United States General Accounting Office

GAO Report to Congressional Committees

July 1995 INSPECTORS

GENERAL

Mandated Studies to

Review Costly Bank

and Thrift Failures

GAO/GGD-95-126

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-259972 

July 31, 1995

The Honorable Alfonse D’Amato

Chairman

The Honorable Paul Sarbanes

Ranking Minority Member

Committee on Banking, Housing,

 and Urban Affairs

United States Senate

The Honorable James A. Leach

Chairman

The Honorable Henry B. Gonzalez

Ranking Minority Member

Committee on Banking and

 Financial Services

House of Representatives

This report presents the results of our review of the compliance of the

Inspectors General (IG) offices for the Board of Governors of the Federal

Reserve System, Federal Deposit Insurance Corporation (FDIC), and the

Department of the Treasury with section 38(k) of the Federal Deposit

Insurance Act (FDIA) as amended in 1991.1

 This section of FDIA requires the

IGs to issue reports on depository institutions—banks or thrifts—whose

failures result in “material losses” to deposit insurance funds, i.e., basically

those that exceed $25 million. The section directs the IGs to determine why

a bank’s or thrift’s problems resulted in a material loss to a deposit

insurance fund and to make recommendations for preventing such losses

in the future.2

 Finally, the section requires us to annually review reports

issued by the IGs, verify the accuracy of one or more of these reports, and

make recommendations as needed to improve the supervision of

depository institutions.

In carrying out our responsibilities under section 38(k), our objectives

were to (1) assess the adequacy of the preparations, procedures, and audit

guidelines that IGs have established for performing material loss reviews

1

12 USC Section 1831o(k).

2

The Treasury IG is responsible for auditing failed national banks supervised by the Office of the

Comptroller of the Currency, but did not become responsible for doing investigations of thrift failures

that cause material losses until July 1, 1995. On that date, the Savings Association Insurance Fund

became responsible for paying, or paying off, the insured deposits of failed thrifts, and the Treasury IG

became responsible for reviewing thrift failures whose cost to the Savings Association Insurance Fund

meet the criteria specified by section 38(k). Until that date, the Resolution Trust Corporation—which

is not an insurance fund as defined by the section—was responsible for paying, or paying off, the

insured deposits of failed thrifts.

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(MLR) to ensure compliance with their responsibilities under the section;

(2) verify the information contained in the MLR reports upon which the IGs

based their conclusions; (3) recommend improvements, if necessary, in

bank supervision based on a review of the MLR reports issued between July

1, 1993, and June 30, 1994; and (4) assess the economy and efficiency of

the current MLR process.

Scope and

Methodology

To satisfy our objectives, we discussed the IGs’ plans, policies, procedures,

and MLR audit guidelines with IG officials and bank regulators. We assessed

the MLR audit guidelines for their completeness, detail, and relevance to

the IGs’ audit objectives. We compared the MLR audit guidelines to audit

guidelines that we developed and used in our earlier reports on the causes

of bank failures and the adequacy of bank supervision. In addition, we

verified the information contained in the two MLR reports completed

between July 1, 1993, and June 30, 1994, the first year that section 38(k)

was in effect. A detailed description of our objectives, scope, and

methodology is provided in appendix I. The IGs for FDIC, the Federal

Reserve, and Treasury provided written comments on a draft of this

report, which are discussed on pages 21 and 22 and are reprinted in

appendixes III, IV, and V.

We did our work between April and October 1994 in Washington, D.C.;

Irvine, CA; San Francisco; and Denver in accordance with generally

accepted government auditing standards.

Results in Brief The Federal Reserve, FDIC, and Treasury IGs have effectively positioned

themselves to satisfy their MLR responsibilities as required by section 38(k)

of FDIA, as amended. The IGs have established a Statement of

Understanding (SOU) to coordinate their approaches to performing MLRs,

initiated and completed several pilot studies, hired staff with banking and

audit experience, and developed relevant training programs. Moreover, the

IGs have developed comprehensive and detailed audit guidelines for

performing MLRs that were refined on the basis of the IGs’ experiences in

completing the pilot studies. Although these guidelines differ somewhat

among IGs, we believe that, if effectively implemented, the guidelines are

adequate for determining the causes of bank failures resulting in material

losses and assessing the quality of supervision of those banks.

The Federal Reserve and FDIC IGs each issued a MLR report during the first

year that the MLR requirement went into effect. The Federal Reserve IG

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issued a report on Jefferson Bank and Trust (JBT) in Colorado, and the FDIC

IG issued a report on The Bank of San Diego (TBSD) in California. We found

that the IGs fully described and supported the reasons for the failures of

JBT and TBSD. The IGs also assessed the adequacy of the banks’ supervision,

although the FDIC IG could have more fully evaluated the effectiveness of

FDIC’s supervisory enforcement actions in the TBSD report.

We believe the JBT and TBSD reports provide important information about

the causes of these banks’ failures and the quality of their supervision.

However, the limited number of reports that have been issued to date do

not provide a sufficient base of evidence to ensure valid conclusions about

the bank regulators’ overall performance. Therefore, we do not make any

recommendations to the bank regulators to improve supervision in this

report.

Meanwhile, the costs associated with producing MLR reports can be

considerable and include personnel and financial expenditures and some

temporary operational disruptions to the IG offices. Another potential

limitation of the current MLR requirements is that they do not always give

IGs sufficient time to review reports that are prepared by other FDIC

officials who also investigate the causes of bank failures. On the basis of

discussions with IG officials, we identified various options that could

improve the efficiency and/or effectiveness of the current MLR process.

Background The FDIC, the Federal Reserve, and the Office of the Comptroller of the

Currency (OCC) and the Office of Thrift Supervision (OTS)—which are part

of the Department of the Treasury—share responsibility for regulating and

supervising banks and thrifts in the United States. FDIC regulates

state-chartered banks that are not members of the Federal Reserve system

while the Federal Reserve regulates state-chartered banks that are

members of the system. OCC regulates nationally chartered banks, while

OTS regulates thrifts.3 The regulators carry out their oversight

responsibilities through, among other things, conducting annual

examinations and issuing enforcement actions for unsafe and unsound

banking practices.

Congress amended FDIA in 1991 after the failures of about 1,000 banks

between 1986 and 1990 had resulted in billions of dollars in losses to the

Bank Insurance Fund (BIF). The amendments were designed largely to

3

State regulatory authorities share responsibility for regulating and supervising banks and thrifts that

they charter with FDIC, the Federal Reserve, and OTS.

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strengthen bank supervision and to help avoid a taxpayer bailout of the BIF

similar to the nearly $105 billion in taxpayer funds that Congress provided

between 1989 and 1993 to the Resolution Trust Corporation to protect the

depositors of failed thrifts. The amendments require the banking

regulators to take specified supervisory actions when they identify unsafe

or unsound practices or conditions. For example, the regulators can close

banks whose capital levels fall below predetermined levels. Congress also

added section 38(k) to FDIA to (1) ensure that the regulators learn from any

weaknesses in the supervision of banks whose failures cause material

losses and (2) make improvements as needed in the supervision of

depository institutions.

The IGs for the Federal Reserve, FDIC, and the Treasury—which is

responsible for auditing OCC and OTS—are officials responsible for

identifying fraud, waste, and abuse and recommending improvements in

agency operations. Each IG oversees a staff of auditors and investigators to

assist in carrying out its mission. The staff engages in a range of activities,

including criminal investigations, financial audits, and audits of the

economy and efficiency of agency programs and operations.

Section 38(k) of FDIA requires the IGs to review the failures of depository

institutions when the estimated loss to a deposit insurance fund becomes

“material”: i.e., when the loss exceeds $25 million and a specified

percentage of the institutions’ assets. (See table 1.)

Table 1: Applicable Percentage of the

Bank’s Assets on a Sliding Scale Time period Percentage

July 1 - June 30

1993 - 1994 7%

1994 - 1995 5

1995 - 1996 4

1996 - 1997 3

After 1997 2

Source: Section 38(k) of the FDIA Act.

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The MLR reports must be completed within 6 months of the date that it

becomes apparent that the loss on a bank or thrift failure will meet the

criteria established by the section.4

Before July 1, 1993, when the section’s requirements went into effect, the

IGs had each done pilot studies of previous bank or thrift failures to gain

experience in this type of audit. Between July 1, 1993, and February 28,

1995, four banks that met the section’s requirements failed. The Federal

Reserve IG issued MLR reports on JBT in Lakewood, CO, and Pioneer Bank

in Fullerton, CA; the FDIC IG issued MLR reports on TBSD and The Bank of

San Pedro, CA.5

 The Treasury IG had not initiated any MLRs as of

February 28, 1995, because there had not been any failures of nationally

chartered banks or thrifts that met the section’s requirements.

Inspectors General

Made Substantial

Efforts to Prepare for

Material Loss Reviews

Our review indicated that all of the IGs made substantial efforts in

preparation for meeting their MLR responsibilities under section 38(k). In a

coordinated effort, the IGs entered into a SOU that outlined their approach

to conducting the MLRs which, among other things, specified when IGs

should initiate a MLR. The IGs also initiated pilot studies of depository

institution failures before the effective date of section 38(k) (July 1,

1993) to develop and refine audit procedures and to familiarize their staffs

with this type of review. Finally, the Federal Reserve and FDIC IGs hired

additional staff with banking and financial audit expertise to meet

anticipated demands for conducting MLRs. All three IGs enrolled their staff

in relevant training courses.

Inspectors General

Entered Into a Statement

of Understanding

The FDIC, Federal Reserve, and Treasury IGs entered into a SOU in

preparation for conducting MLRs. The SOU is intended to ensure that

(1) statutory requirements for doing a MLR are met as effectively as

possible, (2) the IGs’ work is consistent relative to MLRs, (3) mutual

4

The section defines a loss incurred as follows:

• when FDIC is appointed receiver of the institution and it is or becomes apparent that the present

value of a deposit insurance fund’s outlays with respect to the institution will exceed the present value

of the receivership dividends or other payments on claims held by FDIC, or:

• if FDIC provides assistance to the institution while an ongoing concern and it is not substantially

certain that the assistance will be repaid within 24 months after the date on which the assistance was

initiated or the institution ceases to repay the assistance in accordance with its terms.

5

In this review, we focused our audit work on reports on Jefferson Bank and Trust and The Bank of

San Diego since they were issued in the first year that section 38(k) went into effect. Although we read

the MLR reports on The Bank of San Pedro and Pioneer Bank, we did not attempt to verify the

information contained in these reports.

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cooperation and efficient use of resources are maximized, and

(4) privileged and confidential information contained in failed bank

records is protected from unauthorized disclosure. The SOU was finalized

on August 18, 1994.

Among other provisions, the SOU details how FDIC’s Division of Finance

(DOF) is to notify each IG office that a bank failure is expected to result in a

material loss, thereby documenting that a MLR must be initiated. The FDIC IG

is to be the primary liaison between the FDIC DOF and the Federal Reserve

and Treasury IGs. The FDIC DOF is to notify the FDIC IG by letter when it

“books” a material loss to BIF on a bank failure. If the bank was regulated

by FDIC, the date of the letter starts the 6-month clock for the FDIC IG to

complete its MLR. If the bank was regulated by the Federal Reserve or OCC,

the FDIC IG is to notify the responsible IG by letter of the material loss. The

date of this letter starts the 6-month clock for the Federal Reserve or

Treasury IG office to complete its MLR.

Inspectors General Offices

Completed Pilot Studies

Each of the three IG offices we contacted conducted pilot studies on banks

or thrifts that failed before July 1, 1993, the effective date of section 38(k).

The officials we contacted said they did the pilot studies to develop

policies and procedures to do MLRs after section 38(k) went into effect.

The officials also said that they wanted to train their new staff in how to

do this type of review and to establish contacts with officials in the bank

regulatory agencies. The Treasury IG office did pilot studies on two

California institutions, the Mission Viejo National Bank and the County

Bank of Santa Barbara; the FDIC IG office did pilot studies on Coolidge

Bank and Trust, located in Boston, and Union Savings Bank, located in

Patchogue, NY; and the Federal Reserve IG office did a pilot study on the

Independence Bank of Plano, located in Texas.

Inspectors General Hired

and Trained Staff to

Perform MLRs

The FDIC and Federal Reserve IGs also hired additional staff in 1992 and

1993 to assist in performing MLRs and to fully staff their agency oversight

functions. The FDIC IG hired 12 additional staff members for a total of 37

staff members to conduct MLRs and other program audits. In addition to

persons with auditing experience, the new staff included four banking

specialists. These more experienced staff were hired to provide training to

junior staff on banking examination procedures, including loan reviews to

assess a bank’s asset quality. According to FDIC IG officials, all of the staff

had enrolled in the FDIC’s examiner training program to learn more about

the bank supervisory process.

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The Federal Reserve IG hired 5 additional staff members in 1993 to give it a

total of 11 staff for completing MLRs and other audit work on bank

supervision. These five staff persons have expertise in areas such as bank

loan analysis, consumer compliance regulations, and auditing computer

systems. The Federal Reserve IG had also sent these individuals to banking

classes conducted by the American Institute of Certified Public

Accountants and the Federal Reserve’s examiner classes. In addition, two

IG officials enrolled in the American Bankers Association banking course

at Stonier College in Delaware.

At the time that these hirings occurred, numerous costly bank failures

were projected to occur between 1993 and 1995. A FDIC IG official said that

additional staff were needed to meet the anticipated workload associated

with these potential MLRs. However, the number of bank failures declined

substantially in 1993 and 1994 as a result of low interest rates and an

improving economy. The number of bank failures fell from 122 in 1992 to

42 in 1993 and 13 in 1994. Only four banks failed between July 1, 1993, and

February 28, 1995, with losses exceeding the statutory threshold, thereby

prompting the IGs to initiate MLRs. FDIC and Federal Reserve IG officials we

contacted said that MLRs represent only a part of their overall efforts to

assess bank supervision. The officials plan to use the staff hired in 1992

and 1993 to do future MLRs and other audit work on the economy and

efficiency of agency supervisory operations.

Treasury IG officials said that the organization did not receive additional

resources to hire more staff for conducting MLRs. Although the Treasury IG

office plans to divert staff to work on MLRs as needed, other mandated

work could limit their ability to do so. For example, the IG is required to do

audit work on the Treasury Department’s compliance with the Chief

Financial Officers Act of 1990 (CFO).6

 The Treasury IG also has developed a

comprehensive training module on how to conduct MLRs for its current

staff. The module includes separate student and teacher instructions so

Treasury IG staff with banking experience can train staff with limited

banking experience. The modules are also designed to be self-taught and

can be used without assistance. Some of the issues covered in the training

module include an introduction to banking; a section on how to analyze

and evaluate causes of bank failures; and an assessment of enforcement

6

Among other things, the CFO Act created chief financial officer positions in 23 major federal agencies.

These officers must have substantial financial management experience and are responsible for, among

other things, developing integrated accounting systems, directing agency financial operations, and

approving and managing agency financial management systems. The act also specifies that the Office

of Management and Budget establish qualification standards for the CFOs.

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actions, including the effectiveness and timeliness of regulator

enforcement actions.

Inspectors General

Developed

Comprehensive MLR

Audit Guidelines

We reviewed the MLR guidelines that the IGs had developed for their

completeness and relevance for satisfying the MLR objectives and

compared the guidelines to our audit guidelines for investigating costly

bank failures. On the basis of this analysis, we believe the IGs’ audit

guidelines, if effectively implemented, represent a comprehensive

approach to identifying the causes of bank failures and assessing the

adequacy of their supervision. Although many provisions of the guidelines

are similar, the Federal Reserve and FDIC IG audit guidelines differ from the

Treasury IG guidelines in that they generally call for doing extensive loan

portfolio reviews in every case when loan losses are determined to be the

primary causes of failure. By contrast, the Treasury IG is to perform such

loan reviews on a case-by-case basis.

MLR Audit Guidelines Are

Adequate for Assessing

Causes of Bank Failures

Our review of the IGs’ audit guidelines to do MLRs found that the guidelines

represent a comprehensive approach for assessing the causes of bank

failures. Under established guidelines, senior IG officials are to maintain

contact with the bank regulators to identify troubled banks whose failures

could cause material losses. The guidelines direct the IG staff to obtain and

review basic documents about these troubled banks—such as examination

reports dating back several years; enforcement actions; and historical

financial data, such as asset growth over time. When a bank fails and

causes a material loss, the IG staff are to interview responsible bank

examiners and other regulatory officials and meet with former bank

officials and FDIC closing personnel. Through reviewing these documents

and interviewing knowledgeable officials, the IGs are to identify and

document the major reasons for the banks’ failures. These reasons may

include rapid growth; poor loan underwriting and documentation; loan

concentrations, such as in real estate; and insider abuses.

The Federal Reserve and FDIC IGs’ MLR audit guidelines differ from the

Treasury IG audit guidelines in that they generally call for the staff to

review failed bank loan portfolios when loan losses are determined to be

the primary cause of failure. FDIC IG officials we contacted said that they

need to review loan portfolios to arrive at an independent judgment as to

why the banks failed. The officials said that they do not rely solely on

documents generated by the bank regulators—such as examination

reports and supporting workpapers—to determine the cause of failure.

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Although the Federal Reserve IG follows a similar procedure to the FDIC IG

for selecting a sample of loans to review, Federal Reserve IG officials said

that they perform loan reviews primarily to assess the quality of bank

supervision. These Federal Reserve IG loan review procedures are

discussed later in this section.

Under the loan review audit guidelines, FDIC IG staff are to select a sample

of the loans on the books of banks whose failures result in material losses.

The sample is to include classified (troubled) loans and nonclassified

loans as well as a mixture of commercial, real-estate, and consumer loans.

Once a bank fails and causes a material loss, the staff are to visit the bank

and review the sampled loans. The guidelines direct the staff to comment

on, among other things, the quality of the bank’s loan underwriting

standards. The IG staff are to use lending standards that the regulators

have issued to bank examiners to assist in making these assessments.

According to an FDIC IG official, the staff review the loan files to identify

the management strategy or lending weaknesses that ultimately caused the

bank to fail. By reviewing information in the loan files dating back several

years, for example, he said the staff could determine whether bank

management had adopted an aggressive growth strategy without adequate

regard for maintaining credit standards.

Unlike the FDIC IG guidelines, the MLR audit guidelines developed by the

Treasury IG do not call for loan reviews even if loan losses were the

primary cause of failure. As a result of the time and resources necessary to

complete a MLR, the guidelines state that the Treasury IG staff should

generally rely on OCC examination reports and workpapers and discussions

with examiners to assess the causes of a bank’s failure. However, the

guidelines do direct the IG staff to initiate loan reviews similar to those

done by the FDIC and Federal Reserve IG staff in certain situations. The

Treasury IG staff are to do a loan review if they determine that OCC’s

records do not adequately address or develop the problem(s) that resulted

in a bank’s failure. For example, it may be necessary to do a loan review or

examine the bank’s records if it appears that insider abuse caused the

bank to fail and the OCC examiners did not adequately develop the related

issues.

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MLR Audit Guidelines Call

for Assessing the Bank

Regulators’ Supervisory

Performance

Our reviews of the IG MLR guidelines showed that they call for the IG staff to

assess the timeliness and effectiveness of bank supervisory activities.

Based on reviews of examination reports and supporting workpapers, as

well as discussions with bank examiners, the IG staff are to assess the

adequacy of the supervision of failed banks. For example, the IG staff are

to determine whether the regulators complied with their policies and

procedures in supervising the banks. Among other requirements, the IG

staff are directed to determine whether the bank regulators selected an

adequate sample of loans to evaluate at each bank examination and made

determinations about the bank’s financial condition. The IG staff are also

to review the supporting workpapers for each examination to determine

whether the regulators had adequate support for their findings on the

quality of each bank’s loan portfolio.

The guidelines also direct the IG staff to determine whether the bank

regulators had taken timely and effective enforcement actions—such as

Memorandums of Understanding, Cease and Desist Orders (C&D), and Civil

Money Penalties—against banks that engage in unsafe or unsound

practices. For example, the Treasury IG guidelines direct the staff to focus

their analysis on problems that the bank regulators identified during the

course of examinations, particularly those that resulted in the bank’s

failure. The IG staff are to determine what enforcement actions, if any,

were taken against the bank by OCC to get the bank to correct these

problems, and the guidelines direct the IG staff to determine why OCC did

not take particular enforcement actions against a bank. Moreover, the

guidelines call for the IG staff to evaluate OCC’s oversight of banks that are

subject to enforcement actions to ensure that bank managers comply with

the provisions of such actions. Once this analysis has been completed, the

IG staff are to reach a conclusion about the timeliness and forcefulness of

the OCC’s enforcement actions. The FDIC IG and Federal Reserve IG MLR

guidelines contain similar provisions.

Federal Reserve IG officials we contacted said they primarily use the loan

review process discussed earlier to assess the adequacy of the Federal

Reserve’s examinations of bank lending activities. In the recent MLR audit

of Pioneer Bank, the officials said they reviewed a sample of 40 large

commercial and commercial real estate loans in the bank’s portfolio. The

staff reviewed these loans in a manner similar to that done by bank

examiners. For example, the staff determined, from a review of

information in the files, whether they believed each loan should be

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classified as “substandard,” “doubtful,” or “loss.”7 The staff used the

regulatory examination standards that were in place at the time the loans

were originated to make these classifications.8

Next, the staff compared their loan review findings to the findings of the

Federal Reserve examiners who actually examined the bank in the years

before the bank’s failure. The IG officials said they tried to determine the

reasons that their loan classifications differed from those of the Federal

Reserve examiners and assess whether the examiners had adequate

justification for their classifications. The IG staff concluded that the

Federal Reserve examiners overlooked substantial weaknesses in the

bank’s lending practices over the years. Although the Federal Reserve IG

officials said this type of analysis is complicated and time consuming, they

believe it is often necessary for assessing the overall quality of the bank’s

supervision.

However, FDIC IG officials said that when they conduct a loan review they

use it for the purposes of determining the causes of bank failures rather

than determining the adequacy of bank supervision. The officials said that

they generally do not use loan reviews to assess bank supervision because

it is difficult to replicate the conditions that existed when FDIC examined

banks in the past.

JBT and TBSD MLR

Reports Fully

Describe Causes of

Bank Failures, but

FDIC IG Could Have

Expanded Its

Analyses

During the first year that section 38(k) went into effect, the Federal

Reserve and FDIC IGs each used the audit guidelines discussed above to do

a MLR report. We believe that these reports fully describe and support the

causes of the banks’ failures. The IGs also assessed the supervisory efforts

of the bank regulators and recommended specific steps the regulators

could take to improve their oversight efforts. However, the FDIC IG could

have more fully evaluated the effectiveness of FDIC’s supervisory

enforcement actions in the TBSD report.

MLR Reports Fully

Describe Causes of Failure

On December 27, 1993, the Federal Reserve IG issued a report on JBT,

which failed on July 2, 1993. The report concluded that the bank failed as a

7

Examiners use classifications to determine the likelihood that a loan will be repaid. “Substandard”

refers to loans whose repayment is in question as a result of the weakened financial condition of the

borrower or the decline in value of the collateral pledged to secure the loan. “Doubtful” refers to loans

that are substandard and whose repayment is highly questionable. “Loss” refers to loans that are

generally considered uncollectible.

8

The Federal Reserve IG staff said they made separate classifications of each loan in the sample for

several years before the bank’s failure.

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result of a massive securities fraud perpetrated by its investment adviser;

the fraud resulted in a $43 million loss for the bank. The IG staff decided

not to do a loan review for the JBT investigation because trading in

government securities, rather than loan losses, caused the bank’s failure.

Instead, the IG staff focused its investigation on reviewing JBT’s securities

trading activities and the Federal Reserve’s oversight of this trading.

On April 29, 1994, the FDIC IG issued a report on TBSD, which failed on

October 29, 1993. The report concluded that the bank failed as a result of

poor loan underwriting, excessive real estate lending, high expenses, and

poor management. As part of the MLR, FDIC staff reviewed a sample of 60 of

TBSD’s loans, including 41 real-estate loans. The IG staff identified many of

the deficiencies in the bank’s lending practices through the loan analysis.

We reviewed the workpapers the IGs developed to support the JBT and TBSD

reports to (1) ensure that the IGs complied with the MLR guidelines and

(2) verify the basis for the reports’ conclusions about the causes of the

banks’ failures. We also interviewed officials from the IGs’ offices, as well

as examination officials from the Federal Reserve and FDIC, respectively.

On the basis of our review, we believe that the reports fully describe and

support the causes for each bank’s failure. See appendix II for more

information about each report.

FDIC IG Could Have

Expanded Its Analysis of

Enforcement Actions

Our review of the JBT and TBSD reports and their supporting workpapers

also found that the Federal Reserve and FDIC IGs generally complied with

their guidelines on assessing the quality of bank supervision. As examples,

the IGs obtained copies of bank examination reports dating back several

years, collected economic data about the regions in which the banks were

located, and interviewed bank regulators. In addition, IG audit teams

traveled to the banks’ locations to review bank records and interview bank

officials.

The IGs also identified certain deficiencies in Federal Reserve and FDIC

supervisory practices. For example, the Federal Reserve IG, in the JBT

report, identified specific steps that the Federal Reserve could take to

improve its oversight of bank securities trading activities. Moreover, the

FDIC IG, in the TBSD report, recommended that FDIC evaluate on a

case-by-case basis the need to collect better data about the quality of bank

assets before approving the merger of weak banks. The FDIC IG further

recommended that FDIC develop examination guidance to ensure that

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banks place reasonable limits on the financing of speculative real-estate

projects.

The IGs also obtained and reviewed copies of enforcement action

documents that were taken against JBT and TBSD and summarized those

actions in the MLR reports. However, we found that the FDIC IG did not fully

evaluate whether FDIC ensured that TBSD complied with outstanding

enforcement actions as provided in the MLR audit guidelines. We did such

an analysis of FDIC supervision’s follow-up efforts of its enforcement

actions against TBSD. From our review, we determined that TBSD continued

its aggressive real-estate lending activities even though FDIC had initiated

an enforcement action intended to limit the bank’s exposure. We also

found that FDIC supervision did not ensure its enforcement actions were

effective to get bank management to better control its real-estate lending.

These additional insights may have strengthened the FDIC IG’s

recommendations to include supervisory follow-up of the effectiveness of

actions taken.

In 1985, FDIC issued a C&D against TBSD that, among other provisions,

required the bank to improve its lending standards. On May 9, 1988, FDIC

lifted the C&D, but the bank continued to have problems, such as high loan

losses and high overhead expenses. According to the TBSD report

workpapers, in September 1988, a FDIC examiner recommended that FDIC

sign a Memorandum of Understanding with TBSD that would require the

bank to correct its lending and operational problems. However, in

April 1989, FDIC agreed to a resolution by TBSD’s Board of Directors, in lieu

of a Memorandum of Understanding, that required changes in the bank’s

operations. For example, the resolution called on the bank to assess its

loan exposure to the commercial real-estate construction industry and the

financial consequences for the bank in the event of a downturn in that

industry. The resolution further directed TBSD management to consider

capping its commercial real-estate loans as a percentage of the bank’s total

loans, assets, and capital.

Despite the board resolution, bank management continued to pursue an

aggressive commercial real-estate lending strategy, and FDIC did not take

forceful actions to correct these problems for 2 years. The FDIC TBSD report

showed that the bank’s construction and commercial real-estate loans

increased by nearly 75 percent from about $47 million to $82 million

between year-end 1988 and year-end 1991. Many of these real-estate loans

contributed to the bank’s failure in 1993. California state banking

regulators examined TBSD in 1989 and 1990 and gave its overall operations

Page 13 GAO/GGD-95-126 Mandated Studies
B-259972 

relatively high ratings: i.e., an overall CAMEL9 rating of “2” in 1990. FDIC

officials did not begin to discover the extent of TBSD’s loan loss problems

until their examinations of the bank in late 1990 and in 1991. On the basis

of these exam findings, FDIC signed a Memorandum of Understanding with

TBSD in April 1991 that required the bank to improve its operations.

TBSD also disregarded the board resolution’s provisions that it consider

capping total commercial real-estate loans as a percentage of its assets

and capital. Specifically, commercial real-estate loans grew from

35 percent of banks total assets to 42 percent between year-end 1988 and

year-end 1991. In the same period, commercial real-estate loans increased

from 423 percent of TBSD’s total capital plus reserves to 597 percent. The

insights we gained from this analysis may have been beneficial to the FDIC

IG in assessing FDIC’s oversight of TBSD and in making its recommendations

for improving bank supervision.

Limited Benefits of

Current MLR Process

Are Achieved at

Certain Costs

For this report, we focused our assessment on the plans, policies, and

audit guidelines that the IGs have developed for complying with the MLR

mandate. Although the current MLR process produces important benefits in

understanding the circumstances surrounding individual bank failures, the

benefits so far may have had a limited impact in improving bank

supervision overall. We do not make any recommendations for improving

bank supervision in this report since only two MLR reports were issued in

the first year that the mandate went into effect and only two more reports

had been issued as of February 1995. Further, certain costs associated

with producing MLR reports should be considered; these costs include IG

financial and personnel expenditures, some temporary disruptions to IG

office operations, and duplication of effort among investigators. In

addition, our continued annual reviews of the MLR process may not add

value beyond this initial assessment. We conclude this section by

providing a discussion of the reasons for and against various options that

could be considered to address the MLR requirement.

MLRs Produced Important

but Limited Benefits

IG officials we contacted said that the JBT and TBSD reports had produced

important benefits. These IG officials said that MLRs initiated to date had

generated significant information about the causes of individual bank

9

The results of an onsite examination by banking regulators are summarized in a report addressed to

the bank’s board of directors. The examination usually results in the examiner assigning a numerical

rating to each of these bank components—capital, assets, management, earnings, and liquidity

(CAMEL). The examiner is to assign a composite CAMEL rating to the bank. CAMEL ratings range

from 1, the best rating and the lowest level of supervisory concern, to 5, the worst rating and the most

serious level of supervisory concern.

Page 14 GAO/GGD-95-126 Mandated Studies
B-259972 

failures, the quality of these banks’ supervision, and the opportunity to

train the IG staff in the bank supervisory process. A senior FDIC IG official

also said that MLRs provided important information about other areas of

bank management and supervision that may need to be evaluated. For

example, he told us that as a result of the MLR investigation of the Bank of

San Pedro, the FDIC IG may review banks’ use of “money desks” to fund

their lending operations.10

In addition, an IG official said that the MLR process provides the office with

a strong justification for assessing other aspects of bank supervision. For

example, before the MLR requirement, the office had not yet established an

overall program for assessing bank supervision. However, the official said

that the MLR process provided the IG with a formal basis for assessing the

regulators’ supervisory efforts and allowed the IG to establish working

relationships with supervisory officials.

Although the JBT and TBSD reports provided valuable information about the

circumstances surrounding these banks’ failures, we are not making any

recommendations for improving bank supervision on the basis of these

reports. We do not believe that the two cases done during the first year or

the total of four cases that had been completed as of February 1995

represent a sufficient base of evidence to arrive at conclusions about the

overall quality of bank supervision. To make recommendations, we would

need to review a larger sample of MLR reports. This larger sample would

allow us to identify any common problems or trends in bank regulation

that need to be corrected.

Some IG officials we contacted said that the MLRs completed to date

provide little basis for identifying supervisory trends. For example, a FDIC

IG official said that there has not been an adequate number of MLR reports

issued to draw overall conclusions about the adequacy of bank

supervision. In addition, a Federal Reserve IG official said that it is difficult

to convince agency supervisory officials to accept recommendations

contained in a MLR report since the recommendations would be based on

only one bank’s failure. In its MLR report on the failure of the Pioneer Bank,

the Federal Reserve IG chose not to make any recommendations for

improving overall bank supervision even though the report identified

certain supervisory weaknesses.

10A money desk is a mechanism by which orders are executed for bank customers, correspondent

banks, or a bank’s own account. Banks can use money desks to attract deposits from outside of their

geographical area. For example, according to the FDIC IG report, The Bank of San Pedro attracted

$25 million in deposits in the early 1990s by offering above-market interest rates to depositors

nationwide.

Page 15 GAO/GGD-95-126 Mandated Studies
B-259972 

It should be pointed out that MLRs are just one part of the IGs’ overall

efforts to evaluate the quality of bank supervision nationwide. For

example, in September 1994, the FDIC IG issued a report on FDIC’s efforts to

implement provisions in the Federal Deposit Insurance Corporation

Improvement Act (FDICIA)11 that require the prompt closure of

capital-deficient banks.12 At the time of our review, the Federal Reserve IG

was doing audits of the Federal Reserve’s examinations of commercial

real-estate loans and its bank examination program. In addition, the

Treasury IG was doing studies on OTS’ implementation of various sections

of FDICIA and the effectiveness of OCC’s examinations of national banks.

Costs Associated With the

Current MLR Process

The benefits of the MLR reports completed to date have been achieved at

certain costs to the IG offices. IG officials said that a significant amount of

financial and personnel resources are needed to do MLRs. In the 4 MLRs

initiated as of February 28, 1995, by the FDIC and Federal Reserve IGs,

between 5 to 11 staff visited the banks’ premises within the first several

weeks of their failures. These staff conducted initial interviews with

regulatory and bank personnel, reviewed bank examination records, and

conducted loan reviews. For example, in one recent FDIC IG MLR, six staff

spent 2 weeks reviewing loan files on the bank’s premises. A FDIC IG official

said that the number of staff needed to perform MLRs should decline in the

future as the organization gains experience in this type of work.

IG officials also said that the resources necessary to complete a MLR report

within the 6-month deadline can have temporary but disruptive effects on

their normal operations. Treasury IG officials said that approximately

30 percent of their staff are already dedicated to assessing executive

agency financial systems as required by the CFO Act. The Treasury IG

officials estimate that 50 percent of their staff resources would be

dedicated to CFO work by 1996. Therefore, an increasing MLR workload

could hinder the Treasury IG’s ability to devote sufficient staff resources to

meet its CFO Act and other audit obligations. Similarly, Federal Reserve

and FDIC IG officials said that the resources necessary to complete the JBT

and TBSD reports within the 6-month deadline caused certain operational

challenges. For example, these officials said they had to pull staff from

other ongoing studies to assist in the material loss investigations.

1118 USC Section 1811 et seq., as amended by Section 131(a) of the Federal Deposit Insurance Act of

1991. Public Law 102-242, Section 131(a), 151 Stat 2236, 2263-64 (1991).

12Federal Deposit Insurance Corporation, Office of Inspector General, Audit of FDIC’s Implementation

of the Prompt Corrective Action Provisions of FDICIA (Sept. 23, 1994).

Page 16 GAO/GGD-95-126 Mandated Studies
B-259972 

We believe that these disruptive effects on the IGs’ operations could be

magnified should there be a substantial increase in the number of costly

bank failures, particularly in the case of the Treasury IG, which did not

receive additional staffing to do MLRs. Although the Federal Reserve and

FDIC IGs have increased their staffing in recent years, they could also face

substantial pressures to complete MLR reports within 6 months should

numerous banks fail simultaneously. For example, a FDIC IG official

estimated that the organization could handle a maximum of about 14 MLRs

per year.

MLRs Do Not Always

Allow for Use of FDIC

Investigators’ Reports

Another potential limitation of the current MLR process is that it does not

always allow time for the IGs to review reports prepared by FDIC’s Division

of Asset Services (DAS) investigators who also investigate the causes of

bank failures. Like MLR reports, these reports provide information about

individual bank failures. However, Federal Reserve and FDIC IG officials

question whether it would be beneficial to review these DAS reports and

mentioned that these reports were often not available until months after

banks failed.

DAS is responsible for recovering a portion of FDIC’s outlays to resolve bank

failures by selling each failed bank’s assets to private sector bidders. DAS

also sends investigators to failed banks to determine whether FDIC could

pursue civil claims against any bank officials culpable for the losses to

help offset the costs of the failure. It is the policy of the DAS investigators

to issue a report within 90 days of a bank failure—although the process

can take longer—that documents their findings. This report is called a Post

Closing Report (PCR). DAS has issued PCRs on JBT and TBSD.

In our discussions, a Treasury IG official said that PCRs provide information

that could be useful in doing MLR reports. The official also said it may

make sense for the IGs to wait until DAS has issued PCRs before initiating

MLRs. If the IGs initiated MLRs after PCRs, this could allow the IGs to avoid

duplicating the work of the DAS investigators and it would allow the IGs to

plan the scope of their MLR audit work on the basis of information

contained in the PCRs.

However, Federal Reserve and FDIC IG officials said that there is no

significant relationship between MLRs and the DAS investigations. The

officials said that DAS investigations are more narrowly focused than MLRs

and, therefore, have limited use. For example, Federal Reserve IG officials

pointed out that PCRs, unlike MLR reports, do not assess the quality of bank

Page 17 GAO/GGD-95-126 Mandated Studies
B-259972 

supervision. IG officials also said that they consult with FDIC DAS

investigators during the course of MLRs to obtain information. Finally, the

FDIC and Federal Reserve officials said that PCRs were often not available

until months after a bank failure. For example, the JBT PCR was completed

nearly 4 months after the failure, and the TBSD PCR was completed about 7

months after the failure. As discussed earlier, MLR reports must be

completed within 6 months of a bank’s failure.

Although the PCR’s primary purpose is to assess whether FDIC should

pursue civil actions against former bank officials, the reports contain some

information that is similar to that found in MLR reports. For example, we

reviewed PCRs that were issued for JBT and TBSD. Like the MLR reports,

these PCRs provide historical information about each bank and the results

of regulator exam findings. The PCRs also established the causes of the

banks’ failures and documented the provisions in any enforcement actions

taken against the banks.

Our Annual Reviews May

No Longer Be Necessary

As discussed earlier in this report, the IGs have generally positioned

themselves effectively to meet their responsibilities under the MLR

requirement. In addition, if bank failures continue at a relatively low rate

as projected over the next several years, MLR reports will not provide

either the IGs or us with an adequate basis for assessing the overall quality

of bank supervision and making needed recommendations for

improvement. Therefore, our annual reviews of the MLR process may no

longer add value to either the MLR or supervisory processes.

MLR Options Several options are available concerning the current MLR process that we

discussed with IG officials. Specifically, the current MLR process could be

maintained, repealed, or amended so that the IGs have more discretion on

the number and timing of MLRs to perform each year. Table 2 presents

several reasons for and against each of these options.

Page 18 GAO/GGD-95-126 Mandated Studies
B-259972 

Table 2: Available Options Concerning the Material Loss Review Process

Option Reason for option Reason against option

1. Maintain the current MLR process. May continue to hold the bank regulators

accountable for their performance in

supervising individual banks.

May provide an inadequate basis for

assessing the overall quality of bank

supervision if relatively few banks fail over

the next several years.

May provide the IG staffs with detailed

knowledge and understanding of what

causes bank failures and how bank

supervision works.

May continue to involve costs, such as

personnel and travel expenditures.

May provide the IGs with the ability to

identify issues in bank supervision

warranting further analysis.

May not permit the IGs to take advantage

of other reviews or investigations of bank

failures, such as PCRs produced by FDIC

DAS investigators.

May allow for broader assessments of the

overall quality of bank supervision if there is

a substantial increase in the number of

bank failures.

May divert the IG staff from doing broader

audits of bank supervision.

2. Repeal the MLR requirement. Would eliminate the costs associated with

performing mandatory MLRs.

May reduce bank regulators’ accountability

for their supervision of individual banks.

May allow the IGs to use their resources

cost effectively by focusing their efforts on

broader aspects of bank supervision and

doing individual case studies of bank

failures only where determined necessary.

May reduce the IGs’ ability to identify

issues in bank supervision that require

further investigation. 

May decrease the IGs’ contacts with bank

supervisory officials and current knowledge

and understanding of the supervisory

process.

3. Amend section 38(k) so that the IGs have

the discretion to determine the number,

timing, and scope of MLRs to initiate each

year.

May allow the IGs to use their resources

cost effectively by focusing their efforts on

broader analysis of the overall quality of

bank supervision, particularly in years

when few banks are projected to fail.

May lead to inconsistent approaches and

numbers of MLRs performed by the various

IGs.

May maintain the bank regulators’

accountability for their supervision of

individual banks.

May extend the period of time it takes the

IGs to issue reports on costly bank failures.

(continued)

Page 19 GAO/GGD-95-126 Mandated Studies
B-259972 

Option Reason for option Reason against option

May allow the IGs to take advantage of

other audit and investigative reports.

May permit the IGs to do a sample of MLRs

in years when there is a substantial

increase in the number of bank failures.

This could potentially minimize the IGs’

resource requirements during such periods.

Source: GAO.

Conclusions Congress added section 38(k) to FDIA so that the regulators would learn

from any weaknesses in the supervision of costly bank failures and

possibly avoid such weaknesses in the future. We believe that MLR reports

can provide important information about individual bank failures and that

the IGs have generally positioned themselves effectively to meet their

responsibilities. However, the current MLR requirements may not be the

most cost-effective means of achieving improved bank supervision.

The Federal Reserve, FDIC, and Treasury IGs have made substantial efforts

in preparation for performing MLRs as required by section 38(k). The IGs

have also developed detailed and comprehensive MLR guidelines that, if

effectively implemented, are adequate for meeting the IGs’ responsibilities

under section 38(k). The Federal Reserve and FDIC IGs have each used the

guidelines to prepare MLR reports that fully described the causes of the JBT

and TBSD failures. However, the FDIC IG could have gained greater insights

on bank supervision if it had expanded its analysis of the effectiveness of

the enforcement actions that FDIC took against TBSD.

Although the MLR process can produce important benefits in understanding

the circumstances surrounding individual bank failures, these benefits

have been limited and are achieved at certain costs. IG officials we

contacted said that the two MLR reports completed during the first year

that section 38(k) went into effect did not provide an adequate base of

evidence to assess the overall quality of bank supervision.

The limited benefits may have been outweighed by the costs associated

with producing the MLR reports, which include IG personnel and financial

expenditures; temporary disruptions in IG office operations; and potential

duplication of effort among the IGs and FDIC DAS. However, if the IGs had

Page 20 GAO/GGD-95-126 Mandated Studies
B-259972 

more flexibility to determine the number and timing of MLRs to perform

each year, they could (1) have more flexibility to utilize their resources,

particularly in years when there are numerous bank failures;

(2) potentially take advantage of PCRs issued by DAS; and (3) do broader

analysis of the overall quality of bank supervision. A more flexible

approach could still maintain the original intent of section 38(k), which

was to hold the bank regulators accountable for their actions. Thus,

Congress may wish to consider whether the currently required approach

remains the best available. Similarly, we believe that requiring us to

perform annual reviews of MLRs may no longer add sufficient value to the

MLR or bank supervisory processes to warrant continuation.

We do not make any recommendations for improving overall bank

supervision in this report because we agree with the IG officials that the

limited number of reports produced so far does not provide an adequate

base for identifying improvements.

Recommendation We recommend that the Inspector General of FDIC, in future MLR reports,

take steps to more fully assess the effectiveness of FDIC’s enforcement

actions.

Matters for

Congressional

Consideration

Congress may wish to consider whether the current MLR requirement,

which requires the IGs to report on bank and thrift failures costing the

deposit insurance funds in excess of $25 million, is a cost-effective means

of achieving the requirement’s intended benefit—to help improve bank

supervision. If it determines that the requirement is not cost effective,

Congress can choose to either repeal or amend the requirement. Of these

options, amending the current MLR requirement may be more desirable

because it would allow the IGs to continue their bank supervision work

and also provide them greater flexibility in managing their resources.

Moreover, Congress should consider repealing our mandate to review MLRs

on an annual basis.

Agency Comments

and Our Evaluation

The IGs for the Federal Deposit Insurance Corporation, the Board of

Governors of the Federal Reserve System, and the Department of the

Treasury provided written comments on our draft report, which are

reprinted in appendixes III, IV, and V. The three IGs agreed with the

report’s overall conclusions that the IGs have effectively positioned

themselves to carry out their responsibilities and have developed

Page 21 GAO/GGD-95-126 Mandated Studies
B-259972 

comprehensive and detailed audit guidelines. In response to our

recommendation, the FDIC IG agreed to take steps to more fully evaluate

the effectiveness of FDIC’s supervisory enforcement actions in future MLRs,

even though he did not necessarily agree that our analysis of TBSD’s

compliance with FDIC enforcement actions provided additional insights

into the effectiveness of FDIC’s supervision of TBSD.

The IGs also agreed that Congress should consider amending section 38(k)

of FDIA so that the IGs have more discretion on the number, timing, and

scope of MLRs to initiate each year. The Federal Reserve IG stated that,

although MLR reports may not be the most cost-effective means of

achieving improved bank supervision, they allow the staff to focus their

analysis on the implementation of bank supervision policies and

procedures over time relative to a particular bank. He also said that the

Federal Reserve IG office may be able to make broader recommendations

with respect to bank supervision as additional MLRs are completed and that

additional flexibility with regard to the MLR requirement would allow the

organization to better manage its resources while preserving the intent of

the legislation.

The IGs also provided comments that were generally technical in nature

and are incorporated in this report where appropriate.

We are sending copies of this report to the Inspectors General for the

Federal Deposit Insurance Corporation, the Board of Governors of the

Federal Reserve System, the Department of the Treasury, and other

interested parties. We will also make copies available to others upon

request.

This report was prepared under the direction of Mark J. Gillen, Assistant

Director, Financial Institutions and Markets Issues. Other major

contributors to this review are listed in appendix VI. If you have any

questions about this report, please call me on (202) 512-8678.

James L. Bothwell

Director, Financial Institutions

 and Markets Issues

Page 22 GAO/GGD-95-126 Mandated Studies
Page 23 GAO/GGD-95-126 Mandated Studies
Contents

Letter 1

Appendix I 

Objectives, Scope,

and Methodology

26

Appendix II 

Summary on the

Failures of the

Jefferson Bank and

Trust and the Bank of

San Diego

28

Jefferson Bank and Trust 28

The Bank of San Diego 29

Appendix III 

Comments From the

Inspector General of

the Federal Deposit

Insurance

Corporation

30

Appendix IV 

Comments From the

Inspector General of

the Federal Reserve

System

31

Appendix V 

Comments From the

Inspector General of

the Department of the

Treasury

33

Page 24 GAO/GGD-95-126 Mandated Studies
Contents

Appendix VI 

Major Contributors to

This Report

37

Tables Table 1: Applicable Percentage of the Bank’s Assets on a Sliding

Scale

4

Table 2: Available Options Concerning the Material Loss Review

Process

19

Abbreviations

BIF Bank Insurance Fund

C&D Cease and Desist Order

CFO Chief Financial Officer’s Act of 1990

DAS Federal Deposit Insurance Corporation’s Division of Asset

Services

DOF Federal Deposit Insurance Corporation’s Division of Finance

FDIA Federal Deposit Insurance Act

FDIC Federal Deposit Insurance Corporation

FDICIA Federal Deposit Insurance Corporation Improvement Act

IG Inspector General

JBT Jefferson Bank and Trust

MLR material loss review

OCC Office of the Comptroller of the Currency

OTS Office of Thrift Supervision

PCR Post Closing Report

SOU Statement of Understanding

TBSD The Bank of San Diego

Page 25 GAO/GGD-95-126 Mandated Studies
Appendix I 

Objectives, Scope, and Methodology

In accordance with section 38(k) of the Federal Deposit Insurance Act as

amended, our objectives were to (1) assess the adequacy of the

preparations, procedures, and audit guidelines that the Inspectors General

(IG) have established for performing material loss reviews (MLR) to ensure

compliance with their responsibilities under the section; (2) verify the

information contained in the MLR reports upon which the IGs based their

conclusions; (3) recommend improvements, if necessary, in bank

supervision based on a review of the MLR reports issued between July 1,

1993, and June 30, 1994; and (4) assess the economy and efficiency of the

current MLR process.

To accomplish these objectives, we interviewed staff from the Federal

Reserve, Federal Deposit Insurance Corporation (FDIC) and Treasury IG

offices on the plans, policies, and procedures they had established to

perform MLRs, including their audit guidelines, staffing, and training

programs for employees assigned to perform MLRs. We also conducted a

round table discussion session with representatives from each of the IG

offices to share their views on some of the MLR issues and concerns.

Additionally, we met with bank supervision officials and bank examiners

from the Federal Reserve and FDIC to obtain their views on the MLR

process. We also reviewed the legislative history of the Federal Deposit

Insurance Corporation Improvement Act of 1991, pilot studies completed

by the IGs, and our previous reports on bank failures and bank supervision.

To assess the adequacy of the IGs MLR audit guidelines, we reviewed them

for their completeness and relevance to the MLR objectives. We also

compared the MLR audit guidelines to audit guidelines that we had

developed for investigating costly bank failures.1

 We developed these

guidelines to (1) understand why so many depository institutions failed in

the late 1980s and early 1990s causing substantial Bank Insurance Fund

(BIF) losses and (2) recommend improvements in depository institution

supervision. These guidelines produced report findings that were praised

as complete and accurate even by bank regulators whose examination

practices were sometimes criticized in the reports. The guidelines involve

obtaining and reviewing copies of

1

Bank Insider Activities: Insider Problems and Violations Indicate Broader Management Deficiencies

(GAO/GGD-94-88, Mar. 30, 1994), Bank and Thrift Regulation: Improvements Needed in Examination

Quality and Regulatory Structure (GAO/AFMD-93-15, Feb. 16, 1994), Bank Supervision: OCC’s

Supervision of the Bank of New England Was Not Timely or Forceful (GAO/GGD-91-128, Sept. 16,

1991), Bank Supervision: Prompt and Forceful Regulatory Actions Needed (GAO/GGD-91-69, Apr. 15,

1991), Failed Banks: Accounting and Auditing Reforms Urgently Needed (GAO/AFMD-91-43, Apr. 22,

1991), Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, Mar. 4, 1991), Thrift Failures: Costly

Failures Resulted From Regulatory Violations and Unsafe Practices (GAO/AFMD-89-62, June 16, 1989),

and Bank Failures: Independent Audits Needed to Strengthen Internal Control and Bank Management

(GAO/AFMD-89-25, May 31, 1989).

Page 26 GAO/GGD-95-126 Mandated Studies
Appendix I 

Objectives, Scope, and Methodology

• historical financial data, which is available from the bank regulators,

showing information such as the growth in the bank’s loan portfolio over

time;

• regulatory examinations and their supporting workpapers that had been

done on a particular bank 5 to 10 years before its failure;

• enforcement actions that the regulators had taken against the bank for

unsafe and unsound practices, such as Memorandums of Understanding or

Cease and Desist Orders;

• correspondence between the bank and the regulator primarily responsible

for its supervision; and

• the Post Closing Reports that identify both the causes of bank failures and

determine whether FDIC should pursue civil claims against bank officials to

help compensate the BIF for any losses incurred in resolving the failures.

Moreover, we reviewed the two MLR reports issued by the Federal Reserve

IG and FDIC IG during the first year that section 38(k) went into effect: the

reports on Jefferson Bank and Trust in Colorado and The Bank of San

Diego in California, respectively. We substantiated the accuracy of the MLR

reports’ findings and recommendations on the causes of the banks’ failures

by generally following our audit guidelines discussed above. We reviewed

the reports’ supporting workpapers and interviewed Federal Reserve and

FDIC examination officials. We also reviewed the two MLR reports to

identify potential recommendations that we could make to improve the

overall quality of bank supervision. Although we reviewed the MLR reports

on The Bank of San Pedro and Pioneer Bank, we did not verify the

information contained in these reports because they were issued in the

second year that section 38(k) went into effect.

We did our work between April and October 1994 in Washington, D.C.;

Irvine, CA; San Francisco; and Denver in accordance with generally

accepted government auditing standards.

Page 27 GAO/GGD-95-126 Mandated Studies
Appendix II 

Summary on the Failures of the Jefferson

Bank and Trust and the Bank of San Diego

In the first year that section 38(k) went into effect—July 1, 1993, to

June 30, 1994—two banks failed and caused material losses. The Federal

Reserve Inspector General (IG) issued a material loss review (MLR) report

on the Jefferson Bank and Trust (JBT), and the Federal Deposit Insurance

Corporation (FDIC) IG issued a MLR report on The Bank of San Diego (TBSD).

We read these reports, reviewed their supporting workpapers, and

interviewed Federal Reserve IG and FDIC IG officials and agency officials

responsible for the supervision of these banks. This appendix summarizes

the MLR reports’ findings and recommendations.

Jefferson Bank and

Trust

On December 27, 1993, the Federal Reserve IG issued a MLR report on JBT of

Lakewood, CO, which failed on July 2, 1993. The report concluded that JBT

failed as the result of a massive securities fraud perpetrated by its

investment adviser. The investment adviser diverted approximately

$43 million worth of JBT’s government securities for his own benefit and

provided fictitious records to the bank so that it was not aware of the

securities’ diversion. In December 1991, JBT liquidated its account with the

investment adviser. However, JBT was subsequently sued by the Iowa

Trust, another client of the investment adviser, which claimed that a

portion of its securities had been diverted to pay JBT. A U.S. District Court

ruled in favor of Iowa Trust, and JBT was forced to turn over

approximately $43 million in government securities. Colorado closed JBT

on July 2, 1993, because the bank was no longer solvent. The investment

adviser pled guilty to defrauding the bank, and other investors, and was

sentenced to a federal prison term.

The Federal Reserve IG’s report on JBT also recommended steps that the

Federal Reserve could take to improve its oversight of bank securities

trading. For example, the report recommended that the Federal Reserve

ensure compliance with a policy the IG contends limits the percentage of

assets, such as government securities, that a bank can keep with a

securities dealer. This policy, which is one of the recommendations for a

bank’s selection of a securities dealer included in the Board of Governors’

Commercial Bank Examination Manual, sets guidelines for limiting the

aggregate value of securities a bank should keep with a selling dealer. The

IG concluded that if JBT had followed this recommendation with respect to

the government securities diverted by its investment adviser, the bank

would have sustained a loss of approximately $1.6 million instead of its

loss of approximately $43 million.

Page 28 GAO/GGD-95-126 Mandated Studies
Appendix II 

Summary on the Failures of the Jefferson

Bank and Trust and the Bank of San Diego

The Board disagreed with the IG’s recommendation, contending that the

policy does not apply to pure safekeeping arrangements, but only to those

involving a credit risk arising from transactions between a bank and a

securities dealer. Specifically, the Board maintained that the policy is an

attempt to “limit banks’ exposures to questionable securities transactions

involving credit risks—not safekeeping risks.” Thus, according to the

Board, the policy did not apply to the arrangement between JBT and its

broker-dealer because they had purely a safekeeping relationship, rather

than a credit relationship.

The Bank of San

Diego

On April 29, 1994, the FDIC IG issued a MLR report on TBSD, which failed on

October 29, 1993. In December 1992, TBSD, with the approval of FDIC,

merged with its two affiliates, Coast Bank and American Valley Bank, to

form the consolidated TBSD. The report concluded that TBSD failed as a

result of weak loan underwriting; concentrations in high-risk, real-estate

loans; high overhead expenses; and inadequate oversight by bank

management. The report stated that, in the 1980s, TBSD adopted a strategy

of making high-risk loans to real-estate developers in southern California.

By 1991, high-risk, real-estate loans comprised more than 50 percent of the

consolidated bank’s loan portfolio. The IG concluded that many developers

defaulted on their loans in the early 1990s when the real-estate market

declined in California. TBSD had inadequate capital and loan loss reserves

to cover these losses, and California subsequently closed the bank.

The report concluded that FDIC’s supervision of TBSD was in compliance

with applicable laws and regulations and that it properly identified and

addressed the conditions that caused the bank to fail. The report

recommended that FDIC issue regulations to implement provisions in FDICIA

that are designed to improve bank lending practices. The report also

concluded that the FDIC’s decision in 1992 to approve the merger between

TBSD and its affiliates was reasonable. FDIC approved the merger so that the

banks could reduce their expenses and so that managers responsible for

their condition could be removed. However, the IG found that it may have

been appropriate for FDIC to have obtained more current information about

the banks’ asset quality problems before it approved the merger. These

asset quality problems proved to be more substantial than originally

believed in December 1992 and resulted in the bank’s failure the following

October. FDIC generally concurred with the IGs’ conclusions and

recommendations.

Page 29 GAO/GGD-95-126 Mandated Studies
Appendix III 

Comments From the Inspector General of

the Federal Deposit Insurance Corporation

Page 30 GAO/GGD-95-126 Mandated Studies
Appendix IV 

Comments From the Inspector General of

the Federal Reserve System

Page 31 GAO/GGD-95-126 Mandated Studies
Appendix IV 

Comments From the Inspector General of

the Federal Reserve System

Page 32 GAO/GGD-95-126 Mandated Studies
Appendix V 

Comments From the Inspector General of

the Department of the Treasury

Page 33 GAO/GGD-95-126 Mandated Studies
Appendix V 

Comments From the Inspector General of

the Department of the Treasury

Page 34 GAO/GGD-95-126 Mandated Studies
Appendix V 

Comments From the Inspector General of

the Department of the Treasury

Now on pp. 4 and 5.

Now on p. 9.

Now on p. 16.

Now on p. 16.

Page 35 GAO/GGD-95-126 Mandated Studies
Appendix V 

Comments From the Inspector General of

the Department of the Treasury

Now on pp. 19-20

and 21.

Page 36 GAO/GGD-95-126 Mandated Studies
Appendix VI 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Nolani T. Courtney, Evaluator-in-Charge

Wesley M. Phillips, Evaluator

Phoebe A. Jones, Secretary

Office of the General

Counsel, Washington,

D.C.

Paul G. Thompson, Attorney

San Francisco Field

Office

Bruce K. Engle, Evaluator

(233429) Page 37 GAO/GGD-95-126 Mandated Studies
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