institutions may already have irreversible financial and operational problems that would inevitably result in substantial insurance fund losses by the time their capital deteriorates to the point where mandatory enforcement actions are triggered under section 38. In addition, troubled institutions often fail to report accurate information on their true financial conditions. As a result, many troubled institutions that have serious safety-and-soundness problems may not be subject to section 38 regulatory actions.

			Capital Is a Lagging Indicator of Financial and Operational Deterioration

Capital has been a traditional focus for regulatory oversight because it is a reasonably obvious and accepted measure of financial health. However, our work over the years has shown that, although capital is an important focus for oversight, it does not typically begin to decline until an institution has experienced substantial deterioration in other components of its operations and finances. It is not unusual for an institution’s internal controls, asset quality, and earnings to deteriorate for months, or even years, before conditions require that capital be used to absorb losses. As a result, regulatory actions, such as requirements for capital restoration plans or growth limits, may have only marginal effects because of the extent of deterioration that may have already occurred.

			Reported Capital Levels Do Not Always Accurately Reflect Institutions’ Financial Troubles

Relating regulatory actions to capital alone has another inherent limitation in that reported capital levels do not always accurately reflect troubled institutions’ actual financial conditions. Troubled institutions have little incentive to report the true level of problem assets or to establish adequate reserves for potential losses. As a result, some institutions’ reported capital levels were often artificially high. The reporting of inaccurate capital levels was evident from 1980 to 1990 as many of the troubled institutions, which reported some level of capital before failing, ultimately generated substantial losses to the insurance fund. Thus, capital-driven regulatory responses would likely have had limited effectiveness since the institutions were already functionally insolvent. As illustrated by the following example, troubled institutions’ reported capital levels can plummet rapidly in times of economic downturn.

				Problems Experienced by Regulators in the 1980s With New England Banks

In the 1980s, many New England banks, with average equity capital ratio levels exceeding the regulatory minimum requirements then in existence, were engaged in aggressive high-risk commercial real estate lending. These banks frequently ignored basic risk diversification principles by committing a substantial percentage of their lending portfolios to construction, multifamily housing, and commercial real estate lending—in some cases as high as 50 percent. This practice tied their future financial health to those industries.
When the New England economy fell into recession in the late 1980s and early 1990s, many of the poorly managed banks in the region experienced a deterioration in their asset quality, earnings, and liquidity well before their capital levels declined. For example, once regulators recognized the recession’s effect on the Bank of New England portfolios, examiners required the bank to adversely classify an increasing number of loans—especially commercial real estate loans whose repayment was questionable due to the economic downturn. As the level of classified loans increased, the examiners required the Bank of New England to establish reserves for potential loan losses, which reduced the bank’s earnings. Subsequently, the bank suffered continued earnings deterioration and had to use its capital to absorb those losses.
The Bank of New England’s managers and regulators had few options for maintaining solvency and, ultimately, for minimizing insurance fund losses. The available options included reducing the institution’s inventory of classified loans by selling assets, raising capital through public offerings, or selling the institution to a healthy buyer. The managers’ and regulator’s ability to carry out these strategies was constrained by the region’s economic downturn, since few investors were willing to purchase the assets of problem banks or to inject new capital into them without some form of financial assistance from FDIC. Ultimately, the bank failed, resulting in a loss to the bank insurance fund of $841 million. Other failed banks in the New England area followed a similar pattern, resulting in substantial losses to the insurance fund.

			Most Troubled Institutions Were Not Subject to Section 38 Capital Standards

Another reason that section 38, used alone, is a limited mechanism to protect deposit insurance funds, is that most troubled institutions do not fall into undercapitalized categories, including some that ultimately fail. Consequently, regulators overseeing even the most troubled institutions generally would not be compelled to initiate mandatory enforcement actions under section 38.
We reviewed data compiled by FDIC that showed that many severely troubled institutions in the period from December 1992 to December 1995 did not fall into section 38’s undercapitalized categories. Therefore, these institutions were not subject to the section’s mandatory enforcement actions. On a quarterly basis, FDIC reports on the number of “problem” institutions. These institutions have regulator-assigned composite ratings of 4 or 5 because they typically have severe asset quality, liquidity, and earnings problems that make them potential candidates for failure. These institutions are also typically subject to more intensive oversight, including more frequent examinations by regulators and more frequent required reporting by the institutions on their financial conditions.
As of December 31, 1995, 193 banks and thrifts were on FDIC’s problem institution list. However, only 29 institutions were categorized as undercapitalized under section 38 criteria. We made similar comparisons for 1992 through 1995 and found that only 15 to 24 percent of the problem institutions were categorized as undercapitalized under section 38 criteria (see table 3.1).
Moreover, a recent study assessed the effectiveness of the current section 38 capital standards in identifying problem institutions and mandating enforcement actions by applying the section 38 standards to the troubled banks of an earlier period. The study concluded that the majority of banks that experienced financial problems between 1984 and 1989 would not have been subject to the capital-based enforcement actions of section 38, if they had been in effect. For example, the study found that 54 percent of the banks that failed within the subsequent 2 years would have been considered to be well- or adequately capitalized between 1984 and 1989. Thus, even if the section 38 standards had been in place in the 1980s, these troubled banks would not have been subject to section 38’s mandatory restrictions and supervisory actions.
The study attributed the limitations that the current section 38 standards have in identifying troubled financial institutions to weaknesses in the risk-based capital ratio used by the regulators. Specifically, the study stated that the risk-based ratio does not (1) account for the fact that many banks do not adequately reserve for potential loan losses or (2) assign an adequate risk weight to cover the level of adversely classified assets that a bank may have on its books. Although the regulators are in the process of revising the risk-based capital standards, the revisions announced as of September 1996 do not address the two previously mentioned factors. The regulators’ efforts to revise the risk-based capital standards are discussed later in this chapter and in appendix I.

			Mechanics National Bank’s Failure Illustrates Limitations of Capital Standards

The 1994 failure of one of the banks reviewed by the Treasury OIG, Mechanics National Bank of Paramount, California, illustrated some of the limitations of section 38 capital standards. The Treasury OIG found that despite OCC’s aggressive use of section 38 enforcement actions, OCC did not reverse the bank’s decline or prevent material loss to the bank insurance fund. The bank’s failure also demonstrated that severely troubled banks may not be subject to section 38’s restrictions and mandatory enforcement actions for a substantial period.
According to the Treasury OIG report, the Mechanics National Bank pursued an aggressive growth strategy between 1988 and 1991 that contributed substantially to its failure. The bank concentrated its loan portfolio in risky service station loans and speculative construction and development projects. Under a Small Business Administration lending program, the bank also developed a significant portfolio of loans that was poorly underwritten and inadequately documented. In 1990, a downturn in the California economy generated a substantial deterioration in the bank’s loan portfolio. In 1991, OCC issued a cease-and-desist order against the bank that required substantial improvements in the bank’s operations and financial condition. Despite the cease-and-desist order, the bank’s asset quality and earnings continued to deteriorate over the next several years.
The Treasury OIG report said that when section 38 capital standards became effective in December 1992, the Mechanics National Bank had a ratio of classified assets-to-capital of about 309 percent and had experienced losses of $4.3 million during 1992. OCC had just completed an examination of the bank in December 1992, which concluded that the bank was likely to fail. At that time, despite apparent asset quality and earnings problems, the bank’s capital had not deteriorated to the point where it was undercapitalized according to section 38 criteria. The bank’s capital ratios fell within the adequately capitalized category. The bank continued to be categorized as adequately capitalized during the first and second quarters of 1993, despite its high levels of classified assets and mounting losses. In July 1993, OCC reclassified the bank to the undercapitalized level. On January 10, 1994, OCC notified the bank that it was critically undercapitalized because its total capital-to-asset ratio had fallen below 2 percent. The regulators closed the bank in April 1994.
Although the Treasury OIG report criticized OCC’s supervision and enforcement activities for the period between 1988 and 1991, the report found that the agency’s use of section 38 enforcement authority during 1993 and 1994 was appropriate. For example, the OIG report highlighted OCC’s use of its section 38 reclassification authority to remove two Mechanics National Bank officers who were thought to be largely responsible for the bank’s problems. OCC also used its section 38 authority to close the bank on April 1, 1994, within 90 days of the notification of its critically undercapitalized status. Nevertheless, OCC’s enforcement actions under section 38 were largely ineffective in minimizing the losses that were already embedded in the bank’s loan portfolio before it fell to the undercapitalized level. The bank’s estimated loss to the insurance fund of $37 million represented 22 percent of the bank’s total assets of $167 million.

			The Bank Insurance Fund Continues to Absorb Losses Despite the Implementation of Section 38

The impact of section 38’s implementation on minimizing losses to the insurance funds is difficult to assess. Between 1985 and 1989, losses to the bank insurance fund ranged from approximately 12 to 23 percent of the assets of failed banks with a 5-year weighted average of about 16 percent. As we reported in 1991, this high rate of losses indicated that regulators were not (1) taking forceful actions that effectively prevented dissipation of assets or (2) closing institutions when they still had some residual value.
There have been some signs of improvement since the 1985-to-1989 period as illustrated in table 3.2. During the first 2 full years that section 38 was in effect, 1993 and 1994, the rates of loss were 17 and 10 percent, respectively, for a weighted average of 15 percent. While these loss rates are still significant, it is too early to assess section 38’s long-term effectiveness in reducing losses to the insurance funds compared with preceding years. However, it does suggest that the implementation of section 38 alone is likely to provide only limited assurance that bank failures will not have significant effects on the insurance funds.

		Section 39 Safety-And-Soundness Standards Do Little to Increase the Likelihood of Early Regulatory Action

As discussed in chapter 2, the full implementation of section 39 began on October 1, 1996. However, the guidelines and regulations developed by regulators to implement section 39 do little to reduce the degree of discretion regulators exercised from 1980 to 1990. In particular, the safety-and-soundness standards contained in the guidelines are general in nature and do not identify specific unsafe or unsound conditions and practices even though the regulators have already established measures that could have served as a basis for more specific requirements. Moreover, the guidelines and regulations do not require regulators to take corrective action against institutions that do not meet the standards for safety and soundness.

			Unsafe and Unsound Conditions and Practices Are Not Specifically Defined

In two 1991 reports, we recommended that Congress and regulators develop a formal, regulatory trip wire system that would require prompt and forceful regulatory action tied to specific unsafe banking practices. The trip wire system we envisioned would have been specific enough to provide clear guidance about what actions should be taken to address specified unsafe banking practices and when the actions should be taken. The intent was to increase the likelihood that regulators would take forceful action to stop risky practices before the capital of the bank begins to fall and it is too late to do much about the condition of the bank or insurance fund losses. The trip wire system was also to consist of objective criteria defining conditions that would trigger regulatory action.
In contrast, the safety-and-soundness standards, contained in the guidelines developed to implement section 39, as amended, consist of broad statements of sound banking principles that are subject to considerable interpretation by the regulators. For example, the standards for asset quality state that the institution should establish and maintain a system to identify problem assets and prevent deterioration of those assets in a manner commensurate with its size and the nature and scope of its operations. Specifically, the guidelines direct institutions to do the following: conduct periodic asset quality reviews to identify problem assets and estimate the inherent losses of those assets, compare problem asset totals to capital and establish reserves that are sufficient to absorb estimated losses, take appropriate corrective action to resolve problem assets, consider the size and potential risks of material asset concentrations, and provide periodic asset reports containing adequate information for management and the board of directors to assess the level of asset risk.
Although the asset quality standards identify general controls and processes the regulators expect institutions to have, the standards do not provide specific, measurable criteria of unsafe conditions or practices that would trigger mandatory enforcement actions. In our 1991 report on deposit insurance reform, we suggested that the classified assets-to-capital ratio could serve as an objective criterion because the ratio is routinely used by bank examiners to identify deteriorating asset quality. For example, we reported that the regulators become increasingly concerned when a bank’s classified assets-to-capital ratio increased to 50 percent or more. Similarly, during the interagency process used to develop the section 39 safety-and-soundness standards, FRS had proposed that the regulators take mandatory enforcement actions when a bank’s classified assets-to-capital ratio reached 75 to 100 percent. However, the regulators decided not to include this requirement after CDRI provided them with the option of omitting quantifiable measures of unsafe and unsound conditions. Without such specific criteria, regulators will continue to exercise wide discretion in determining whether a depository institution’s asset quality deterioration is at a point where enforcement actions are necessary.
Similarly, the section 39-based loan documentation standards do not establish specific criteria for regulators to use to assess an institution’s safety and soundness. The regulators believed that general standards provide an acceptable gauge against which compliance can be measured, while at the same time allowing for differing approaches to loan documentation. However, this approach to loan documentation standards differs from the long-standing approach that the regulators have established in their examination manuals. These standards contain specific loan documentation requirements that examiners are to use in assessing the safety and soundness of depository institutions. For example, real-estate construction loan files are to include current financial statements, inspection reports, and written appraisals. Since the section 39 standards do not contain similar documentation requirements, we believe the standards are open to considerable interpretation and do little to limit the wide discretion regulators have in determining whether banks have adequate loan documentation practices.
Furthermore, the loan documentation standards do not provide or state a specific level of noncompliance at which enforcement actions will be required. Although it may be difficult to develop quantifiable criteria for making such enforcement decisions, there are various regulatory “rules of thumb” in place that we believe could serve as the basis for triggering mandatory actions. For example, in its 1988 report on the reasons why banks fail, OCC found that banks with loan documentation problems in 15 to 20 percent or more of their loan portfolios were typically operating in an unsafe and unsound manner.

			Regulators Have Discretion to Require Section 39 Compliance Plans, and Requirements Are Not Specific

As discussed earlier, CDRI amended the section 39 mandate that regulators require a depository institution to file a compliance plan if the institution is found not to be in compliance with the standards. The new provision allows regulators greater flexibility in deciding whether to impose such a requirement. In the July 10, 1995, Notice of Final Rulemaking, the four regulators (OCC, FRS, FDIC, and OTS) stated that they expect to require a compliance plan from any institution with deficiencies severe enough to threaten the safety and soundness of the institution. However, as discussed in the previous section, regulators have not developed quantifiable criteria or other specific guidance for measuring an institution’s compliance with the section 39 safety-and-soundness standards. Therefore, it is not clear how regulators would determine whether an institution’s noncompliance with generally accepted management principles is “severe” enough to warrant regulatory action.
In addition, the implementing regulations do not provide any specific criteria for compliance plans beyond those contained in the section 39 legislation. The regulations merely state that compliance plans should identify steps that the institution is to take to correct the identified problems and the time by which the steps are to be taken. In contrast, section 38 and its implementing regulations establish more specific criteria for CRPs. For example, CRPs must specify capital levels that the institution expects to achieve for each year the plans are in effect. In addition, CRPs must show how the institution will comply with any restrictions on its activities under section 38 and the types of businesses and activities in which the institution will engage. Section 38 requires regulators to reject any CRP unless it contains such information, is based on realistic economic assumptions, and would not appreciably increase risk to the institutions. In the absence of similar criteria, there is less assurance that the compliance plans developed under section 39 will consistently result in the prompt remediation of deficiencies.

		Various Ongoing Initiatives May Result in Improved Regulatory Oversight

FDICIA contained a number of reforms and provisions that were designed to complement sections 38 and 39. FDICIA’s corporate governance and accounting reform provisions directed depository institutions to improve their corporate governance and the information they report to the regulators. FDICIA also required regulators to revise their risk-based capital standards to ensure that those standards take adequate account of interest rate risk, concentrations of credit, and nontraditional activities. In addition, regulators have stated that their oversight of depository institutions has improved, and they are in the process of modifying their examination approaches to emphasize the monitoring of risk-taking by depository institutions. However, we did not evaluate the effectiveness of these various initiatives because many had not been fully implemented or tested.

			FDICIA’s Corporate Governance Requirements Can Enhance Management Accountability and Regulatory Oversight

FDICIA placed a number of new requirements on depository institutions to improve their corporate governance and the information they provide to the regulators. As previously discussed, FDICIA requires all but small (total assets of less than $500 million) depository institutions to submit annual reports to the regulator on the institutions’ financial conditions and management. The report is to include management’s assessment of (1) the effectiveness of the institution’s internal controls and (2) the institution’s compliance with the laws and regulations designated by the regulator. In addition, FDICIA required the institution’s external auditors to report separately on these assertions made by management. Furthermore, FDICIA requires depository institutions to have an independent audit committee composed of outside directors who are independent of institutional management.
As we reported in 1993, these new requirements have the potential to significantly enhance the likelihood that regulators will identify emerging problems in banks and thrifts earlier. For example, regulators can use the result of an institution’s management assessments and external auditor’s reviews to identify those areas with the greatest risk exposure. This identification process should allow the regulators to improve the quality and efficiency of their examinations. While these FDICIA requirements may result in the early identification of troubled institutions, they do not ensure that regulators will take consistent supervisory actions to address safety-and-soundness problems before they adversely affect an institution’s capital levels.

			Regulators Are Revising Their Risk-Based Capital Standards

In response to FDICIA section 305 requirements, regulators have recently undertaken revisions of the risk-based capital standards that they use to implement provisions of section 38. Specifically, regulators have revised or are revising the risk-based capital standards to cover risks associated with concentrations of credit, nontraditional financial products, and interest rate movements. As of September 1996, the revisions to the risk-based capital standards announced by the regulators will not change the capital ratios used for section 38 purposes. Instead, regulators plan to use the examination process to identify institutions that have excessive and poorly managed risk exposure, due to concentrations of credit, nontraditional products, or interest rate risk. Regulators said that they will require such institutions to hold greater levels of capital than those required of other institutions. See appendix I for a more detailed discussion of section 305’s requirements and the regulators’ planned revisions to risk-based capital standards.

			Other Regulatory Initiatives May Improve Depository Institution Oversight

Regulators have stated that they have learned from their experiences in the 1980s and that their approach to depository institution oversight has changed. The regulators said that they have recognized the need to take proactive steps to prevent institutions from engaging in unsafe and unsound practices. For example, OCC, FRS, and FDIC are developing new examination procedures to better monitor and control bank risk-taking (see app. II). A July 1996 proposal to revise the rating system used by the regulators also reflects the increased emphasis on evaluating an institution’s risk exposure and the quality of its risk management systems.
Efforts by the regulators to improve federal oversight through examinations focused on risk management, along with the accounting and corporate governance provisions of FDICIA, could help provide early warning signals of potential safety-and-soundness problems. However, whether this potential for earlier detection will be translated into corrective action is subject to some question because the regulators still have a great deal of discretion under section 39, as amended. Although the section 38 capital standards appear to have played some role in strengthening the condition of the banks and thrifts, other factors have also contributed to this improvement, including lower interest rates and an improving economy. Despite the apparently sound financial condition of the bank and thrift industry, the possibility cannot be ruled out that the current strong performance of the bank and thrift industry is masking management problems or excessive risk-taking that is not being addressed by regulators. For example, the financial press reported in November 1995 and March 1996 that delinquent consumer loans, such as credit card loans, grew considerably during these years and that this growth was partially attributed to lower credit standards. Whether the regulators are more successful in detecting risk management problems and then taking the requisite corrective actions may not be fully known until another downturn in the economy affects the bank and thrift industry.

		Conclusions

In 1991, Congress enacted FDICIA, in part, because of concerns that the exercise of regulatory discretion during the 1980s did not adequately protect the safety and soundness of the banking system or minimize insurance fund losses. FDICIA’s Prompt Regulatory Action provisions were originally enacted to limit regulatory discretion in key areas and to mandate regulatory responses against financial institutions with safety-and-soundness problems. The implementation of section 38 has provided capital categories and mandated actions that regulators should take if banks or thrifts fall into specific categories. However, section 39, as amended, appears to leave regulatory discretion largely unchanged from what existed before the passage of FDICIA.
Sections 38 and 39 provide regulators with additional enforcement tools that they can use to obtain corrective action or close institutions with serious capital deficiencies and/or safety-and-soundness problems. These provisions include the enforcement tool that allows regulators to remove bank officials believed to be the cause of the institution’s problems as well as other actions intended to stop the institution from engaging in risky practices. Moreover, section 38 appears to have encouraged institutions to raise additional equity capital and should help prevent capital-deficient institutions from compounding losses.
Despite such benefits, severely troubled institutions may not be subject to mandatory restrictions and supervisory actions under section 38 due to its reliance on capital as the basis for regulatory intervention. In addition, section 39 does not require regulators to take actions against poorly managed institutions that have not yet reached the point of capital deterioration. Legislative and regulatory changes have resulted in the guidelines’ taking the form of broad statements of general banking principles rather than as specific measures of unsafe and unsound conditions. Furthermore, regulators have not established criteria for determining when a institution is in noncompliance with the guidelines.
The implementation of FDICIA’s other provisions and various initiatives undertaken by the regulators to improve their examination process may help to increase the likelihood that regulators will take prompt and corrective regulatory action. FDICIA’s accounting and supervisory reforms provide a structure to strengthen corporate governance and to facilitate early warning of safety-and-soundness problems. In addition, regulators have stated that their approach to supervision has changed since the 1980s, and they are developing new examination procedures to be more proactive in monitoring and assessing bank risk-taking. However, we did not evaluate the effectiveness of these initiatives because many of them have not been fully implemented or tested. Therefore, at present, it is difficult to determine if these initiatives will result in the earlier detection of safety-and-soundness problems and, if so, whether regulators will take strong and forceful actions early enough to prevent or minimize future losses to the insurance funds due to failures.

		Agency Comments and Our Evaluation

In its comments on our report, OCC agreed with our conclusion that sections 38 and 39 may not always result in prompt and corrective regulatory action. Nonetheless, OCC believes that FDICIA’s combination of section 38 mandatory restrictions and the regulatory discretion retained under section 39 allows regulators to tailor their supervision to suit an institution and its particular problems.
The Federal Reserve Board of Governors stated that it had no formal comments but that the report appeared to accurately describe the Federal Reserve’s policies, procedures, and practices with respect to the implementation of FDICIA’s Prompt Regulatory Action provisions, as amended.
OTS stated that section 38 effectively encourages institutions to avoid becoming or remaining undercapitalized. OTS emphasized that the section 39 standards are untested, and it supported the flexibility built into section 39. OTS believes that existing discretionary supervisory and enforcement tools are adequate to deal with most safety-and-soundness issues, apart from capital.
FDIC also supported the discretionary and flexible nature of the section 39 safety-and-soundness standards. FDIC pointed out that the overwhelming number of comments that the regulators received on the section 39 standards were in favor of general rather than specific standards. FDIC stated that the section 39 standards adopted by the regulators minimize regulatory burden while recognizing that there is more than one way to operate in a safe-and-sound manner.
We do not disagree that there is a need for some degree of regulatory discretion. Rather, we see the issue as one of striking a proper balance between the need for sufficient regulatory discretion to respond to circumstances at a particular institution and the need for certainty for the banking industry about what constitutes an unsafe or unsound condition and what supervisory actions would be expected to result from those conditions. The subjective nature of the standards continues the wide discretion that regulators had in the 1980s over the timing and severity of enforcement actions. Such discretion resulted in the regulators’ not always taking strong actions early enough to address safety-and-soundness problems before they depleted an institution’s capital. However, we note that the implementation of FDICIA along with various regulatory initiatives undertaken since the passage of FDICIA may help in the earlier detection of institutions with safety-and-soundness problems. These initiatives, along with the regulators’ willingness to use their various enforcement authorities—including sections 38 and 39—to prevent or minimize potential losses to the deposit insurance funds, will be instrumental in determining whether the proper balance between discretion and certainty has been attained.

Summary:
Why GAO Did This Study

GAO reviewed the Federal Reserve System's (FRS) and the Office of the Comptroller of the Currency's (OCC) efforts to implement the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) prompt regulatory action provisions and the impact of those provisions on federal oversight of depository institutions.

What GAO Found

GAO found that: (1) regulators have taken the required steps to implement FDICIA prompt regulatory action provisions, but have had to use the additional enforcement powers granted by the provisions against a relatively small number of depository institutions; (2) the improved financial condition of banks and thrifts has allowed them to build their capital levels to the point where only a few institutions were considered undercapitalized according to section 38 standards; (3) OCC and FRS generally took prescribed regulatory actions against the 61 undercapitalized banks reviewed; (4) as of September 1996, regulators had not used their section 39 authority; (5) the final two safety and soundness standards, asset quality and earnings, required to fully implement section 39 became effective on October 1, 1996; (6) the guidelines and regulations issued to date by regulators to implement section 39 do not establish clear, objective criteria for what would be considered unsafe and unsound practices or conditions or link the identification of such conditions to specific mandatory enforcement actions; (7) other FDICIA provisions and initiatives recently announced by regulators should help in the early identification of depository institutions with safety and soundness problems; and (8) the success of these provisions and initiatives will be determined by the regulators' willingness to use their enforcement powers early enough to prevent or minimize losses to the deposit insurance funds.