United States General Accounting Office

GAO Report to Congressional Committees

November 1996 INSPECTORS

GENERAL

Mandated Studies to

Review Costly Bank

and Thrift Failures

G O A

years

1921 - 1996

GAO/GGD-97-4

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-272445 

November 7, 1996

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 second 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

thrifts2

—whose failures result in “material losses” (i.e., basically losses

that exceed $25 million) to deposit insurance funds. The section directs

the IGs to determine why a bank’s or thrift’s problems resulted in a

material loss to an insurance fund and to make recommendations for

preventing such losses in the future. Finally, until amended in

October 1996, the section required 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.3

1

12 USC Section 1831o(k).

2

Thrifts are federally insured financial institutions that have traditionally used customer deposits to

finance home mortgages.

3

This requirement was amended by the General Accounting Office Management Reform Act of 1996,

which the President signed on October 19, 1996. The amendment requires the Comptroller General of

the General Accounting Office to review material loss review (MLR) reports, as the Comptroller

General determines to be appropriate, and recommend improvements in the supervision of depository

institutions. The amendment discontinues the requirement that GAO review MLR reports on an annual

basis. This report was prepared under section 38(k) of FDIA prior to the enactment of this

amendment.

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

were to (1) summarize the findings of the MLR reports initiated during the

second year of the mandate—July 1, 1994, to June 30, 1995—including the

verification of the accuracy of one of these reports; (2) make

recommendations, if necessary, to improve bank supervisory practices;

and (3) assess the economy and efficiency of the current MLR process.

Scope and

Methodology

To meet our first objective, we reviewed reports on two banks that failed

during the second year of the MLR mandate and two banks that failed

during the first year of the mandate but whose losses were not recognized

until the second year. In these latter two cases, FDIC’s initial estimates of

the banks’ losses were below $25 million, but the estimates were revised

above $25 million at a later date requiring the IGs to initiate MLRs. We chose

to verify the accuracy of an MLR report issued by the Treasury IG because

we verified reports issued by the FDIC and Federal Reserve IGs in our first

report on the MLR process.4

 To verify the accuracy of this MLR report, we

reviewed the supporting workpapers, interviewed Treasury IG officials,

and met with examiners involved in the failure.

To meet our second objective, we analyzed the MLR reports issued to date

to determine whether an adequate base of evidence had been established

to make recommendations to the regulators on improving supervisory

practices. We asked IG officials to provide us with their views on the MLR

process and recommendations for improving its cost-effectiveness. To

meet our third objective, we assessed the cost-effectiveness of the current

MLR process by reviewing our previous report which discussed this issue.

The IGs for FDIC, the Federal Reserve, and Treasury provided written

comments on a draft of this report, which are discussed on page 15 and

reprinted in appendixes I, II, and III. We did our work in Washington, D.C.,

and San Francisco between June and August 1996 and in conformance

with generally accepted government auditing standards.

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

Currency (OCC), and the Office of Thrift Supervision (OTS)5

 share

responsibility for regulating banks and thrifts in the United States. FDIC

regulates federally insured state-chartered banks that are not members of

4

Inspectors General: Mandated Studies to Review Costly Bank and Thrift Failures (GAO/GGD-95-126,

July 31, 1995).

5

OCC and OTS are both part of the Department of the Treasury.

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the Federal Reserve System while the Federal Reserve regulates

state-chartered banks that are members of the system. State regulatory

agencies are also responsible for overseeing the operations of

state-chartered institutions, in coordination with FDIC or the Federal

Reserve. OCC regulates nationally chartered banks, while OTS regulates

thrifts.6

 The regulators use a number of devices to carry out their oversight

responsibilities, such as conducting periodic examinations and issuing

enforcement actions against unsafe and unsound banking practices.

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

between 1986 and 1990 resulted in about $14.4 billion in losses to the Bank

Insurance Fund (BIF) and threatened its solvency.7

 The amendments were

designed largely to strengthen bank supervision and to help avoid a

taxpayer bailout of the BIF similar to the approximately $124.6 billion8

 in

direct taxpayer funds that Congress provided to protect the depositors of

thrifts that failed during the 1980s and early 1990s. Among other

provisions, the amendments authorize the banking regulators to take

specified enforcement 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 Treasury—the latter being

responsible for auditing OCC and OTS—are 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 engage in a range of activities, including criminal

investigations, financial audits, and audits of the economy and efficiency

of agency operations.

Section 38(k) of FDIA requires the IGs to initiate MLRs when the estimated

loss of a bank or thrift failure exceeds either $25 million or a specified

6

State regulatory authorities also share responsibility with OTS for regulating and supervising

state-chartered thrifts.

7

BIF had a deficit balance of $7 billion at the end of 1991 but has since recovered substantially and had

a balance exceeding $25 billion in 1995.

8

In addition to $124.6 billion in direct taxpayer costs, which included funds provided to the Resolution

Trust Corporation, there was also $7.5 billion in indirect taxpayer costs, such as tax benefits provided

to the acquirers of troubled thrifts. See Financial Audit: Resolution Trust Corporation’s 1995 and 1994

Financial Statements (GAO/AIMD-96-123, July 2, 1996).

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percentage of the institution’s assets (see table 1) when that percentage

represents an amount greater than $25 million. An MLR report 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 section

38(k).9

Table 1: Percentage Loss of a Failed

Institution’s Assets That Requires the

Initiation of an MLRa

Time periodb Percentage

1993 - 1994 7

1994 - 1995 5

1995 - 1996 4

1996 - 1997 3

After June 30, 1997 2

aThe estimated loss must exceed $25 million.

bEach time period is from July 1 to June 30 of the following year.

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

In July 1995, we issued our first report on the MLR process, as required by

section 38(k). It assessed the plans and procedures that the IGs initiated to

comply with the MLR mandate as well as the two reports that were issued

in the first year—July 1, 1993, to June 30, 1994. We found that the IGs had

effectively positioned themselves to meet the requirement by developing

audit guidelines, providing additional training, and hiring staff with

appropriate banking expertise. We also found that the two reports issued

the first year, one by the FDIC IG and one by the Federal Reserve IG, were

generally accurate in describing the causes of the banks’ failures and the

quality of their supervision. We recommended that the FDIC IG take further

steps to assess the adequacy of regulatory enforcement actions, which the

IG agreed to implement. We also found that the MLR process as currently

structured may not be the most cost-effective means of achieving

improved bank supervision because, among other reasons, the limited

number of reports issued did not provide a comprehensive basis to

recommend overall changes in bank regulatory practices.

9

The section defines a loss as incurred when (1) FDIC is appointed receiver of the institution and it

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 (2) 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.

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Results in Brief The Federal Reserve, FDIC, and Treasury IGs issued a total of four MLR

reports on banks that failed or whose losses were recognized during the

second year of the MLR mandate. Our review of these reports found that

the four banks failed for similar reasons including: rapid growth, excessive

loan concentrations in the commercial real estate industry, poor internal

controls, and violations of laws and regulations. The reports also identified

certain weaknesses in the bank regulators’ oversight of these institutions;

for example, in three of the four cases bank regulators either did not take

sufficiently aggressive enforcement actions to correct identified safety and

soundness deficiencies or to ensure that troubled banks complied with

existing enforcement actions. Our review of the Treasury IG’s report on the

failure of Mechanics National Bank (MNB) of Paramount, California, found

that it accurately described the causes of the bank’s failure and the

weaknesses in regulatory oversight of the bank.

We are not making any general recommendations to the bank regulators

because the relatively small number of reports issued in the first 2 years of

the mandate—six—does not provide a sufficient basis to reach overall

conclusions about the quality of their supervisory practices. In our view,

the limited basis that these reports provide for making recommendations

about overall bank supervision raises questions about the

cost-effectiveness of the MLR process as currently structured. There are

other reasons to question the cost-effectiveness of the current process,

including the fact that certain MLR requirements are relatively inflexible

and divert IG staff and resources from broader reviews of the quality of

bank supervision. In our previous report, we identified options that could

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

which we believe continue to merit congressional consideration.

IG Reports Found

That Banks Failed for

Similar Reasons

The four MLR reports that we reviewed (see table 2) found that the banks

failed for similar reasons. In particular, the reports found that the banks,

primarily during the 1980s, engaged in unsafe and unsound practices, such

as rapid growth, significant concentrations in real estate loans, inadequate

lending practices, and violations of laws and regulations. When the real

estate industry suffered a substantial downturn in the early 1990s, the

banks suffered substantial losses which ultimately caused their failures.

The reports also identified various shortcomings in bank regulatory

practices; for example, the reports on MNB and The Bank of Hartford cited

OCC and FDIC for not ensuring that the banks complied with existing

enforcement actions, and the Pioneer Bank report cited the Federal

Reserve for not taking more aggressive enforcement actions to correct

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identified deficiencies. However, only the FDIC IG issued recommendations

in its two reports to improve bank supervision. The Treasury and Federal

Reserve IGs did not issue specific recommendations because, among other

reasons, they did not believe that one MLR report provided an adequate

basis for such recommendations.

Table 2: Reports Initiated During the

Second Year of the MLR Mandate $ in millions

Bank

Estimated loss to

BIF IG office

Mechanics National Bank, Paramount,

California

$ 36.6 Treasury

The Bank of San Pedro, San Pedro, California 28.8 FDIC

The Bank of Hartford, Hartford, Connecticut 31.3 FDIC

Pioneer Bank, Fullerton, California 27.3 Federal Reserve

Source: IG MLR reports on these bank failures.

Mechanics National Bank OCC closed MNB on April 1, 1994, during the first year of the MLR mandate,

but FDIC did not estimate that its total loss on the MNB failure would exceed

$25 million until April 18, 1995, which was during the second year of the

mandate. Consequently, the Treasury IG initiated its MLR as of April 18,

1995, and issued the report on September 29, 1995. In our view, the report

accurately described the causes of MNB’s failure and identified

shortcomings in OCC’s oversight of the institution.

The report concluded that MNB engaged in a variety of unsafe and unsound

banking practices between 1988 and 1994 that contributed substantially to

its failure. For example, the report found that the bank nearly doubled in

size between 1988 and 1991 and made significant loan commitments to the

commercial real estate sector. Further, the bank established a substantial

inventory of loans guaranteed by the Small Business Administration (SBA);

many of these loans were for financing gasoline service stations and highly

risky.10 In addition to credit concentrations in the commercial real estate

and service station sectors, MNB suffered from inadequate underwriting

practices, weak appraisal procedures, poor loan documentation,

10Service station loans are risky because the collateral values for such loans can be significantly

reduced by hazardous waste contamination at the site of the property. The bank may also be liable for

the costs of cleaning up the environmental pollution on foreclosed properties.

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suspected fraudulent activities in the SBA portfolio,11 and insider abuses.

When the California commercial real estate sector suffered a substantial

downturn in the early 1990s, many MNB loans defaulted and the bank had

inadequate capital to prevent its eventual insolvency and closure in

April 1994.

The Treasury IG also identified various deficiencies in OCC’s oversight of

MNB. For example, the IG found that the limited safety and soundness

exams that OCC conducted of MNB in 1989 and 1990 were insufficient to

detect the bank’s weak underwriting and loan administration practices.

Therefore, many of the bad loans that resulted in MNB’s eventual failure

were already on its books by the time OCC conducted the full-scope

examination in 1991 that first identified the severity of the bank’s

problems. The report also concluded that OCC’s enforcement actions

proved ineffective in getting MNB management to correct identified unsafe

and unsound practices. Specifically, MNB continued to make a substantial

number of poorly underwritten commercial real estate loans even after

OCC issued a cease and desist order against the bank in 1991 which

required substantial improvements in the bank’s lending operations. The

report faulted OCC for not imposing civil money penalties on bank officials

for continued violations of the cease and desist order. However, the IG

made no specific recommendations in the report to improve OCC

enforcement practices because the IG believed that (1) the passage of laws,

such as the 1991 amendments to FDIA, and rules and procedures should

address many of the supervisory weaknesses identified in the MNB report;

and (2) one report did not provide a sufficient base of evidence for making

recommendations.

Our analysis of the MNB report found that it accurately described the

causes of the bank’s failure and the shortcomings in OCC’s oversight

activities. This assessment is based on our review of the report’s

supporting documentation and on discussions with IG staff and OCC

officials. We also note that OCC’s Senior Deputy Comptroller for

Administration agreed with the IG’s findings in OCC’s official written

response to the report.

11SBA guarantees between 70 to 90 percent of each SBA loan with the bank liable for the remaining

percent. MNB’s SBA loan portfolio primarily consisted of the nonguaranteed portion of SBA loans

because the bank typically sold the guaranteed portion to the secondary market. In addition, MNB

could be liable for the guaranteed portion of the SBA loans that were sold if they were approved based

on misrepresentation or fraud.

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The Bank of San Pedro The State of California closed The Bank of San Pedro on July 15, 1994, and

the FDIC IG issued its MLR report on December 21, 1994. The report cited

numerous causes of the bank’s failure, including excessive concentrations

in a real estate development subsidiary, poor underwriting practices,

inadequate loss reserves and capital, failure to comply with regulatory

enforcement actions, and repeated violations of laws and regulations. As

was the case with MNB, the substantial downturn in the California real

estate economy, coupled with the bank’s poor management practices,

caused significant losses to San Pedro’s loan portfolio that ultimately

caused the bank to fail.

The report found that FDIC was in compliance with applicable laws and

regulations and properly identified the causes of San Pedro’s failure.

However, the IG did recommend that FDIC evaluate the need for developing

regulations to control the use of money desks by troubled banks.12 Even

though San Pedro was undercapitalized, management used the bank’s

money desk to raise volatile deposits nationwide by offering above-market

interest rates.13 The use of volatile deposits by irreversibly troubled

institutions can delay their failure and potentially increase insurance fund

losses, according to the report. The report also reiterated the importance

of recommendations that the IG made in a previous MLR report covering

such areas as controlling loan concentrations and excessive overhead

expenses.14

The Bank of Hartford The State of Connecticut closed the Bank of Hartford on June 10, 1994, but

FDIC did not estimate that the associated losses would exceed $25 million

until the spring of 1995. The FDIC IG initiated its MLR as of June 6, 1995, and

the report was issued on December 1, 1995.

According to the MLR report, The Bank of Hartford failed as a result of

several unsafe and unsound practices. In particular, the bank committed a

significant percentage of its loan portfolio to the multifamily and

commercial real estate sectors; such loans represented 47 percent of the

bank’s total loan portfolio in 1991, which exposed the bank to significant

losses when the Connecticut real estate sector declined. The bank also

12A 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.

13Because these deposits were highly sensitive to interest rates, they were considered volatile by the

regulators.

14FDIC Inspector General, The Failure of the Bank of San Diego (April 29, 1994).

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failed to adequately assess the ability of loan guarantors to fulfill their

commitments and engaged in poor loan administration practices, such as

the failure to obtain updated financial information on large borrowers.

Further, within 12 months prior to its failure, the bank purchased

$27 million in derivative financial instruments without performing the

necessary analysis as required by FDIC policy guidelines. FDIC experienced

a loss of $5.8 million on the sale of the derivative instruments after the

Bank of Hartford was closed.

The report identified weaknesses in FDIC’s oversight of the bank and

recommended improvements. For example, the report found that FDIC and

state examiners did not identify the bank’s credit concentrations in

multifamily loans until 1991 even though they were apparent in 1987. By

the time FDIC entered into a cease and desist order with the bank in

July 1992 that required the bank to reduce its loan concentrations, more

than 33 percent of its commercial real estate loans were considered in

danger of default. Moreover, the report found that the bank’s purchase of

$27 million in derivative instruments without a proper risk analysis was

contrary to a cease and desist order against the bank and FDIC investment

guidelines. However, the report pointed out that FDIC increased its

oversight activities when the derivatives purchases were identified. Among

other suggestions, the IG recommended that all undercapitalized banks be

required to obtain written approval from FDIC prior to purchasing

derivative instruments.

Pioneer Bank The State of California closed Pioneer Bank on July 8, 1994, and the

Federal Reserve IG issued its MLR report on January 6, 1995. Like the other

three banks discussed above, Pioneer failed primarily as the result of its

rapid growth and substantial commitment to the commercial real estate

sector. Commercial real estate loans accounted for 44 percent of Pioneer’s

total loans in 1991 and exposed the bank to substantial losses when the

economy deteriorated. In addition, Pioneer suffered from weak liquidity

and poor appraisal and underwriting practices.

The report found that the Federal Reserve identified Pioneer’s deficiencies

during on-site examinations and tried to get bank officials to correct safety

and soundness violations through enforcement actions. Further, the report

concluded that Federal Reserve’s actions, both formal and informal, were

within the range of acceptable actions for a bank with Pioneer’s problems.

However, the report also identified certain weaknesses in the Federal

Reserve’s supervisory practices. For example, examiners did not always

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detect appraisal violations, or adequately address underwriting and credit

administration weaknesses. Also, enforcement actions taken by the

Federal Reserve were not always sufficiently aggressive given the severity

of the safety and soundness deficiencies identified. The IG did not make

any recommendations in the report since it only assessed one bank failure.

However, the IG did suggest that the Federal Reserve take the report’s

findings on appraisal violations, underwriting weaknesses, and

supervisory actions under advisement.

MLR Process Appears

to Have Limited

Cost-Effectiveness

We believe there are reasons to question whether the time and resources

that the IGs commit to the MLR process, as currently structured, are

cost-effective. Although the six MLR reports initiated during the first 2 years

of the mandate identified important information about individual bank

failures, they do not provide us with an adequate base of evidence to

recommend cross-regulator improvements in bank supervision. IG officials

have also found it difficult to justify recommendations based on a limited

sample of reports, and have said that certain MLR requirements,

particularly the $25 million threshold for initiating an MLR, are relatively

inflexible, resulting in administrative burdens and expenditures. Even if

there were a substantial increase in costly bank failures requiring MLR

reports, we believe it is questionable whether the labor-intensive demands

and short reporting deadlines of the MLR process would make the potential

benefits worth the costs. As stated in our previous report on the MLR

process, we believe it would make sense for Congress to provide the IGs

with more flexibility in initiating MLRs.

Limited Number of Reports

Provide Inadequate Basis

for Making

Recommendations

We stated in our first report on the MLR requirement that reports on

individual bank failures provide important information about the causes of

individual bank failures and the quality of the banks’ supervision. The

reports also familiarize IG staff with the examination process and have

identified areas that require further investigation. As examples, FDIC IG

officials told us that the report on the Bank of San Pedro served as the

basis for doing a broader audit on troubled banks’ use of money desks,

and Treasury IG officials said that the MNB report served as the basis for

initiating a study on OCC officials’ compliance with certain

conflict-of-interest disclosure requirements. Additionally, in March 1996,

FDIC Division of Supervision officials in Washington, D.C., disseminated the

findings of two IG MLR reports for the benefit of bank examiners in regional

offices across the country.

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However, we do not believe that the six MLR reports on bank failures

issued during the first 2 years of the mandate provide a sufficient basis for

identifying trends in bank supervisory practices or making

recommendations that would apply equally to the Federal Reserve, FDIC,

OCC, and OTS. The limited basis for making overall recommendations is

demonstrated by the fact that four of the six failed banks were located in

California and only one of the reports applies to OCC while none applies to

OTS. IG officials have also found it difficult to justify recommendations to

the regulators based on the MLR reports initiated during the first 2 years of

the mandate. For example, the Treasury and Federal Reserve IGs did not

make recommendations in the MNB and Pioneer Bank reports, respectively,

at least in part because the IG officials did not believe that the reports

provided a sufficient evidentiary base. We believe that such

recommendations, if necessary, should be based on larger samples of

failed bank cases located in different regions of the country or on broader

reviews of bank supervisory practices.

We recognize that the four MLR reports discussed above identify certain

commonalities (e.g., the banks failed due to real estate concentrations and

regulators did not take adequate enforcement actions) which suggest

potential areas for improvements in supervisory practices. However, we

are not convinced that four reports provide an adequate basis for specific

recommendations. Further, the reports’ major findings address

weaknesses in bank supervision during the 1980s, such as the reluctance

of the regulators to take strong enforcement actions to address repeated

safety and soundness violations, which have already been documented

and served as the basis for the regulatory reform amendments to FDIA that

were enacted in 1991.15 For example, FDIA now directs that the regulators

require troubled banks whose capital has fallen to preestablished levels to

file plans that detail how they will improve their financial condition and

correct unsafe and unsound practices. Therefore, to the extent that the

reports are focused on historical practices that have been addressed in

whole or in part by legislation or changes in supervisory practices, their

applicability may be limited.

Although a substantial increase in the number of bank failures requiring

MLRs would provide a better base for making recommendations, we believe

there are reasons to question whether the benefits of issuing MLR reports

under such circumstances would justify the costs. The MLRs initiated to

date have been labor-intensive efforts that required substantial interaction

between IG staff and regulatory officials as well as several visits to bank

15See Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, Mar. 4, 1991).

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failure locations to review loan files and other records. The IG offices are

required to initiate these efforts to meet the 6-month deadline established

by section 38(k), but the presence of IG staff at bank locations during a

wave of bank failures as occurred during the late 1980s and early 1990s

may not be desirable. During such periods, bank examiners, FDIC

failed-bank resolution officials, and IG staff may not have adequate time

and resources to devote to the preparation of in-depth case studies on the

causes of individual bank failures. Further, our past reports have found

that poorly managed banks tend to make weakly underwritten loans

during strong economic periods and that by the time banks begin to

experience substantial financial deterioration, the ability of bank

managers and regulators to avert failure may be substantially limited.

Therefore, a series of MLR reports issued in the midst of a bank crisis may

have limited short-term practical effects because the bad loans generating

the failures may have been on the banks’ books for years. We believe the

four MLR reports discussed in this report illustrate this point because they

found that the banks engaged in shortsighted and ultimately unsafe real

estate lending policies, primarily during the strong economic period of the

1980s, that were directly responsible for their failures when the local

economies weakened substantially in the early 1990s.

Certain MLR Requirements

Are Relatively Inflexible

and Place Administrative

Burdens on IG Offices

IG officials we contacted said that certain MLR requirements specified in

section 38(k) can place administrative burdens on their offices. In

particular, they said that FDIC sometimes underestimates potential

insurance fund losses when banks fail, so the IGs must sometimes initiate

MLRs months after failures have occurred when FDIC revises its initial loss

estimates above $25 million. The Treasury and FDIC IGs did not initiate the

MNB and Bank of Hartford MLRs until about a year after their failures,

because FDIC’s initial loss estimates were revised upward substantially.

Under a Statement of Understanding between the IG offices that

coordinates the MLR process, the IGs are to monitor certain bank failures

whose estimated losses are below $25 million for five full quarters after

the failure date to ensure that FDIC loss estimates do not exceed the

statutory threshold over time.16 IG staff said that monitoring certain

failures, which may involve preliminary contacts with regulatory officials

and obtaining documents, whose estimated losses could exceed

$25 million, proves unnecessary if the estimates stay below the statutory

16The initial estimates on the cost of bank failures are based on FDIC officials’ best estimates at the

time of failure of what the recoveries will be on the sale of a particular bank’s assets. They may also be

based on FDIC’s historical recoveries on the sale of failed bank assets. The initial estimates are revised

over time as FDIC actually sells assets and tabulates its recoveries.

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threshold. More important, IG officials may experience difficulties

obtaining information they believe is necessary to do an MLR when FDIC

substantially revises its initial loss estimates upward with minimal warning

months after a failure has occurred.17 For example, in early 1996, FDIC

revised the estimated loss on Guardian Bank in California, which failed in

January 1995, from $8 million to more than $25 million. This revised

estimate required the Federal Reserve IG to initiate an MLR since the bank

was regulated by the Federal Reserve. IG officials said they were not fully

prepared to initiate the MLR and had some difficulties obtaining required

bank records because they had already been shipped to other storage

locations throughout the country. In one instance, IG officials said they had

to visit an FDIC storage facility in Chicago to review certain records. In

addition, the IG officials said that key regulatory personnel involved in

overseeing Guardian were no longer available or could not recall certain

events due to the passage of time.

We also pointed out in our previous report that the 6-month deadline for

MLRs may require IG officials to divert staff from ongoing, broad reviews of

bank regulation and other issues. For example, Treasury IG officials said

that 30 to 50 percent of their staff resources are already committed to

assessing executive agency financial systems as required by the Chief

Financial Officers Act of 1990 (CFO). Therefore, MLR audits could place

additional workload demands on the Treasury IG staff that are not

committed to CFO work, particularly since the organization did not hire

additional personnel to do MLRs. Moreover, the FDIC IG office is undergoing

a substantial downsizing, which means that MLRs will place more stringent

requirements on the organization in the future. FDIC IG officials said the

staff responsible for MLRs and other bank supervision work declined from

an authorized level of 37 in 1994 to 25 in 1996 and may fall to 11 in 1997.

The Federal Reserve IG staff available to do MLRs has remained stable, but

officials we contacted said they were not able to initiate all of their

planned audits on bank supervision in 1996 due to the Guardian Bank MLR.

As discussed earlier, we believe there is reason to question whether the

IGs’ resource commitments to the MLR process are justifiable, given their

limited impact on improving bank supervision.

17In March 1994, the FDIC IG issued a report on the FDIC’s loss estimation process entitled Audit of

the Cost Estimate Process for Failed Bank Resolutions. In September 1996, the FDIC IG issued a

related study entitled Follow-Up Audit: Cost Estimate Process for Bank Resolutions.

Page 13 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
B-272445 

Providing IGs With More

Flexibility Could Improve

the Cost-Effectiveness of

the MLR Process

We suggested in our previous report that providing the IGs with more

discretion on the number and timing of MLRs to initiate each year could

improve the cost-effectiveness of the MLR process. For example, more

discretion would allow the IGs to focus their efforts on broader reviews of

the overall quality of bank supervision rather than diverting staff to

conduct mandatory MLRs within the 6-month deadline. Additional

discretion could also minimize the current administrative burdens that

have been generated by difficulties in estimating the cost of bank failures;

for example, the IGs could be allowed to make decisions on whether to

initiate an MLR based on their professional judgment rather than a

predetermined loss estimate. We did not suggest repealing the MLR

mandate entirely because we believe the process holds the regulators

accountable for their supervisory practices. Further, IG officials told us

that MLRs provide important information that can be incorporated into

broader studies of bank supervision.

Conclusions The four MLR reports we reviewed found that the banks failed for similar

reasons. In particular, the banks grew at rapid rates and committed an

excessive percentage of their lending portfolios to the commercial real

estate sector, primarily during the 1980s. When the real estate industry

suffered substantial downturns in California and Connecticut during the

early 1990s, the banks’ exposure to that industry and poor lending

practices caused substantial losses and eventual insolvency. The reports

also identified various weaknesses in the regulators’ oversight efforts,

such as the failure to get banks to comply with existing enforcement

actions, and the FDIC IG chose to make recommendations for improvement

to FDIC while the Treasury and Federal Reserve IGs did not. Our review of

the MNB report verified its major findings.

We are not making any recommendations for improving overall bank

supervision in this report because the limited number of MLR reports

produced so far does not provide an adequate basis for identifying

improvements. As currently structured, there are reasons to question the

cost-effectiveness of the MLR process, such as the limited basis it provides

for making recommendations to improve bank supervision and the

administrative burden and expenditures that the requirement places on the

IG offices. As we found in our previous report, providing the IGs with more

discretion in choosing the number and timing of MLRs to initiate each year

could improve the cost-effectiveness of the MLR process while preserving

the congressional intent of section 38(k), which was to hold bank

regulators accountable for their actions.

Page 14 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
B-272445 

Matters for

Congressional

Consideration

As we stated in our previous report, Congress may wish to consider

whether the current MLR requirement is a cost-effective means of achieving

improved bank supervision. If it determines that the requirement is not

cost-effective, we suggest that Congress consider amending the

requirement so that the IGs have more flexibility in choosing the number

and timing of MLRs to initiate each year.

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 I, II, and III, respectively. The IGs generally agreed

with our findings and conclusions as well as our suggestion that Congress

consider amending section 38(k) of FDIA so that the IGs have more

discretion in the number, timing, and scope of MLRs to initiate each year.

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 make copies available to others upon request.

This report was prepared under the direction of Susan S. Westin, Assistant

Director, Financial Institutions and Markets Issues. The other major

contributor was Wesley M. Phillips, Evaluator-in-Charge. If you have any

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

Thomas J. McCool

Associate Director, Financial Institutions

 and Markets Issues

Page 15 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Contents

Letter 1

Appendix I 

Comments From the

Inspector General of

the Federal Deposit

Insurance

Corporation

18

Appendix II 

Comments From the

Inspector General of

the Federal Reserve

System

19

Appendix III 

Comments From the

Inspector General of

the Department of the

Treasury

20

GAO Comments 22

Tables Table 1: Percentage Loss of a Failed Institution’s Assets That

Requires the Initiation of an MLRa

4

Table 2: Reports Initiated During the Second Year of the MLR

Mandate

6

Page 16 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Contents

Abbreviations

BIF Bank Insurance Fund

CFO Chief Financial Officers Act of 1990

FDIA Federal Deposit Insurance Act

FDIC Federal Deposit Insurance Corporation

IG Inspector General

MLR material loss review

MNB Mechanics National Bank

OCC Office of the Comptroller of the Currency

OTS Office of Thrift Supervision

SBA Small Business Administration

Page 17 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Appendix I 

Comments From the Inspector General of

the Federal Deposit Insurance Corporation

Page 18 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Appendix II 

Comments From the Inspector General of

the Federal Reserve System

Page 19 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Appendix III 

Comments From the Inspector General of

the Department of the Treasury

Page 20 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Appendix III 

Comments From the Inspector General of

the Department of the Treasury

Page 21 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
Appendix III 

Comments From the Inspector General of

the Department of the Treasury

The following are GAO’s comments on the Treasury IG’s comments dated

October 3, 1996.

GAO Comments 1. The IG stated that unsafe banking practices were the primary cause of

MNB’s failure while a declining economy precipitated eventual losses. We

have clarified the language on pages 6-7 in response to the IG’s comment.

2. The IG said that an increasing MLR workload would not affect the office’s

CFO work since such work is done by a separate unit. We clarified the

language on page 13 to make clear that MLRs could place greater resource

demands on IG staff not engaged in CFO work.

3. The IG stated that an underlying implication of our argument is that the

weak credit losses of the 1980s will also be the primary cause of bank

failures in the future. However, the IG said that this implication is not

necessarily the case and that banks are moving into new areas, such as

fee-based services, that involve risks different from credit risk that could

cause future bank failures.

We acknowledge that many banks are moving into new activities that

represent risks different from traditional credit risks. Such activities must

be carefully managed and monitored to ensure that they do not pose

unacceptable risks to the safety and soundness of banking institutions. It

is possible that the period between the time these problems arise and

losses are ultimately recognized could be shorter.

4. The IG said that doing a few MLRs during strong economic periods may

be beneficial in providing important prospective information about bank

supervision to Congress, regulators, and the IGs as compared with

initiating a series of MLRs during a banking downturn.

We state in our report that MLRs have certain beneficial impacts on bank

supervision but raise questions about the cost-effectiveness of the process

as currently structured. By allowing the IGs greater discretion in the

number, timing, and scope of MLRs to initiate as we have suggested, we

believe the benefits of the MLR process will be enhanced while costs will be

reduced.

(233498) Page 22 GAO/GGD-97-4 Mandated Reviews of Costly Bank and Thrift Failures
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