Federal Deposit Insurance Corporation 

FDIC


Banking
 Banking

Review
 Review

1999
 

Volume 12, No. 2
 

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Table of Contents

FDIC
 

Banking


Review
 

1999
 

Volume 12, No. 2
 

Chairman

Donna Tanoue

Division of Research

and Statistics,

Director

Wm. Roger Watson 

Deputy Directors

Barry Kolatch
 

Steven A. Seelig
 

Editor

Steven A. Seelig

Editorial Committee

Jack T. Reidhill
 

Detta Voesar
 

Managing Editor

Detta Voesar

Editorial Secretary

Cathy Wright

Design and Production

Geri Bonebrake 

The views expressed are

those of the authors and do

not necessarily reflect official positions of the Federal

Deposit Insurance Corporation. Articles may be

reprinted or abstracted if

the FDIC Banking Review

and author(s) are credited.

Please provide the FDIC's

Division of Research and

Statistics with a copy of any

publications containing reprinted material.

Single­copy subscriptions

are available to the public

free of charge. Requests for

subscriptions, back issues

or address changes should

be mailed to: FDIC Banking

Review, Office of Corporate

Communications, Federal

Deposit Insurance Corporation, 550 17th Street, N.W.,

Washington, DC 20429.

Financially Distressed Banks: How Effective Are

Enforcement Actions in the Supervision Process?

by Timothy J. Curry, John P. O'Keefe, Jane Coburn,

and Lynne Montgomery Page 1

This article investigates the effects of bank examinations and enforcement

actions on the behavior of problem banks.

The Consequences of National Depositor Preference

by James A. Marino and Rosalind L. Bennett Page 19

The authors examine the history of depositor preference laws and the

potential costs and benefits of the national depositor preference legislation

which was enacted in 1993.

Recent Developments Affecting Depository Institutions

by Lynne Montgomery Page 39

This regular feature of the FDIC Banking Review contains information on

regulatory agency actions, state legislation and regulation, and articles and

studies pertinent to banking and deposit insurance issues.
Effectiveness of Enforcement Actions

Financially Distressed Banks:
 

How Effective Are 


Enforcement Actions in
 

the Supervision Process?
 

by Timothy J. Curry, John P. O'Keefe,
 

Jane Coburn, and Lynne Montgomery*
 

0ne major purpose of federal and state regulation of banks is to ensure that institutions

maintain safe­and­sound business practices.

The main tool used to achieve this goal is bank supervision in general-and bank safety­and­soundness examinations in particular. Regulators conduct on­site

examinations to ensure that bank operations are consistent with sound banking practices. When on­site

examinations identify unsafe, unsound, or illegal banking practices, regulators use a variety of supervisory enforcement actions to require institutions to take

corrective measures. These enforcement actions are

intended to accomplish several things, including:

bringing about alterations in the practices and behavior

that caused the problems, stabilizing the institutions,

and averting potential losses to the deposit insurance

fund. Violations of enforcement agreements are a serious matter-noncompliance often carries heavy penalties, including the termination of deposit insurance. 

This article investigates the effects of bank examinations and enforcement actions on the behavior of

problem banks. We provide information on the effectiveness of supervision of distressed institutions

through the issuance of formal enforcement actions

during the 1980s and 1990s, a period of greater stress

and turmoil for U.S. financial institutions than any other since the Great Depression. The first section discusses the legal and regulatory framework for the

application of formal enforcement actions. The second

section focuses on the enforcement polices available to

the FDIC: kinds of actions, procedures used, and

number and types of enforcement actions issued by

the FDIC in recent decades. The third section reviews previous empirical studies and then discusses

the methodology, the sample and data, and the model,

variables, and results. The last section presents the

conclusions.

Evolution of Bank Enforcement Powers 

The Banking Act of 1933 gave the federal banking

supervisory agencies limited powers to force banking

institutions to follow agency directives.1 It also granted the FDIC, as the insurer of commercial banks, the

power to terminate federal deposit insurance for any

institution found guilty of serious offenses.2 0ver

time, however, the power to take deposit insurance

away from a financial institution proved to be an in­

* Timothy J. Curry is a financial economist, John P. 0'Keefe is a Section Chief, Jane Coburn and Lynne Montgomery are senior financial

analysts in the FDIC's Division of Research and Statistics. The authors wish to thank Richard Bogue of the FDIC's Legal Division for

helpful comments and assistance.

1 For an article on the statutory history of bank enforcement powers,

see Huber (1988). Although most agencies have similar enforcement

powers, this article focuses primarily on the Federal Deposit

Insurance Corporation (FDIC). As deposit insurer, it is the only

agency with the power to terminate a financial institution's deposit

insurance.

2 The standard for terminating deposit insurance is a high one and

must involve findings of unsafe and unsound banking conditions or

practices, or violations of law or regulations. 

1
FDIC Banking Review

flexible and impractical enforcement tool. The FDIC

must move rapidly to deal with day­to­day issues involving unsafe or unsound banking practices or to remove dishonest and incompetent officials from the

banks it supervises. Termination of deposit insurance

involves a lengthy and complicated legal process, and a

successful attempt is often tantamount to a death

penalty for the institution.3 In other words, terminating deposit insurance is analogous to wielding a blunt

instrument in a surgical procedure that requires a more

refined tool. As a result, the FDIC and most other regulatory agencies used other methods of forcing changes

in bank behavior.4 In summary, the early enforcement

powers of the bank regulatory agencies were often illsuited to dealing with institutions that were unwilling

to cooperate with regulatory officials or had dishonest

officers. As a consequence, the supervision of troubled

banks was sometimes ineffective.

In response to what were perceived as weak bank

enforcement laws, Congress passed the Financial

Institution Supervisory Act of 1966 (FISA), which

greatly expanded bank enforcement powers for all federal regulatory agencies. FISA permitted the banking

agencies to issue cease­and­desist (C&D) orders

against financial institutions to halt specific practices of

the bank. C&D powers were broadly applicable and

thus were flexible enough to be used against all aspects

of a bank's business, from loan operations to internal

controls. In addition to prohibiting certain practices,

C&D orders usually required bank officials to take "affirmative actions" to correct conditions resulting from

the violations or practices that provided the basis for

the order. 

But the procedures for rendering a permanent C&D

order could lead to untimely delays in the implementation of such orders, often compounding supervisory

problems. Thus, in the most serious cases FISA also

permitted the banking agencies to issue temporary

C&D orders that become effective immediately upon

service. This authority improved the supervision of

troubled banks: temporary C&D orders could help

prevent further deterioration of the institution.

Temporary orders were imposed when certain practices were likely to cause insolvency, dissipate the

bank's assets or earnings, weaken the bank's condition,

or otherwise prejudice the interests of the bank's depositors.5 Although the power to issue C&D orders

would solve many of the earlier enforcement problems

facing the banking agencies, such orders would not be

effective in dealing with activities of dishonest officers

and directors. Thus, an additional provision in FISA

authorized the agencies to remove individuals affiliated with commercial banks, including officers, directors,

and employees, and to issue prohibition orders to bar

their involvement with another federally insured bank. 

Bank enforcement powers for the federal banking

agencies were broadened further by passage of the

Financial Institutions Regulatory and Interest Rate

Control Act of 1978 (FIRIRCA). This Act gave the

banking authorities the right to bring C&D orders not

only against a bank but also against practices of individual officers and directors of a bank. Moreover,

FIRIRCA granted the FDIC and the other agencies

the authority to assess civil money penalties (fines)

against both banks and individuals for failing to meet

the terms of C&D orders, violating any written agreements, or willfully or flagrantly violating federal or state

laws and regulations. Generally these fines were approximately $1,000 per day, but under specific circumstances they could range up to $10,000 per day.

In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) further enhanced the FDIC's enforcement powers by granting

regulators the right to apply all existing enforcement

authority against not only the bank itself and the officers, directors, and employees or any individuals acting

as agents of the bank, but also against other "affiliated

parties" such as outside accountants, consultants, attorneys, or other contractors.6 Thus, cease­and­desist actions, removal or prohibition of individuals from the

institution, and all other enforcement actions could be

brought against anyone in this group. FIRREA also

3 Few attempts actually result in the removal of federal deposit insurance. However, just the threat to remove deposit insurance is a potent weapon in the attempt to force improvement in the condition of

the institution and to obtain the institution's cooperation. 

4 For example, the federal supervisory agencies in the past attempted

to seek the cooperation of offending banks by conducting special examinations and lengthy regular examinations; and in some cases, all

expenses were billed to the banks. To force compliance with agency

mandates, the agencies also used their leverage in other areas: when

institutions requested permission to open banking offices, to merge

with other organizations, or to make bank holding company acquisitions, for example, supervisory authorities often conditioned their

approval upon changes in the other aspects of the requesting banks'

operations-aspects the agencies were concerned about, such as

capital levels. See Huber (1988), 128-29. 

5 For the FDIC, the standard for issuing a temporary C&D order is

higher than for a regular C&D order. Temporary C&D orders can

be issued only in the most serious circumstances, when the potential

solvency of the institution is threatened. 

6 To apply formal enforcement authority to outside or "affiliated parties" of the bank, such as contractors, the law sets up a higher standard for regulators to meet. Regulators must show that these parties

"knowingly or recklessly" violated laws and regulations, thereby

causing loss or damage to the institution. 

2
Effectiveness of Enforcement Actions

significantly expanded the amount of civil money

penalties that could be levied against both banks and

individuals: these may now extend to $1 million a day

for knowingly violating laws and regulations and thereby causing substantial loss to the institution. The assessment schedule for fines depends on the

seriousness of the infraction, which is weighted by such

factors as the willfulness or recklessness of the conduct,

the existence of violations of fiduciary duty, the presence of pecuniary gain or personal benefit, and the intentions of the perpetrating parties.7

The types of banking practices that could lead to the

initiation of enforcement actions include the following,

among others: 

Management Problems

� unsatisfactory management

� poor loan administration

� insufficient corporate planning 

� inadequate internal controls

Financial Problems

� inadequate capital

� inadequate loan­loss reserves 

� large volume of subquality assets 

� excessive asset growth

� undue concentration of loans 

� failure to recognize or charge off losses 

� operating losses or inadequate earnings 

� poor liquidity

� unwarranted dividends or other insider payments 

� failure to file with regulators, or filing of inaccurate reports 

The FDICCs Enforcement Policies

In this section we focus on the enforcement policies

of the Federal Deposit Insurance Corporation-the

federal agency that regulates state nonmember banks.

We survey the kinds of enforcement actions available

to the FDIC, the procedures it uses, and the number

and types of enforcement actions it brought during the

period 1980-1996.

Kinds of Bank Enforcement Actions

Several types of enforcement actions are available to

the FDIC. They are discussed here in ascending order

of seriousness (from the informal to the formal; from

those whose existence is not disclosed to the public to

those whose existence is publicly disclosed; and from

those that are not enforceable in court to those that are).

Bank Board Resolution. This is a declaration by a

bank's board of directors outlining a plan to deal with

the bank's safety­and­soundness issues. The resolution sets forth reforms and time frames within which

the reforms should be completed. Regulators permit

this less­harsh informal action when they believe that

the institution is not in serious jeopardy of failure and

that the institution's board and management are cooperating with supervisory officials. The declaration is

not publicly disclosed and is not enforceable in a court

of law. Thus, this type of action is categorized as informal. 

Memorandum of Understanding (MOU). The

M0U represents the next level in the enforcement action process. It is an agreement drafted by regulators

and signed individually by each member of the board

of the affected institution. It outlines specific actions

the bank must take and establishes deadlines for reaching these goals. The existence of an M0U is not public information, nor is it enforceable in a court of law.

Thus, this type of action also is categorized as informal.8

Cease-and-Desist Order. As mentioned above, all

federal banking agencies may pursue cease­and­desist

orders for actions that constitute (1) unsafe and unsound banking practices, (2) violations of federal or

state laws and regulations, and (3) violations of any

written directive entered into with a banking agency.

Note that despite their name, cease­and­desist orders

do more than prohibit certain types of practices; they

usually require, as well, that banking officials take action to correct conditions resulting from the violation

that provided the basis for the order. 

C&D orders are issued after a hearing on the record,

and they remain in effect until remedial actions have

been taken. The hearing takes place between 30 and

60 days from the time the notice is served unless the

institution requests an earlier date. The order takes effect 30 days after the hearing, and remains until it is set

aside by a court order or is terminated by the agency.

C&D orders are made public and generate adverse

publicity for the institution. These actions and those

in the following categories are classified as formal enforcement actions.

7 Under FIRREA, the FDIC was also granted back­up authority to issue enforcement actions against thrift institutions supervised by the

0ffice of Thrift Supervision (0TS).

8 Nevertheless, securities laws affecting publicly traded companies

may require that in all of an institution's public disclosures, it reveal

the existence and terms of an M0U. 

3
FDIC Banking Review

Suspension, Removal, or Prohibition of Individuals

from a Federally Insured Depository Institution.

Bank regulators have the power to suspend, remove, or

prohibit individuals from associating with an insured

depository institution for specific violations of laws,

regulations, or agreements. In addition, individuals

who have been convicted of criminal violations of laws

can be barred for life from working or associating with

a federally insured institution. 

Civil Money Penalties (CMPs). CMPs may be imposed for violations of laws, regulations, C&D orders,

or other written agreements. As mentioned above, the

amounts of the fines levied are proportional to the seriousness of the violations and can range from $1,000 per

day for simple violations to $25,000 per day for reckless

actions or breaches of fiduciary responsibility-and up

to $1 million per day if regulators find evidence of

"knowingly" committed acts that cause significant loss

to the institution or significant gain to individuals.

Regulators use a matrix to determine the extent of the

penalty, basing it on the intent of the violators and their

history of infractions. Cooperation by bank officials is

a mitigating factor in the assessments of CMPs.

Penalties are assessed by written notice, and an aggrieved party may request a hearing on the penalty assessment within ten days of notice. The imposition of

CMPs, like the imposition of cease­and­desist orders,

is always accompanied by public notification of the

event by regulators, and such notification may deter

potential future violators.

Suspension or Termination of Deposit Insurance.

Suspension or termination of deposit insurance is the

most serious type of enforcement action the FDIC can

bring. This type of action is brought as a last resort to

force a bank to improve conditions in the institution by

altering its banking practices, especially if officials are

not cooperating with supervisory officials. 

Placement in Conservatorship or Receivership.

The chartering agencies for commercial banks and

thrift institutions have the authority to place troubled

and uncooperative or recalcitrant institutions into an

FDIC conservatorship or receivership in preparation

for the sale or liquidation of the institution. This type

of action is the most severe inasmuch as it results in the

termination of the charter, or the right of private parties

to operate a financial institution. 

Procedures Used 

The FDIC's enforcement action process begins

when the agency notifies bank officials of any financial

weaknesses, operational problems, or violations of

banking laws or regulations that were identified during

an examination. Examiners assign an overall, or composite, safety­and­soundness rating on a scale of "1" to

"5," with a 1 rating the highest (representing a low level of supervisory concern) and a 5 rating the lowest,

representing a critically deficient level of performance

and thus the highest degree of supervisory concern.

Composite ratings of 4 bestow "problem bank" status

and require remedial actions on the part of the troubled

bank.9 The safety­and­soundness ratings are also

known by the acronym CAMELS, after the six areas

examiners review: Capital adequacy, Asset quality,

Management, Earnings, Liquidity, and Sensitivity to

market risk.

Under FDIC procedures, if a bank emerges from

the examination with supervisory concerns or problembank status, bank supervisors may notify bank officials

that an enforcement action against the bank might be

issued, usually within three months from the date of

the examination. However, when the composite examination rating is 3, a less­stringent informal action is

generally pursued, except in the circumstance noted

below. The 3 rating implies that although failure is

only a remote possibility, the bank has weaknesses

that, if not corrected, could worsen and put the bank in

a more severe situation. The informal action (in the

form of a bank board resolution or an M0U) may be directed, for example, at persuading bank management

to strengthen its underwriting policies or increase its

reserves for future loan losses. Although informal actions communicate supervisory concerns and require a

plan to address those concerns, they are not administratively or judicially enforceable in a court of law in the

event the agreed­upon corrective actions are not taken.

If the condition of the institution at the time of the 3

rating represents an improvement over earlier periods,

informal actions may not always be issued. 

The FDIC takes a more serious formal enforcement action, such as issuing a cease­and­desist order,

when a bank's prospects for failure are more than a remote possibility. As a general policy, at the time of the

examination when the institution receives a 4 or 5 rating, FDIC examiners notify participants that a formal

action will be pursued. (Again, regulators may choose

not to issue a formal action when the current condition

of the bank clearly reflects significant improvement resulting from earlier actions or when individual circumstances make this supervisory tool inappropriate. For

example, the replacement of existing with new management may permit regulatory authorities the use of

9 Some 3­rated banks are also considered to be problem banks.

4
Effectiveness of Enforcement Actions

an informal M0U in place of

the formal C&D order-although if the bank still warrants

a problem­bank rating, the belief that bank management has

recognized the problems and

will implement a corrective action is not always a sufficient

basis for precluding formal actions.) Formal actions are also

brought when informal actions

have been unsuccessful in addressing supervisory concerns,

either because bank management has failed to abide by the

agreements or because the institution continues, nonetheless, to deteriorate. As

mentioned above, besides prohibiting unsafe or unsound

practices and violations of law,

the FDIC usually requires the

institution to correct conditions

resulting from such violations or

practices. For example, if a

bank is operating with an excessive amount of substandard

loans, a cease­and­desist order

may require the bank both to

reduce the dollar volume of

such loans to an amount specified in the order and to adopt

sound lending policies and

practices. 

To eliminate the need for

time­consuming formal hearings, the FDIC attempts to get

the parties to agree to the order

while waiving their right to an

administrative hearing. In

waiving this right, the institution neither admits nor denies

wrongdoing. The institution's

waiver reduces the time required to put the order in place.

If an institution chooses to contest the order, the implementation of the enforcement

action is delayed pending a

hearing before an administraIf an organization fails to get relief at this level, it has the right of appeal in

the federal courts. Under certain conditions, such actions can result in

lengthy delays in the implementation of the formal actions. If regulators

have serious concerns about the solvency of the bank, including concerns

about fraud, dissipation of assets, or other matters that require immediate

attention, they have the statutory authority to issue a temporary C&D order that becomes effective as soon as it is served. The bank has the right

to appeal the temporary order to a federal judge within ten days of the action and request an injunction.

The FDIC monitors bank compliance with both informal and formal enforcement provisions by requiring timely progress reports, usually monthly or quarterly, and by scheduling subsequent examinations and visitations. If

monitoring reveals that a bank is failing to comply with provisions of an enforcement action, regulators may assess fines for noncompliance. As with all

regulatory actions, the lifting or cancellation of C&D orders is considered

when the institution's overall condition has improved and the bank has

substantially complied with the terms of the order. Enforcement actions requiring remedial measures generally remain in effect for approximately two

years. However, in the more serious cases, actions can last up to three or four

years and during this period are subject to amendments mandating further

actions by the institution. 

Number and Types of Formal Enforcement Actions Issued,
 

1980-1996
 

Table 1 shows the number of formal FDIC enforcement actions taken from

1980 to 1996. During the 1970s, when the number of problem banks was

Table 1

FDIC Formal Enforcement Actions by Examination Rating, 1980-1996

CAMELS Rating at Examination before

Enforcement Action

Year Number 1 2 3 4 5

1980 47 1 3 2 33 8

1981 40 2 6 2 23 7

1982 96 3 2 4 58 29

1983 244 0 3 5 170 66

1984 188 2 5 9 101 71

1985 284 1 9 6 164 104

1986 183 0 5 4 87 87

1987 203 2 2 9 90 100

1988 178 4 3 6 77 88

1989 164 0 5 6 80 73

1990 160 0 4 7 84 65

1991 244 0 9 12 127 96

1992 237 0 19 15 147 56

1993 161 2 13 31 71 44

1994 104 7 34 13 26 24

1995 71 3 26 8 20 14

1996 78 8 17 11 17 25

Total 2,682 35 165 150 1,375 957

tive law judge and the is­ Source: FDIC.

suance of the final order by Note: Formal actions for safety­and­soundness purposes only issued against FDIC­supervised banks

(state nonmember and mutual savings banks). the FDIC Board of Directors.

5
FDIC Banking Review

relatively small, the FDIC did not widely use formal supervisory enforcement actions. During the 1980s and early 1990s, however, as the

problem­bank population increased dramatically, the number of formal

enforcement actions issued by the FDIC increased accordingly, going

from only 47 in 1980 to a peak of 284 in 1985. From 1986 through

1990, as the number of problem banks decreased, the issuance of formal actions also declined, with an annual average of approximately

178. But the growing number of problem banks in New England

caused the number of FDIC formal actions to increase again, peaking

at 244 in 1991 and gradually declining thereafter as the economy improved and commercial bank earnings rebounded.

The greatest proportion of actions were brought against 4­rated

banks, which accounted for over half of all formal actions. Generally

such institutions suffer from serious problems but are usually salvageable. An additional 36 percent of the total were issued against 5­rated

banks, which are thought to have substantial risk of failing within one

year. Actions against these banks are intended to correct the problems

if possible, but if the institution is too ill to recover, the objective is to

limit losses before failure. A small number of actions (200) were

brought against highly rated (1­ and 2­rated) banks. 0ver half of these

actions dealt with the removal and suspension of officers and directors. 

Table 2 shows the types of formal enforcement actions issued by the

FDIC from 1980 to 1996. The largest number consists of cease­anddesist actions issued under Section 8(b) of the Federal Deposit

Insurance Act (FDI Act), accounting for over 60 percent (1,637) of the

total number of actions. These actions are generally issued to curb

practices like insider abuses, unsound underwriting practices, inaccurate loan­loss reserve accounting, and unwise dividend polices and

other types of unauthorized fund transfers. 0ther major formal action

Table 2
 

FDIC Formal Enforcement Actions by Type, 1980-1996
 

Section Number Description

8(a) 425 Termination of insurance

8(b) 1,637 Cease­and­desist order

8(c&b) 96 Temporary cease­and­desist order

8(e) 459 Removal, prohibition, suspension of individuals 

8(a&t) 2 Temporary suspension of deposit insurance 

8(g) 20 Suspension/prohibition of individuals for

criminal acts misconduct 

8(I) 2 Petition for enforcement of administrative order

ILSA* 13 Capital directives 

PCAt 28 PCA directives

Total 2,682

categories, categorized by FDI Act

sections where authorized, include

Section 8(a) proceedings for termination of insurance and Section

(8)(e) removals of officers, directors,

and other principals; actions in

those two categories accounted for

an additional 33 percent (884) of the

total. Miscellaneous actions make

up the remainder. 

Empirical Analysis of the

Effect of Formal

Enforcement Actions

Because information on formal

actions was not publicly reported

until 1989, few empirical studies

have evaluated the effects of enforcement actions on bank behavior. The limited evidence that is

available generally suggests that

banks operating under formal enforcement actions alter their banking practices to a greater extent

than banks not operating under

formal actions. In two empirical

studies of New England banks,

Peek and Rosengren (1995, 1996)

analyzed the effects that formal actions had on capital levels, commercial real­estate lending, and

overall lending for the years

1989-1994. 0ver this period, more

than one­third of the banks in New

England had enforcement actions

outstanding against them and were

under intense pressure to raise capital and restrict certain types of

real­estate lending. Peek and Rosengren's findings showed that although poorly capitalized banks

shrank their assets more than better capitalized institutions did to

meet capital requirements, the reduction was more dramatic if regulators had imposed formal actions.

Source: FDIC. In addition, banks that were operNote: Formal actions for safety­and­soundness purposes only. ating under formal agreements cut

*International Lending Supervision Act. their commercial real­estate lend­ tPrompt corrective action.

ing as well as overall lending to a

6
Effectiveness of Enforcement Actions

greater extent than did banks that were not under

similar agreements.10

In another study, Curry et al. (1997) found that most

financially distressed banks in the years 1980-1995 exhibited greater reductions in asset growth, larger restrictions on dividends, and higher levels of capital

infusions during the periods before the examinations

that reduced their supervisory examination ratings to 4.

However, the exp ost results were generally more pronounced if the banks were 4­rated and operating under

a formal enforcement action.11 Two other studiesPeek, Rosengren, and Jordan (1999) and Brous and

Leggett (1996)-focused upon the "announcement effects" that formal actions have upon stock prices or

shareholder wealth. Both found that the announcement effects of formal actions resulted in large negative

abnormal stock returns for publicly traded organizations.

In our analysis, problem­bank behavior is related to

the dates of regulatory intervention, specifically the

date of the on­site examination that produced a formal

enforcement action or a composite CAMELS rating

downgrade to problem­bank status (that is, to a composite CAMELS rating of 4). It is important to point

out that CAMELS downgrades may occur with or

without formal enforcement actions, and actions may

occur with or without CAMELS downgrades. We

therefore attempt to control for potential overlap between these two types of intervention in the empirical

tests. The intervention date is also referred to as the

"event date." Since banks report their financial condition at the end of each calendar quarter, the empirical

analysis matches the exact event date to the quarter

during which intervention occurred, henceforth referred to as the "event quarter." We anticipate that

bank management will react to the deteriorating financial condition of the institution before the bank examination that produces an adverse rating (or enforcement

action) and will begin to make changes necessary for

survival. However, we hypothesize that at the time of

the on­site examination that produces the CAMELS

downgrade or at the time of the issuance of the formal

enforcement action, examiners might persuade or require management to make additional changes in the

bank's portfolio and operating policies. Thus, we anticipate that for these banks, significant changes occur

during the event quarter. Another hypothesis to be

tested is that formal enforcement actions are more effective than CAMELS ratings downgrades without formal enforcement actions in bringing about behavioral

changes during the event quarter as well as during subsequent quarters, because they are legal decrees and

noncompliance often carries serious penalties. Thus,

the most pronounced changes are expected for those

banks that receive a formal enforcement action. 

The empirical analysis is conducted in two stages.

The first stage examines the effects of bank enforcement actions in a univariate framework, with a graphical presentation of key performance variables for the

various time periods studied. The second stage presents estimates of regression models that test for behavioral differences between the banks that received

formal enforcement actions and those that did not for

the event quarter, as well as for subsequent quarters.

As part of the regression analysis, we also address a potential sample selection bias by using the sample­selectivity estimation method of Heckman (1979) to test

for sample selectivity bias. The Heckman method is

a two­stage model that first uses probit analysis to estimate a selection model. The probit model yields estimates of each bank's odds of being "selected" for some

form of regulatory intervention (actions or downgrades). This variable, which controls for sample selectivity, is then included as an instrumental variable in

the performance model (or behavioral model) which is

estimated using ordinary least squares regression. The

results of the Heckman model estimations are discussed in an appendix to this paper.

Sample and Data

To study the aforementioned relationships, we examined all commercial and mutual savings banks

whose primary federal supervisor was the FDIC over

the 1978-1998 period. FDIC­supervised banks constituted approximately 51 percent of all insured U.S.

commercial banks and savings institutions and accounted for nearly 15 percent of industry assets as of

year­end 1998. 

0ur measures of regulatory intervention include all

but two categories of formal enforcement actions is10 During the New England recession of the early 1990s when banks

were experiencing heavy losses in commercial real­estate lending,

it was difficult for troubled banks to raise external capital to meet

bank capital requirements. Thus, most banks had no option but to

shrink their assets. 

11 In a nonstatistical case study of bank enforcement actions on 72

problem banks in 1991, the U.S. General Accounting 0ffice (GA0)

(1991) found that more­positive changes in bank behavior were

associated with the more­stringent formal enforcement actions than

with informal efforts by the regulators to work with the banks. The

GA0 recommended that regulators take early and more forceful

regulatory action tied to specific unsafe and unsound banking practices. 

7
 

FDIC Banking Review

sued by the FDIC (see table 2) plus all on­site safetyand­soundness examinations by the FDIC or state

banking supervisors.12 Excluded from our intervention measures are formal enforcement actions directed

against individuals-Section 8(e), removal of individuals, and Section 8(g), suspension of individuals-since

these actions can involve lengthy legal cases and are

not generally expected to result in immediate performance changes at banks upon issuance. While formal

enforcement actions are often directed at altering poor

management practices, changes in these practices are

very difficult to measure and document. Consequently, we focus on another goal of formal enforcement actions-altering poor financial performance. To

measure financial performance, we use the quarterly

reports of income and condition (Call Reports) that all

insured banks are required to file with their primary

federal regulator each calendar quarter end. These financial statements include standard income statements and balance sheets, as well as related reports

such as those on nonperforming loans and sources of

new equity capital.

To determine the stability of the relationships, we

analyzed three different subperiods: (1) 1979-1985, (2)

1985-1990, and (3) 1990-1998. Each subperiod corresponds with one of the various regional banking crises

in the United States that occurred over this entire period, including the Southwest banking crisis in the 1980s

and the Northeast crisis in the early 1990s. 

Before proceeding to the empirical analysis, we

find it helpful to know the relative frequency with

which problem banks that receive formal enforcement actions recover or fail. Table 3 follows the

changes in composite CAMELS ratings for a sample of

1,212 FDIC­supervised banks that were initially

ly high percentage, 10.6 percent, had been involved in

FDIC­assisted mergers or liquidations, that is, had

failed, and 4.5 percent had merged with other banks or

been liquidated without FDIC assistance). Two years

after receiving actions, 39 percent of the banks had improved their CAMELS ratings, while 34 percent had

deteriorated further or no longer operated. Indeed, a

very high percentage-17.2 percent-had failed after

two years. These statistics indicate that although a

substantial proportion of banks receiving formal enforcement actions are able to improve their condition,

many fail. The remainder of the empirical analysis investigates banks' responses to formal enforcement actions in more detail and the extent to which the

responses accord with regulators' expectations.

Univariate Results

In the first stage of the analysis, we studied bank behavior before, during, and after the event quarter by focusing on changes in several performance measures,

including asset growth, external equity capital injections, net loan charge­offs, loan­loss provisions, the level of nonperforming loans, and profitability (return on

assets). As mentioned above, the expectation is that as

banks approach "problem" or troubled­bank status,

they will be in retrenchment mode to avoid a condition

that would threaten their solvency. Thus, under these

circumstances banks should be reducing growth or

shrinking assets, generating new equity capital, charging off bad loans, increasing loan­loss provisions, and

fully recognizing nonperforming loans on financial reports. These reactions should be reflected in lower profitability during this period when the bank is on the way

to recovery or failure.

Figures 1-3 show the behavioral patterns for the

CAMELS 4­rated

and received formal

enforcement actions.

0ne year after receiving formal enforcement actions,

46 percent of the

banks were still

CAMELS 4­rated,

approximately 26

percent had improved their CAMELS

ratings, and 28 percent had deteriorated further or ceased

operating (a relativeTable 3
 

Changes in Composite Ratings of 4-Rated Banks
 

Receiving Enforcement Actions
 

Composite One Year Two Years

CAMELS Rating after Action after Action

1 0 4 (0.3%)

2 54 (4.5%) 204 (16.8%)

3 256 (21.1%) 268 (22.1%)

4 558 (46.0%) 326 (26.9%)

5 161 (13.3%) 104 (8.6%)

Assisted Mergers

and Liquidations 128 (10.6%) 208 (17.2%)

Unassisted Mergers

and Liquidations 55 (4.5%) 98 (8.1%)

Total 1,212 1,212

selected performance measures, all

measured as a percentage of bank assets, for two groups

12 All FDIC formal enforcement actions were

tabulated and analyzed

for the years 1980-

1996 only. Call Report

and bank examination

data from earlier and

later years were included to enable us to

study behavior before

and after the imposition of formal actions. 

8
Effectiveness of Enforcement Actions

Figure 1
 

Asset Growth Rates and Capital Infusions of CAMELS 4-Rated Banks
 

before and after Regulatory Intervention 


Median Asset Growth Rates Mean External Equity
 

1978 1985 – 1978 1985–


Percent of Assets Percent of Assets 

8
 4
 

4
 3
 

0 2
 

-4 1
 

-8 0 

-4 -3 -2 -1 0 1 2 3 4 -2 -1 0 1 2 3
 

1985 1990– 1985 1990
 – 8
 2.0 

4
 

1.5
 

0
 

1.0
 

-4
 

0.5
 

-8
 

-12 0.0
 

-4 -3 -2 -1 0 1 2 3 4 -2 -1 0 1 2 3
 

1990 1998– 1990 1998
 –

8
 2
 

4
 

1
 

0
 

-4
 

0
 

-8
 

-12 -1
 

-4 -3 -2 -1 0 1 2 3 4 -2 -1 0 1 2 3
 

Quarter Relative to Intervention Year Relative to Intervention 

Banks Downgraded to CAMELS 4 Rating That Received No Formal Action 

4-Rated Banks That Did Receive Formal Action 

of banks before, during, and after intervention. The
 

first group contains those banks that are CAMELS 4­

rated as of the event quarter during which they received a formal enforcement action. Some of these
 

banks may have also been downgraded to CAMELS 4
 

during the event quarter or during a prior quarter. The
 

second group contains those banks receiving a downgrade to CAMELS 4 rating during the event quarter

without a formal enforcement action. The results for

the selected performance measures generally show

that both groups of banks start to change their behavior within a year before the event quarter and that

those changes tend to accelerate during the event quarter. Furthermore, banks that received formal actions

9
 

 

 

 

 

 

 

 

 

FDIC Banking Review

Figure 2
 

Net Loan Charge-offs and Provision for Loan Losses of CAMELS 4-Rated Banks
 

before and after Regulatory Intervention
 

Median Net Loan Charge-offs Median Provision for Loan Losses 

1978 1985 – 1978 1985–

Percent of Assets Percent of Assets 

-4 -3 -2 -1 0 1 2 3 4 

0 

1 

2 

3 

4 

-4 -3 -2 -1 0 1 2 3 4 

0 

2 

4 

6 

8 

1985 1990– 1985 1990 – 

-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4 

0 

2 

4 

6 

0 

1 

2 

3 

4 

1990 1998– 1990 1998– 

-4 -3 -2 -1 0 1 2 

Quarter Relative to Intervention 

3 4 -4 -3 -2 -1 0 1 2 

Quarter Relative to Intervention 

3 4 

0 

1 

2 

3 

0 

1 

2 

3 

4-Rated Banks That Did Receive Formal Action 

Banks Downgraded to CAMELS 4 Rating That Received No Formal Action 

generally had more pronounced changes in the performance measures during and after the event quarter

than the downgraded bank group had. For example,

changes in the median asset growth rates for banks receiving formal actions were generally much greater

than those for the downgraded banks not receiving actions. 

The other performance measures revealed similar

trends. Mean external capital infusions began before

regulatory intervention and generally accelerated in

the first year after intervention; median net loan chargeoffs and median loan­loss provisions also increased significantly in the quarter before and during the event

quarter in anticipation of the examination and man10
 

 

 

 

 

 

 

 

 

Effectiveness of Enforcement Actions

Figure 3
 

Nonperforming Loans and Profitability of CAMELS 4-Rated Banks
 

before and after Regulatory Intervention
 

Median Total Nonperforming Loans Median Return on Assets 

1978 1985– 1978 1985– 

Percent of Assets Percent of Assets 

-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4 

0 

2 

4 

6 

8 

10 

-4 

-2 

0 

2 

4 

1985 1990– 1985 1990 – 

-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4 

2 

4 

6 

8 

10 

-4

-2

 

2

4

1990 1998– 1990 1998– 

-4 -3 -2 -1 0 1 2 

Quarter Relative to Intervention 

3 4 -4 -3 -2 -1 0 1 2 

Quarter Relative to Intervention 

3 4 

2 

4 

6 

8 

10 

-1 

0 

1 

2 

4-Rated Banks That Did Receive Formal Action 

Banks Downgraded to CAMELS 4 Rating That Received No Formal Action 

dates from the examiners.13 The median level of nonperforming loans also was increasing before and subsequent to intervention for both groups of banks, while

profitability (R0A) was declining, reflecting the

above­mentioned accounting changes in the balance

sheets. For most measures and most time periods analyzed, banks receiving formal actions showed more

pronounced changes than did the downgraded bank

group. It is also important to point out that these

changes in the (annualized) rates of provisioning,

13 Most banks in our sample did not receive external capital injections,

hence the median values for external capital injections were typically zero. However, mean external capital injections for our sample were higher the year after enforcement actions were received.

11
 

FDIC Banking Review

charge­offs, and profits are not due merely to the underlying changes (decline) in total bank assets used to scale the

performance measures. The total dollar values of provisions and charge­offs rose during the event quarter as well.

In general, the univariate results (figures 1-3) show that the reduction in asset growth indicates that moral hazard

was being contained, and banks were not allowed to grow out their problems. In most cases, banks were actually

shrinking assets. In the case of surviving institutions, increased capital injections and additional loan­loss provisioning helped restore equity positions and were instrumental in facilitating recovery. In the case of failed institutions, these actions helped reduce the costs to the deposit insurer.

Empirical Model 

To analyze the effects of the two types of regulatory intervention more fully, a multivariate framework is required.

We hypothesize that bank j's performance during quarter t is dependent upon the bank's condition in the prior quarter, t - 1, and upon the incidence of regulatory intervention during quarter t. It is also possible that banks react to

regulatory intervention gradually, correcting deficiencies over several quarters. Therefore, we include three lagged

regulatory intervention measures.14 The behavioral model is as follows:

(1)	 Performance measure (j, t) = a + b1(Nonperforming loans) (j, t – 1) + b2(Performing loans) (j, t – 1) + 

b3(Changes in nonperforming loans) (j, t – 1) + b4(Other real estate owned) (j, t – 1) + 

b5(Loan income earned but not collected) (j, t – 1) + b6(Equity) (j, t – 1) + 

b7 (Allowance for loan losses) (j, t – 1) + 

b8(Intervention dummy) ( j, t ) + b9 (Intervention dummy) ( j, t – 1) 

b10(Intervention dummy) ( j, t – 2 ) + b11(Intervention dummy) ( j, t – 3 ) + Error term (j, t) 

All performance and condition variables are measured as a percentage of bank assets in order to limit the effects

of potential heteroskedasticity. Furthermore, those performance measures that were computed as quarterly financial flows-provisions for loan losses, net loan charge­offs, and asset growth-were all expressed as annualized rates.

However, several performance measures were available only annually-external capital injections and cash dividends on common and preferred stock.15 We estimated equation 1 using ordinary least squares (0LS) regression

on samples of FDIC­supervised banks that were CAMELS 4­rated as of a quarter end. In addition to controlling

for bank condition through the asset­quality measures, we restricted the regression sample to all CAMELS 4­rated

banks to further limit the potential for the regulatory intervention variable to serve merely as an instrumental variable for bank condition. 

Variables

The performance measures tested include those areas often mentioned in formal enforcement actions:

loan­loss provisions, net loan charge­offs, asset growth,

external capital injections, and cash dividends on common and preferred stock. We hypothesize that these

performance measures are dependent upon bank loan

quality in the prior period as reflected in the levels of

nonperforming and performing loans. Non erforming

loans are defined as all loans past due 30 days or more

on interest and principal repayment plus all nonaccrual loans (loans no longer accruing interest income).

Performingploans are included to incorporate the effects

of general lending risks upon performance and are defined as total gross loans net of nonperforming loans.

Changespinpnon erformingploans are defined as the percentage change in nonperforming loans between periods t and t - 1 and are included to account for the effect

of changes in loan quality over the period. Otherprealpestatepowned is included as another asset­quality measure

and is defined as all real estate owned by the bank, including real estate foreclosed on or acquired because of

loan defaults. Loanpincomepearnedpbutpnotpcollected is the

accumulated amount of earned but uncollected loan

interest income and reflects both asset quality and potential overstatement of interest earnings by management. Equitypca ital reflects both the accumulated

effects of prior performance upon earnings and, because of regulatory capital requirements, may be related to management's ability and desire to provide for

loans losses, to charge off loans, or to increase asset size.

14 The reason we use only three lagged regulatory intervention measures is that problem banks are normally examined at least every

four quarters. As a result, the significance of intervention measures

lagged more than three quarters may be influenced by compounding events, such as subsequent examinations and subsequent formal enforcement actions.

15 For the performance models investigating the effects of regulatory

intervention upon external capital generation and cash dividends,

for obvious reasons we exclude prior­period equity capital as an explanatory variable.

12
Effectiveness of Enforcement Actions

The allowancepforploanplosses reflects the accumulated effects of prior loss provisioning and loan charge­offs, and may influence management's ability and willingness to provide for future loan losses,

make charge­offs, and limit bank asset growth. 

Regression Results

The results of estimation of equation 1 for loan­loss provisioning

are shown in tables 4a and 4b. These tables report results for the

two regulatory intervention measures, broadly defined as

CAMELS downgrades to a 4 rating (with and without enforcement

Table 4a
 

Effect of Formal Enforcement Actions on Provisions
 

for Loan and Lease Losses
 

Ordinary Least Squares Regression of the Relationships between Provisions for Loan and Lease

Losses and Regulatory Intervention

Explanatory Estimated Coefficients

Variable (Standard Errors)

1978-1985 1985-1990 1990-1998

Intercept ­5.5086** ­2.5056** ­0.8759**

(0.4871) (0.2197) (0.1995)

Nonperforming loans and leases 0.2581** 0.2820** 0.0971**

(0.0189) (0.0111) (0.0098)

Performing loans and leases 0.0559** 0.0324** 0.0243**

(0.0073) (0.0032) (0.0031)

Change in nonperforming loans ­0.0007 0.0003 0.0002

and leases (0.0006) (0.0003) (0.0003)

0ther real estate owned ­0.0898* 0.0079 ­0.0269*

(0.0410) (0.0163) (0.0133)

Income earned but not collected 0.4944** 0.1518* 0.2048*

(0.0878) (0.0655) (0.0911)

Equity capital 0.4260** 0.1541** 0.0287**

(0.0351) (0.0165) (0.0093)

Allowance for loan and lease losses ­0.1766* ­0.2620** ­0.1700**

(0.0763) (0.0449) (0.0367)

Enforcement action dummy 2.8864** 2.7819** 1.1934**

for current quarter, t (0.3757) (0.2540) (0.2389)

Enforcement action dummy ­0.8710* ­0.3585 ­0.1544

for t - 1 (0.3501) (0.2505) (0.2026)

Enforcement action dummy ­0.3875 ­0.0119 0.1025

for t - 2 (0.3410) (0.2450) (0.1908)

Enforcement action dummy ­0.5685 ­0.0795 0.5251**

for t - 3 (0.3457) (0.2432) (0.1795)

Number of observations 4,042 8,907 3,865

R Squared 14.3% 11.4% 5.6%

F­statistic 62.52** 105.01** 22.02**

Note: Two asterisks, **, indicate significance at the 1 percent confidence level, while one

asterisk, *, indicates significance at the 5 percent confidence level.

actions) and formal enforcement actions

(with and without CAMELS downgrades). The relationships between bank

performance measures and prior­period

condition variables were generally in

agreement with expectations. For example, loan­loss provisions were significantly

and positively related to the lagged values

of nonperforming loans, performing loans,

income earned but not collected, and equity capital. Loan­loss provisions were

generally negatively related to both the

lagged allowances for loan losses and, to a

lesser extent, other real estate owned.

Similar intuitively appealing results were

found for net charge­offs and asset growth

models. For the sake of brevity, these results are not discussed further.

We focus instead on the results for the

regulatory intervention dummy variables

for formal enforcement actions and for

CAMELS downgrades to a 4 rating shown

in tables 4a and 4b. The findings show

that for all estimation periods, formal enforcement actions had a significantly positive effect upon both loan­loss provisions

and net loan charge­offs during the quarter in which the formal actions occurred. However, the lagged intervention

measures for formal enforcement actions

were generally not significantly related to

these two performance measures. In addition, formal enforcement actions were

generally not significantly related to asset

growth for any estimation period. Very

similar results were found for the

CAMELS downgrade dummy variable.

In all estimation periods bank CAMELS

downgrades to a 4 rating had a significantly positive effect upon loan­loss provisions

and net loan charge­offs and no significant

relationship with asset growth.

0ne can see the relative effect of both

types of intervention upon performance

by comparing dummy variable coefficients. Table 5 shows that enforcement

actions had a larger effect upon loan­loss

provisioning than did CAMELS downgrades for the 1978-1985 and 1985-1990

periods but not for the 1990-1998 period.

13
FDIC Banking Review

For example, for the 1978-1985 period the coefficients in the provisioning model are 2.8864 and 2.5229 for actions and downgrades,

respectively. This means that among CAMELS 4­rated banks receiving enforcement actions, loan­loss provisioning rates were nearly 2.9 percent (annualized) greater for those receiving actions

during the intervention quarter compared with 2.5 percent greater

for downgraded banks.

Comparisons in table 6 indicate that enforcement actions had a

somewhat larger positive effect upon charge­off rates in the 1978-

1985 and 1985-1990 periods but not for the 1990-1998 period.

Next we consider the effect of regulatory intervention upon

banks' efforts to generate new capital, from external as well as internal sources of funds. These results are shown in tables 7 and 8;

formal enforcement actions were not significantly related to exterTable 4b

Effect of CAMELS Downgrades on Provisions for Loan and Lease Losses

Ordinary Least Squares Regression of the Relationships between Provisions for Loan and Lease

Losses and Regulatory Intervention

Explanatory Estimated Coefficients

Variable (Standard Errors)

1978-1985 1985-1990 1990-1998

Intercept ­5.5020** ­2.4265** ­0.9574**

(0.4817) (0.2188) (0.1983)

Nonperforming loans and leases 0.2681** 0.2795** 0.0960**

(0.0187) (0.0110) (0.0097)

Performing loans and leases 0.0506** 0.0294** 0.0238**

(0.0072) (0.0032) (0.0031)

Change in nonperforming ­0.0010 0.0002 0.0001

loans and leases (0.0006) (0.0003) (0.0003)

0ther real estate owned ­0.0357 0.0280 ­0.0095

(0.0411) (0.0164) (0.0135)

Income earned but not collected 0.4468** 0.1947** 0.1181

(0.0871) (0.0654) (0.0909)

Equity capital 0.3761** 0.1277** 0.0221*

(0.0352) (0.0166) (0.0093)

Allowance for loan and ­0.0964 ­0.2374** ­0.1388**

lease losses (0.0760) (0.0448) (0.0367)

CAMELS downgrade dummy 2.5229** 2.0584** 1.4165**

for current quarter, t (0.2102) (0.1441) (0.1581)

CAMELS downgrade dummy 0.6411** 0.0321 0.2670

for t - 1 (0.2063) (0.1395) (0.1411)

CAMELS downgrade dummy 0.1608 0.0553 0.1790

for t - 2 (0.2125) (0.1454) (0.1391)

CAMELS downgrade dummy ­0.0704 0.3696* 0.4384*

for t - 3 (0.2253) (0.1544) (0.1366)

Number of observations 4,042 8,907 3,865

R Squared 16.1% 12.2% 6.9%

F­statistic 71.52** 113.72** 26.97**

Note: Two asterisks, **, indicate significance at the 1 percent confidence level, while one

asterisk, *, indicates significance at the 5 percent confidence level.

nal capital generation in any period.

There may be two reasons for this latter

result. First, these are problem banks operating during periods of crisis in banking

markets. It is clearly difficult, if possible

at all, to attract outside equity investors

under such circumstances. Second, most

FDIC­supervised banks are small community banks whose access to the capital

market may be limited, hence, these

banks may have had to rely upon dividend reductions to improve equity capitalization.

Formal enforcement actions led to statistically significant reductions in dividends, as a percentage of bank assets, in

the year following actions for the

1978-1985 and 1985-1990 periods but not

for the 1990-1998 period. Interestingly,

results for the influence of CAMELS

downgrades on dividend rates were not

similar. Rather, downgrades were not significantly related to dividend reductions a

year after the downgrade.

Adjustments to the Model

Because of the potential for some overlap between the two intervention measures-CAMELS downgrades and formal

enforcement actions-we investigated

the separate effects of downgrades without actions and actions without downgrades. This required re­estimating the

performance models using alternative intervention dummy­variable specifications. Equation 1 was therefore estimated

with six alternative intervention measures

used in total: the original two measures

discussed above plus four variations on

those measures. The six measures are:

� A dummy variable for the quarter in

which a bank received one formal

action but no other actions during

the time period used for model estimation (1978-1985, 1985-1990, or

1990-1998). See tables 5-8.

� A dummy variable for the quarter in

which a bank was downgraded to a

CAMELS 4 rating regardless of the

14
Effectiveness of Enforcement Actions

Table 5
 

Effects of Alternative Intervention Measures on Provisions
 

for Loan and Lease Losses
 

Alternative Intervention Measures Were Used in Full Provisioning Model (Equation 1)
 

Comparative Ordinary Lease Squares Regression Results for Intervention Variables
 

Intervention during

Current Quarter

(t = 0 ) Dummy Variable

Estimated Coefficients

(Standard Errors)

1978-1985 1985-1990 1990-1998

All enforcement actions 2.8864**

(0.3757)

2.7819**

(0.2540)

1.1935**

(0.2389)

All CAMELS downgrades

to 4 rating in event quarter

2.5229**

(0.2102)

2.0584**

(0.1441)

1.4165**

(0.1581)

Enforcement actions with no

downgrades in event quarter

2.3338**

(0.8370)

2.4302**

(0.3521)

0.6895

(0.4076)

Enforcement actions and

downgrades in event quarter

3.0032**

(0.4177)

3.0950**

(0.3639)

1.4171**

(0.2913)

Downgrades in event quarter

with an action during estimation 

interval

2.0533**

(0.3450)

2.2631**

(0.2645)

0.9681**

(0.2252)

Downgrades in event quarter with

with no actions during estimation 

interval

2.2538**

(0.2295)

1.7985**

(0.1648)

1.5712**

(0.2094)

Number of observations 4,042 8,907 3,865

Note: Two asterisks, **, indicate significance at the 1 percent confidence level.

Table 6
 

Effects of Alternative Intervention Measures on
 

Net Loan and Lease Charge-offs
 

Alternative Intervention Measures Were Used in Full Charge-off Model (Equation 1)

Comparative Ordinary Lease Squares Regression Results for Intervention Variables 

issuance of a formal action during the

estimation period. See tables 5-8.

� A dummy variable for banks receiving a formal action during the quarter but not a downgrade during the

same quarter.

� A dummy variable for banks receiving a formal action and a downgrade

to CAMELS 4 during the same

quarter.

� A dummy variable for banks downgraded to a CAMELS 4 rating in a

quarter and receiving one or more

formal actions at any time during the

estimation period.

� A dummy variable for banks receiving a downgrade to a CAMELS 4

rating during the quarter but not receiving a formal action during the estimation period.

The results from the six intervention

measures are summarized in tables 5-8.

Those results show that formal enforcement actions that occur without

CAMELS downgrades still have a statistically significant, positive effect upon both

loan­loss provisioning and net loan

charge­offs. Similarly, CAMELS downgrades that occur without formal enforcement actions also have a statistically

Intervention during

Current Quarter Estimated Coefficients

(t = 0 ) Dummy Variable (Standard Errors)

1978-1985 1985-1990 1990-1998

All enforcement actions 2.0528** 2.1418** 0.7035**

(0.3271) (0.2050) (0.2098)

All CAMELS downgrades 2.0477** 1.6871** 1.0331**

to 4 rating in event quarter (0.1828) (0.1162) (0.1391)

Enforcement actions with no 1.4683* 2.3675** 0.6858

downgrades in event quarter (0.7271) (0.2836) (0.3577)

Enforcement actions and 2.1905** 1.8619** 0.6765**

downgrades in event quarter (0.3635) (0.2941) (0.2560)

Downgrades in event quarter 1.6660** 1.7626** 0.6550**

with an action during estimation (0.2999) (0.2135) (0.1978)

interval

Downgrades in event quarter with 1.8511** 1.5111** 1.1645**

no actions during estimation interval (0.1996) (0.1329) (0.1841)

Number of observations 4,042 8,907 3,865

Note: Two asterisks, **, indicate significance at the 1 percent confidence level, while one

asterisk, *, indicates significance at the 5 percent confidence level.

significant, positive effect upon loan­loss

provisioning and net loan charge­offsalbeit often a lesser effect than do formal

actions.

Conclusions 

This article analyzes the effects that

bank regulatory intervention had on the

performance of distressed or troubled

banks for the years 1978-1998. Regulatory intervention for troubled banks is

measured as of the date of the bank examination that produced either CAMELS

rating downgrades to problem status or

the issuance of a formal enforcement action. The analysis uses both a univariate

trend analysis and a regression model to

analyze this issue. The results provide

evidence on the effectiveness of the su15
FDIC Banking Review

pervision of troubled banks during the Table 7

most severe banking crisis in the United Effects of Alternative Intervention Measures on States since the Great Depression. External Capital Generation As expected, the overall findings show Alternative Intervention Measures Were Used in External Capital Generation Model (Equation that both examiner downgrades in 1) Comparative Ordinary Lease Squares Regression Results for Intervention Variables

CAMELS ratings and the issuance of for­ Intervention during

Prior Year Estimated Coefficients mal enforcement actions had important ef­

(t = - 1) Dummy Variable (Standard Errors) fects on the performance of distressed

1978-1985 1985-1990 1990-1998 banks. In order to survive, banks began to

All enforcement actions 0.0904 ­0.0608 ­0.2102 change operating policies before the ex­

(0.1870) (0.1186) (0.2053) amination in which they were downgraded

All CAMELS downgrades ­0.2122 ­0.0462 ­0.3548 to problem­bank status or issued a formal

to 4 rating in event quarter (0.1672) (0.0842) (0.1882) enforcement action, but some of these

Enforcement actions with no 1.0504** ­0.040 ­0.0969 changes became more pronounced if a fordowngrades in event quarter (0.3626) (0.1518) (0.3165) mal action was issued at the time of the exEnforcement actions and ­0.2156 ­0.0818 ­0.2481 amination. The univariate trend analysis downgrades in event quarter (0.2102) (0.1806) (0.2452) shows that after receiving formal enforceDowngrades in event quarter ­0.1930 ­0.1254 ­0.2932 ment actions many banks reduced their

with an action during estimation (0.1767) (0.1244) (0.2069) asset growth rates, increased the rate of ex­ interval

ternal equity capital infusions, increased Downgrades in event quarter 0.1275 0.0322 ­0.1476 the rate of net loan charge­offs, increased with no actions during estimation (0.1685) (0.0994) (0.2784)
 

interval the rate of loan­loss provisioning, increased nonperforming assets and reduced Number of observations 1,162 2,151 820

profitability. To this extent, the findings Note: Two asterisks, **, indicate significance at the 1 percent confidence level.

are consistent with earlier empirical work.

The regression model tests whether
 

Table 8 these aforementioned changes lead to staEffects of Alternative Intervention Measures on Dividends on tistically significant differences in performance between banks that received Common and Preferred Stock

formal enforcement actions and those that Alternative Intervention Measures Were Used in External Capital Generation Model (Equation did not. The regression model results 1) Comparative Ordinary Lease Squares Regression Results for Intervention Variables

show that, in general, in those areas over Intervention during

Prior Year Estimated Coefficients which bank management has control, en­

(t = - 1) Dummy Variable (Standard Errors) forcement actions lead to statistically sig1978-1985 1985-1990 1990-1998 nificant differences in performance. The

All enforcement actions ­0.0760* ­0.0907** ­0.0693 areas over which management has a high

(0.0353) (0.0224) (0.0583) degree of control include loan­loss proviAll CAMELS downgrades ­0.0351 ­0.0109 ­0.0121 sioning, net loan charge­offs, and cash divto 4 rating in event quarter (0.0314) (0.0159) (0.0532) idends on common and preferred stock.

Enforcement actions with no ­0.0712 ­0.0874** ­0.0541 Conversely, in those areas where bank

downgrades in event quarter (0.0685) (0.0289) (0.0898) management has relatively limited control

Enforcement actions and ­0.0711 ­0.0839* ­0.0641 and where external factors play a greater downgrades in event quarter (0.0397) (0.0342) (0.0696)

role, enforcement actions did not lead to Downgrades in event quarter ­0.0729* ­0.0537* ­0.0705 statistically significant differences in per­ with an action during estimation (0.0333) (0.0236) (0.0587)
 

interval
 formance. Those areas over which bank

Downgrades in event quarter ­0.0201 ­0.0043 ­0.0163 management has limited control include

with no actions during estimation (0.0317) (0.0187) (0.0782) external capital injections, and to some deinterval gree asset growth. Hence, enforcement

Number of observations 1,162 2,151 820 actions are more likely to be effective in

Note: Two asterisks, **, indicate significance at the 1 percent confidence level, while correcting weaknesses that bank manageone asterisk, *, indicates significance at the 5 percent confidence level. ment can control.

16
(2)

(3)

Effectiveness of Enforcement Actions

Appendix� Sample Selection Bias
 

Although banks subject to formal actions generally showed the largest reactions to intervention, it is

not clear from the preceding analysis how much these differences reflected banks' greater need to fall in

line with formal actions as opposed to the possibility that banks receiving actions were in relatively poorer condition than banks that did not receive them. As noted, not all CAMELS 4­rated banks receive formal actions. The expectation is that the banks in the worst financial condition are more likely to receive

enforcement actions than are other banks. Thus the post­action changes in bank performance may be

more related to who gets served with an enforcement action than with the effects of the action erpse .

To address this problem, we used the Heckman (1979) sample­selectivity estimation procedure involving two sequential equations. The first equation uses a probit model to identify which banks are selected to receive formal enforcement actions. That is, it is modeled as a bivariate discrete choice model

where the event of getting an action for a bank over a given time interval is a function of the bank's financial condition at the start of the period. Alternative selection models were tested, and the most accurate model is as follows:

Action (j, t) = a + b1 (Annual asset growth rate) (j, t – 1) + b2 (Days since last exam) (j, t – 1) + 

b3 (Logarithm of bank assets) (j, t – 1) + b4 (CAMELS = 2 dummy)(j, t – 1) + 

b5 (CAMELS = 3 dummy) (j, t – 1) + b6 (CAMELS = 4 dummy) (j, t – 1) + b7 (CAMELS = 5 dummy) (j, t – 1) 

+ Error term (j, t) 

The second step in the Heckman model is to determine the exp ost effects of enforcement actions on

the financial performance of the bank. The effect of an action can be modeled as being dependent on

the initial condition plus the probability of getting an action. The estimated probability of an action

event is measured through lambda-which is derived from the first equation in the Heckman estimation.

0ne can analyze changes in bank performance on the event date by focusing on changes in several performance measures, including the provision for loan and lease losses and net loan charge­offs. The behavioral model estimated with the use of ordinary least squares regression is as follows: 

Performance measure (j, t) = a + b1 (Nonperforming loans) (j, t – 1) + 

b2 (Performing loans) (j, t – 1) + b3 (Changes in nonperforming loans) (j, t – 1) + 

b4 (Other real estate owned) (j, t – 1) + b5 (Loan income earned but not collected) (j, t – 1) + 

b6 (Equity) (j, t – 1) + b7 (Allowance for loan losses) (j, t – 1) + 

b8 (Estimated odds of action, or lambda) ( j, t ) + Error term (j, t) 

The Heckman estimations were estimated over all FDIC­insured banks, including all CAMELS rating groups. The results for the provisioning and net loan charge­off models show that after the targeting

of formal actions toward the weakest banks is controlled for, the odds of receiving an action had no significant effect upon loan­loss provisioning or net loan charge­offs. Another interpretation of this finding

is that sample­selectivity bias is not a serious enough problem in our sample to prevent the use of ordinary least squares regressions.16

16 The results of estimation of the Heckman model are available from the authors upon request.

17
FDIC Banking Review

REFERENCES
 

Brous, P. A., and K. Leggett. 1996. Wealth Effects of Enforcement Actions against Financially

Distressed Banks. ThepJournalpofpFinancialpResearch 19, no. 4:561-77. 

Curry, T., et al. 1997. Bank Examination and Enforcement. In HistorypofpthepEighties,ppLessonspfor

thepFuture:ppAnpExaminationpofpthepBankingpCrisespofpthep1980spandpEarlyp1990s.pp2 vols.,

421-75. Federal Deposit Insurance Corporation. 

Dahl, D., J. P. 0'Keefe, and G. Hanweck. 1999. The Influence of Examiners and Auditors on

Loan­Loss Recognition. FDICpBankingpReview 11:10-25.

Heckman, J. 1979. Sample Selection Bias as a Specification Error. Econometrica 44:153-61.

Horn, C. M. 1993. ApStrategicpPlanningpGuidepforpBankpRegulatorypExams. American Bankers

Association.

Huber, S. K. 1998. Enforcement Powers of Federal Banking Agencies. AnnualpReviewpofpBanking

Law 7:123-79.

Greene, W. H. 1993. EconometricpAnalysis. 2d ed., 706-14. Macmillan Publishing Company.

Peek, J., and E. Rosengren. 1995. Bank Regulatory Agreements in New England. Federal Reserve

Bank of Boston NewpEnglandpEconomicpReview, May/June: 15-24. 

. 1996. Bank Regulatory Agreements and Real Estate Lending. RealpEstatepEconomics

24:56-73. 

Peek, J., E. Rosengren, and J. J. Jordan. 1999. The Impact of Greater Bank Disclosure amidst a

Banking Crisis. WorkingpPa erpSeriespno.p99­1. Federal Reserve Bank of Boston.

U.S. General Accounting 0ffice (GA0). 1991. BankpSu ervision:ppProm tpandpForcefulpActions

Needed, GA0/GGD­91-69.

18
National Depositor Preference

The Consequences of
 

National Depositor
 

Preference
 

James A. Marino and
 

Rosalind L. Bennett*
 

I

n 1993, Congress passed the 0mnibus Budget

Reconciliation Act and adopted national depositor

preference. Provisions of the legislation elevated the

claims of domestic depositors on the assets of a failed

bank over the claims of foreign depositors and general

creditors. Congress believed that national depositor

preference would result in substantial cost savings to

the Federal Deposit Insurance Corporation (FDIC)

when it resolved failed institutions, but the law may

have had unintended consequences.

Studies suggest that even though national depositor

preference may produce cost savings for the FDIC, it

may also induce bank creditors and depositors to act in

ways that significantly reduce the cost savings. In addition, the effect of national depositor preference on

foreign depositors may induce foreign governments to

act in such a way that the FDIC loses some control of

the resolution process.

The expectation of cost savings to the FDIC from

national depositor preference is based on empirical

studies that focus on small banks. But national depositor preference has a potentially greater effect on large

banks because they have substantial amounts of foreign deposits and other unsecured liabilities. And it is

precisely this same balance­sheet structure that makes

it possible for large shifts in funding to occur when a

bank is in trouble, subverting the intended purpose of

national depositor preference. To see how liabilities

shifted just before failure, we studied six large banks

that failed between 1984 and 1992. Most of these large

banks, however, failed before the implementation of

either the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA) or national depositor preference two years later. Thus, we also discuss

the potential effects of the combination of FDICIA

and national depositor preference on the cost savings to

the FDIC.

Another possible unintended consequence of national depositor preference relates to its treatment of

foreign depositors. Foreign-hence, uninsured-depositors are given the same liquidation priority as general creditors, whereas domestic uninsured depositors

are given a higher priority. If foreign countries perceive

this hierarchy as unfair, they may seize the assets of foreign branches of failed U.S. banks, considerably complicating the resolution of bank failures. Seizure of

such assets is sometimes referred to as "ring fencing."

We discuss policy proposals that may alleviate the potential problem of "ring fencing"; one of the proposals

may, in addition, decrease FDIC losses.

* James A. Marino is an Associate Director and Rosalind L. Bennett is

a financial economist in the FDIC's Division of Research and

Statistics. The authors would like to thank the following people for

insightful comments and suggestions: Christine Bradley, Frederick

Carns, George French, Douglas Jones, Barry Kolatch, Arthur Murton,

John 0'Keefe, and Steven Seelig. We also thank Gary Gillum (of the

Federal Reserve) for data on Federal Reserve advances, and Lee

Davison for assistance with historical background. Erin Robbins provided valuable research assistance. The views expressed here are

those of the authors and not necessarily those of the Federal Deposit

Insurance Corporation.

19
FDIC Banking Review

Definition of Depositor Preference

At the time of failure, the assets and liabilities of the

bank are transferred to a receivership.1 The receiver's

task is to maximize net present value of recoveries for

the receivership claimants. The receivership distributes the proceeds according to a liquidation priority,

which is established by contracts between the claimant

and the institution or by the legal status of the

claimant.

Secured claimants have the highest priority because

they have a contract with the bank for a specific claim

on assets. Secured claimants are followed by a much

larger creditors class composed of depositors and other

general creditors. Holders of subordinated debt, preferred shareholders, and common shareholders follow.

Receivership law or regulation determines the priority

of the receiver for its administrative expenses and the

relative priority of groups of depositors and other general creditors. 

In the United States, receivership law has traditionally given the highest priority to the receiver for its administrative expenses, even placing it ahead of secured

claimants. Depositors and general creditors have received varying treatment. Under the Banking Act of

1933, insured depositors had a higher priority than

uninsured depositors and other general creditors. The

Banking Act of 1935 gave the same priority to all depositors and general creditors. Under the 1993 statute,

all receivership claimants are subject to the following

general preference scheme: 

� administrative expenses of the receiver;
 

� secured claims;2
 

� domestic deposits, both insured and uninsured;

� foreign deposits and other general creditor claims;

� subordinated creditor claims; and 

� shareholders.

It is important to be explicit about what types of deposits are included in each deposit class. Insured and

uninsured deposits are defined by deposit insurance

coverage. A "foreign deposit" is any deposit obligation

of a U.S. depository institution that is payable at an office located outside of any U.S. state, the District of

Columbia, or a territory of the United States.3 Because

of the manner in which the Federal Deposit Insurance

Act of 1950 defines a "deposit," foreign deposits are

not accorded the priority benefit of domestic deposits

and are therefore paid with other general liabilities of

an institution. 

The national depositor preference statute which

grants preference to "deposit liabilities" over other

general creditors, requires domestic depositors, insured

and uninsured, be paid in ffll before remaining creditors can collect their claims. Since the FDIC pays the

insured depositors in full and then stands in their place

to seek recovery, national depositor preference may

lower FDIC losses.

To see how this works, suppose a receivership has

assets with a book value of $100. Total assets net of

losses and administrative expenses are $90, but total

depositor and creditor claims on the receivership are

$100, a difference that implies a $10 total loss (see table

1).4 0nce the secured claims ($20) have been paid, $70

remains for distribution to the other claimants.

With no depositor preference, depositors and general creditors are given the same liquidation priority and

receive their pro rata share of the proceeds. For example, uninsured depositors hold $6 of the total amount of

unsecured claims ($80). They will receive their share

($6/$80-see column two of table 1) of the net value of

assets for distribution ($70-see note "c" of the table),

or $5.25. Since their claim was $6, the loss to uninsured

depositors is $0.75. Similar calculations are made for

the FDIC and for general creditors. Without depositor

preference, most of the $10 total loss is imposed on the

FDIC.

With depositor preference, however, the FDIC and

uninsured depositors stand before the general creditors. In our example, because total deposits ($76) are

more than the net value of assets available for distribution ($70), general creditors receive nothing.

Uninsured depositors and the FDIC receive payments

according to their share of the amount of their combined claims ($76). Depositor preference thus shifts

some of the burden of the $10 total loss away from the

FDIC toward the general creditors for a given liability

structure.

1 For a more detailed discussion of the bank­failure­resolution

process, see Bovenzi and Muldoon (1990). 

2 Secured claims receive priority only for the value of the collateral securing the claim. If the value of the collateral is less than the amount

of the claim, the unsecured portion falls into the priority scheme according to the type of claim.

3 The wording in the Federal Deposit Insurance Act, Sections

(3)(1)(3), (3)(l)(5)(A), is the basis of this definition. The legislation

specifically mentions the following territories of the United States:

Puerto Rico, Guam, American Samoa, the Trust Territory of the

Pacific Islands, the Virgin Islands, and the Northern Mariana Islands.

4 For the sake of simplicity, in this example, all deposits are domestic

deposits.

20
National Depositor Preference

Table 1
 

Illustration of tce Effect of Depositor Preference
 

Failed-Bank Assets

Total book value

Total recoverable value (net of administrative expenses)

$100

$190

Failed-Bank Liabilities

Secured liabilities

FDIC (as subrogeea for insured depositors)

Uninsured depositsb

General creditors

Total Liabilities

20

70

6

4

$100

Net value of assets available for distributionc $170

Claimant Losses 

with No Depositor Preference

Secured liabilities

FDIC (as subrogee for insured depositors)

Uninsured deposits

General creditors

Claim

$ 20.00

70.00

6.00

4.00

Share

6NA

$70/$80d

6/80

4/80

Payment

$20.00

61.25

5.25

3.50

Loss

$ 0.00

8.75

0.75

0.50

Total $100.00 $90.00 $10.00

Claimant Losses 

with Depositor Preference

Secured liabilities

FDIC (as subrogee for insured depositors)

Uninsured deposits

General creditors

Claim

$ 20.00

70.00

6.00

4.00

Share

6NA

$70/$76e

6/76e

6NA

Payment

$20.00

64.47

5.53 

0.00 

Loss

$ 0.00

5.53

0.47

4.00

Total $100.00 $90.00 $10.00

NA = Not applicable.
 

a The insured depositors are covered in full by the FDIC. As a subrogee, the FDIC substitutes for the insured depositors and retains all of their rights as creditors.
 

b In this example, all deposits are domestic.

c The net value of assets available for distribution is total recoverable assets ($90) less secured claims ($20).

d When there is no depositor preference statute, claimants in a given class receive their pro rata share of the net value of assets

available for distribution. In this example, the total amount of unsecured claims is $80. The fraction of unsecured claims held by

the FDIC is $70/$80. Thus, the FDIC receives 7/8 of the net value of assets for distribution ($70/$80 x $70 = $61.25). 

e When there is a depositor preference statute, the insured depositors (represented by the FDIC) and the uninsured depositors

have priority over general creditors. Since the sum of their claims is greater than the net value of assets for distribution, the general creditors will receive no payments. The FDIC receives insured depositors' share of the net value of assets ($70/$76 x $70 =

$64.47), and the uninsured depositors receive their share ($6/$76 x $70 = $5.53).

As this example makes clear, with depositor preference the bank's liability mix at the time of failurespecifically, the proportion of liabilities that are

secured-has a major effect on the proportion of loss

borne by the FDIC. However, as shown below, when

a bank is troubled its liability structure is bound to

change, since depositor preference gives uninsured

and unsecured claimants a powerful incentive to protect themselves from loss. They can do this by withdrawing their funds or obtaining security, in both cases

increasing the losses to the FDIC from failure.

Historical Background and Prior Researcc

As noted above, for most of the FDIC's history (that

is, from 1935 to 1993), all depositors had the same liquidation priority as general creditors. Under the original deposit insurance law, the Banking Act of 1933,

insured deposits were preferred over uninsured de21
FDIC Banking Review

posits and other creditors, but the Banking Act of

1935 overturned this preference and put into effect

the scheme that remained in place until national depositor preference was implemented in 1993. The

1935 scheme gave depositors and general claimants

of a failed bank the same liquidation priority, with

one exception: if the failed bank was state­chartered, the state law (if one was in place) determined

the relative standing of depositors and general creditors. By the time national depositor preference was

enacted, nearly 30 states had depositor preference

statutes (table 2), but most of the institutions to

which these statutes applied were small.

In the early 1980s there was much talk of the desirability of increasing market discipline. And the

Penn Square failure in 1982, which resulted in what

was then the largest payoff in history, heightened

concerns about a potential increase in costs to the

FDIC. In this climate, the FDIC published a study

(1983) arguing for national depositor preference,

maintaining that it would increase market discipline

by imposing greater losses on certain creditors,

thereby enhancing their desire to monitor the condition of depository institutions. 

The FDIC had another reason for favoring national depositor preference: in certain circumstances depositor preference would reduce the

likelihood of a payoff and greatly facilitate the use of

a purchase­and­assumption (P&A) transaction. The

reason the FDIC preferred to use a P&A transaction

was that a P&A met the two essential objectives of

bank­failure­resolution policies most important to

the FDIC at that time. The first objective was to

minimize disruption to the community where the

insolvent bank is located. The second is to minimize the role of the government in owning and

managing bank assets.5 Passing all the deposits will

achieve the first objective. Passing most of the assets will achieve the second. In a typical P&A, the

FDIC does both of those. Therefore, the FDIC

preferred to use a P&A transaction.

At that time, when the FDIC was under an obligation to treat all creditors in a particular class similarly,6 circumstances might have prevented it from

using a P&A. Some failed banks, for example, had

significant amounts of contingent claims, such as

standby letters of credit, loan commitments, and

other potential legal claims. Because those claims,

if they materialized, would be considered general

creditor claims, the FDIC would be obligated to

treat them the same as deposits and, under a P&A,

Table 2
 

State Depositor Preference Statutes
 

State Effective Date

Alaska 0ctober 15, 1978

Arizona September 21, 1991

California June 27, 1986

Colorado May 1, 1987

Connecticut May 22, 1991

Florida July 3, 1992

Georgia 1974a

Hawaii June 24, 1987

Idaho 1979b

Indiana 1943c

Iowa January 1, 1970

Kansas July 1, 1985

Louisiana January 1, 1985

Maine April 16, 1991

Minnesota April 24, 1990

Missouri May 15, 1986

Montana 1927c

Nebraska 1909c

New Hampshire June 10, 1991

New Mexico June 30, 1963

North Dakota July 1, 1987

0klahoma May 26, 1965

0regon January 1, 1974

Rhode Island February 8, 1991

South Dakota July 1, 1969

Tennessee 1969c

Texas August 26, 1985d

Utah 1983c

Virginia July 1, 1983

West Virginia May 11, 1981

Sofrce: 0sterberg (1996) and state statutes.

a Legislation became effective on either January 1 or July 1.

b Passed by both houses of the state legislature on July 1; enactment date

is unclear.

c Neither the month nor the day of enactment is available.

d Texas amended its law in the spring of 1993 and did not have depositor

preference until national depositor preference was enacted in August 1993.

would have to ensure that they were paid in full. The potential cost associated with a large amount of contingent

claims could make a P&A too expensive to justify it relative to the option of a payoff.

5 Bovenzi and Muldoon (1990), 1-2.
 

6 This obligation was established in First Empire Bank, Nee York, et al. v.
 

FDIC. For a detailed discussion of this ruling, see FDIC (1998), 251.

22
National Depositor Preference

The large amount of contingent claims was one reason the FDIC was not able to use a P&A transaction in

the 1982 failure of Penn Square Bank, N.A., 0klahoma

City, 0klahoma. Penn Square had total assets of approximately $500 million. It had issued $2.1 billion in

loan participations that the FDIC believed could result

in lawsuits, thereby creating a huge contingent liability

for any potential acquirer and ultimately for the FDIC.

Since the FDIC was unwilling to assume this risk, depositors of Penn Square were paid off. Had depositor

preference been in effect, the FDIC would have been

allowed to segregate contingent claims and subordinate them to deposit claims, thereby facilitating the

use of a transaction type other than a payoff.

Silverberg (1986), too, argued in favor of depositor

preference. At the time, the FDIC typically covered

all depositors fully in most bank failures. But because

of the FDIC's obligation to treat all creditors in a particular class similarly, depositors and general creditors

had the same liquidation priority. Silverberg objected,

maintaining that if depositors were covered in full, they

should receive a preferred creditor position, and if they

did not, in a P&A transaction other general creditors

would be receiving the benefit of full protection without incurring the cost of an insurance premium.

In 1988, with national depositor preference not yet

enacted, the FDIC developed a rationale for resolving

bank failures that allowed it to avoid treating all creditors of a given class equally. The FDIC maintained

that according to common law, depositors and creditors

could be treated differently as long as nondeposit creditors received at least as much as they would have received in liquidation.7 This pro rata technique was

used in the First Republic transaction, for example.

In a 1989 study the FDIC compared depositor preference with the new pro rata technique, restating its

case for depositor preference but declaring a preference for the pro rata policy. The FDIC requested explicit authority to distinguish between depositor and

nondepositor claims. The agency received such authority when Congress codified the pro rata approach

in the Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA). 0nce the FDIC

was able to facilitate P&A transactions using its authority to distinguish between depositor and nondepositor

claims, its interest in depositor preference largely vanished.

Not only did the FDIC no longer need depositor

preference as a way of facilitiating P&A transactions,

but the expectation of cost savings to the agency from

national depositor preference was also being challenged. In an empirical study, Hirschhorn and Zervos

(1990) examined the effects of the 28 state depositor

preference statutes on the thrift industry during the

1980s, comparing institutions operating with and without depositor preference. Although depositor preference laws appeared to create savings for the FSLIC by

making nondepositor claimants worse off, the empirical analysis indicated that depositor preference materially increased the number of creditors who require

collateral, thus increasing secured liabilities. This increase in secured liabilities shifts losses to all other

creditors, including the FDIC (as subrogee for insured

depositors), thereby increasing the FDIC's losses from

failure.

In sum, by 1993 the FDIC's desire to promote depositor preference had evaporated: the passage of FIRREA had made depositor preference unnecessary in

terms of distinguishing between depositor and nondeposior claims, and empirical analysis had shown that

the cost savings to the FDIC might actually be shortcircuited by creditors who would seek to protect themselves. Nonetheless, the national depositor preference

statute was passed on August 10, 1993, without meaningful public debate. The main impetus behind passage was that it allowed Congress to project cost

savings to the FDIC and use these projected savings to

offset part of the projected U.S. budget deficit.8

When national depositor preference was enacted

into law, the banking crises of the 1980s and early 1990s

were at an end. Total assets of failed banks fell from

$44.2 billion in 1992 to $3.5 billion and $1.4 billion in

1993 and 1994, respectively. Although the budget

planners might have expected more bank failures

-and thus more cost savings-the failures never materialized. Since the enactment of national depositor

preference, the largest bank to fail had total assets of

only $340 million.

Passage of national depositor preference therefore

came at a time when conditions in the banking industry made it unncessary. In addition, public commentators were quick to react, casting doubt on the

assumptions underlying it. Kaufman (1997) suggested

that the potential cost savings (which the 0ffice of

Management and Budget had estimated to be near

$750 million over five years) might be illusory. Since

the long­run dynamic effects were uncertain, he concluded it was not clear whether national depositor pref7 FDIC (1989), 246-48.

8 FDIC (1997).

23
FDIC Banking Review

erence on the whole would be good or bad for the

FDIC.

He also argued that in the long run depositor preference would cause foreign depositors and fed funds

sellers to protect themselves. They can protect themselves in a number of ways: demanding higher interest

rates, requiring collateral for their claims, using put options or acceleration clauses that require payment

when a bank gets into trouble, or altogether refusing to

provide credit to banks. These efforts could result in

an increase in market discipline, but they might also increase the probability of runs at large failing banks.

Thomson (1994) reinforced the argument that nondeposit creditors will not react passively to the subordination of their claims. He held that under national

depositor preference a significant number of nondeposit creditors might convert their claims to claims senior to deposits, thereby increasing the loss to the

FDIC in the event of failure.

Silverberg (1993, 1994) stated that national depositor

preference would result in increased market discipline

and only marginal cost reduction to the FDIC. To support his claim, he compared the balance­sheet structure of failed banks at the time of failure with the

structure several years before failure. He found that as

the banks approached failure, depositors and creditors

sought to protect their interests.

Silverberg (1994) also discussed the implications of

depositor preference for a bank's off­balance­sheet activity. He noted that once the FDIC started imposing

losses on unsecured creditors such as holders of standby letters of credit, off­balance­sheet activity fell in

weak banks and rose in healthy banks. Further, any

potential cost savings from derivative contracts probably would be minimized by a customer's ability to obtain collateral for any exposure. Silverberg conceded,

however, that depositor preference would limit the

FDIC's exposure to certain contingent claims arising

from litigation. 

Silverberg (1994) suggested that the shortcomings of

depositor preference might also have several ramifications for foreign depositors and creditors which banks

could try to contain in various ways. To protect foreign

deposits and creditors, banks could incorporate foreign

operations into separately capitalized banks. 0r legislation could be enacted to insure foreign deposits

and subject them to deposit insurance assessments.

Going one step further, bank holding companies could

create subsidiaries that include not only foreign operations but also off­balance­sheet activities.

0sterberg (1996) conducted a study of commercial

bank failures similar to the Hirschhorn and Zervos

(1990) study of thrift failures. For banks that failed before 1993, he compared those located in depositor preference states with those operating in states without

such laws. He concluded that the portfolios of banks

were similar with and without depositor preference.

But although the portfolios were similar, the cost to the

FDIC of resolving a failed bank between 1986 and

1992 was lower for banks with depositor preference.

He concluded, however, that the proof provided by his

evidence was not strong enough to show that depositor

preference was achieving its intended benefits.

Scifting Liabilities in Large Banks

The crux of the debate, therefore, was whether the

potentially significant cost savings to the FDIC would

be shortcircuited by the behavior of uninsured depositors and unsecured creditors. National depositor preference gave them a greater incentive to protect

themselves. Generally, an exposed creditor can either

seek collateral or leave the institution, and both actions

offer full protection. Table 3 lists the major types of

bank assets and liabilities and specifies which liabilities

are generally either secured or used for collateral.

During the normal course of business, some creditors require security. For a mortgage or other borrowing, for example, some premises and fixed assets may

serve as collateral. By definition, securities sold under

agreements to repurchase are secured. Federal Home

Loan Bank advances are required by law to be collateralized by loans. The Federal Reserve requires collateral for any borrowings from the discount window. 

However, limitations do exist on the extent to which

a large bank can give collateral for its liabilities.

Banking law and regulation typically prohibit the use

of collateral for many liabilities-most notably nonpublic deposits. Public entity depositors usually require that highly marketable securities be used for

collateral-but securities account for less than 14 percent of the assets of banks over $10 billion. Moreover,

this proportion would probably diminish as a bank got

into trouble and was required to fund deposit withdrawals by selling securities.

Rather than requiring collateral, depositors and

creditors can simply withdraw funds, which will drain

liquidity. When faced with such a liquidity drain, a

bank typically sells its highest­quality, most­marketable assets first. If a troubled bank exhausts its supply of high­quality assets, it must sell less­marketable

24
National Depositor Preference

assets, and selling these requires Table 3

more time. In the past, regulators Bank Assets and Liabilities and the market afforded these instiUsed for Security/ tutions such time. It is not clear that

Balance-Sheet Item Can Be Secured? the same amount of time will be

Assets

Cash and balances due from 

depository institutions
 

Securities
 

Federal funds sold 

Securities purchased under 

agreements to resell
 

Loans and lease financing 

receivables
 

Trading assets
 

Premises and fixed assets
 

0ther real estate owned
 

Investments in unconsolidated 

subsidiaries
 

Customers' liability to this bank 

on acceptances outstanding
 

Intangible assets
 

0ther assets
 

Liabilities

Non­public deposits

Public deposits
 

Federal funds purchased 

Securities sold under agreements 

to repurchase

Demand notes issued to the 

United States Treasury
 

Trading liabilities

0ther borrowed money 

(includes discount­window

borrowings and FHLB advances)

Bank's liability on acceptances 

executed and outstanding
 

Subordinated notes and debentures

No

Yes

No

Yes

Yes, for Federal Home Loan

Bank advances and discountwindow borrowings, also some

loans may be offset against deposits

No, but some subject to offset

Yes, primarily mortgages

No, although may be subject to a

prior lien

No

No

No

No

No,a but some subject to offset

against loans outstanding

Yes

Generally not, but may be secured 

as bank weakens

Yes

Yes

No, but some subject to offset 

Discount­window borrowings and

FHLB advances are always

collateralized; otherwise,

generally not secured

No

No

available to large, troubled institutions in the future.9

As for how depositors and creditors have in fact reacted to depositor

preference (state or national), empirical studies, such as those by

Hirschhorn and Zervos (1990) and

0sterberg (1996), are limited by a

relative scarcity of data. As mentioned above, from 1935 to 1993 depositor preference applied only to

state­chartered institutions, and

these were relatively small. Thus,

the studies were able to analyze

only relatively small institutions.

But in theory, the greatest potential

for cost savings to the FDIC from

national depositor preference rests

with large banking institutions,

none of which has failed since 1993.

A bank's liability mix at the time

of failure determines the extent to

which depositor preference lowers

the FDIC's costs, and as table 4

shows, the liability composition of

FDIC­insured banks varies dramatically according to total assets.

Small banks, those with assets of

less than $500 million, tend to rely

more heavily on insured deposits as

a funding base. In these banks domestic deposits make up 93 percent

of total liabilities; estimates indicate

that 85 percent of these domestic

deposits are insured deposits. In

the largest banks, those with assets

above $10 billion, domestic deposits

make up only about half of total liabilities, with insured deposits slightly less than 70 percent of domestic

deposits. For these banks foreign

deposits account for approximately

a Some states allow non­public deposits to be secured.

9 FDICIA, discussed below, requires the

prompt closing of troubled institutions.

25
FDIC Banking Review

17 percent of liabilities, and other borrowing and other

liabilities amount to 33 percent.

Since domestic deposits account for the overwhelming majority of small­bank liabilities, not surprisingly

0sterberg (1996) found that for these institutions, depositor preference resulted in only modest cost savings

to the FDIC. Further, since small institutions have

few general creditors, it would be relatively easy for

such creditors to flee or shift to a secured status before

failure.

The data required to measure accurately the effect

of national depositor preference on large banks are not

always available. In particular, uninsured and unsecured balances of large banks at the time of failure are

not always accurate, even in data supplied by the

FDIC, because accurate data were not always needed.

Before 1992, most large­bank failures were handled

without loss to depositors and other creditors, so there

was no need for the FDIC to make an insurance determination. (The process of determining insurance requires detailed analysis of bank liabilities to determine

those that are uninsured and unsecured. It is therefore

extremely labor intensive and expensive, especially for

a large bank.)

What is known is that liabilities may shift in large

banks before failure, and figures 1-6 show the shifts in

the balance sheets before failure for a set of large banks

that failed between 1984 and 1992. This failure group

consists of Continental Illinois National Bank and

Trust (CINB),10 First Republic Bank (Dallas), MBank

(Dallas), Bank of New England, Southeast Bank

(Miami), and First City (Houston)11. Balance­sheet

10 CINB did not fail, but received open­bank assistance from the

FDIC. For the purposes of this study, a bank requiring financial assistance from the FDIC to cover losses is considered to have failed.

11 The second failure of this institution, in 1992.

Table 4
 

Average Asset and Liability Composition by Asset Size of BIF-Insured Banks,
 

December 31, 1998 ($Millions)
 

Less than

$500 Million

$500 Million to

$5 Billion

$5 Billion to

$10 Billion

Over

$10 Billion

Number of banks

Total assets

Securities

as a percent of total assets

Pledged securities

Unpledged securities

9,533

$103,990

26,794

25.8%

7,659

7.4%

19,135

18.4%

775

$1,356,388

343,485

25.3%

111,549

8.2%

231,936

17.1%

68

7,021,725

1,367,901

19.5%

444,217

6.3%

923,685

13.2%

87

$46,084,166

7,292,407

15.8%

2,988,051

6.5%

4,304,357

9.3%

Total liabilities

Total deposits

as a percent of total liabilities

Domestic deposits

Foreign deposits

Estimated insured deposits

Estimated uninsured depositsa

Brokered deposits

Municipal deposits

a Includes foreign deposits.

$ 93,304

$ 86,807

93.0%

86,730

93.0%

77

0.1%

73,919

79.2%

12,812

13.7%

669

0.7%

1,736

1.9%

$1,229,448

$ 975,050

79.3%

962,176

78.3%

12,874

1.0%

758,784

61.7%

203,392

16.5%

30,463

2.5%

8,163

0.7%

$6,355,083

$4,669,049

73.5%

4,598,675

72.4%

70,374

1.1%

3,463,074

54.5%

1,135,601

17.9%

86,866

1.4%

48,009

0.8%

$42,508,334

28,570,584

67.2%

22,173,579

52.2%

6,397,005

15.0%

15,336,257

36.1%

$ 6,837,322

16.1%

480,736

1.1%

214,556

0.5%

26
National Depositor Preference

data are from the Call Reports filed quarterly with federal regulators. Data reflecting the balance­sheet position on the date of closing (when available) are from

the FDIC's Financial Information Management

System (FIMS).12

The six figures show total liabilities and total deposits-broken down into foreign/domestic and insured/uninsured-for several years before failure.

These data are merger­adjusted, so that data for merged

institutions are included throughout the time series.

In addition, the six figures identify capital­adequacy status of the banks, defined by the categories put

forth in the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA): "well­capitalized," "adequately capitalized," "undercapitalized,"

"significantly undercapitalized," or "critically undercapitalized."

Estimates of insured deposits were not available for

every period. Before March 1991, banks reported deposits over $100,000 annually on the June Call Report;

thereafter, banks reported them quarterly. These Call

Report data can be used to estimate insured deposits,

but these estimates are only that: estimates.13 In a few

of the failed banks, insured deposits at the time of failure are available from FDIC FIMS data. 

The identification of significant financial difficulties

can occur long before failure. The six figures make it

clear that in the case of Bank of New England, for example, financial difficulties were apparent in late 1989,

but the bank did not fail until January 1991. Many of

the banks in Texas struggled financially for even longer

periods. The figures also make it clear that a troubled

bank's liability structure changes considerably as it approaches failure. In all of these cases total liabilities decreased, uninsured and unsecured liabilities fell

relative to insured deposits, and foreign deposits declined.

12 FIMS data for insured deposits represent an initial estimate made

at the time of closing. These estimates are rough, since only limited information on multiple accounts and pass­through coverage is

available.

13 A sum of all deposits in a bank that are $100,000 or less may result

in either an over­ or an underestimation of the true level of insured

deposits. For example, depositors may have multiple accounts at a

single bank, all of which are under $100,000, such that the sum of

these accounts exceeds the insurance limit. And loan customers

may be able to offset loan balances against uninsured deposits.

Such factors would mean that our estimate of insured deposits was

too high. Alternatively, the FDIC grants pass­through coverage on

certain large deposits in which multiple individuals have interests.

This pass­through coverage would mean that our estimate of insured deposits was too low. Since data on multiple accounts and

pass­through coverage are not available, appropriate adjustments

cannot be made.

Figure 1
 

Continental Illinois Bank�Balance-Sceet Scifts before Failure
 $Billions 

50 

45 

40 

35 

30 

25 

20 

15 

10 

5 

0 

Total liabilities 

Total deposits 

Domestic deposits 

Penn Square 

failed 

July 5, 1982 

Bank run 

May 1984 

12/81 3/82 6/82 9/82 12/82 3/83 6/83 9/83 12/83 3/84 6/84 9/84 12/84 

Other liabilities Foreign deposits Domestic deposits

27
FDIC Banking Review

Although precise data on the uninsured and unsecured liabilities at the time of failure are unavailable,

the data suggest that both types of liability generally

declined rapidly just before failure. A notable exception was Continental Illinois. If these pre­failure

trends continued in these large banks, unprotected depositor and creditor claims would have been small at

the time of failure. 

0f the six banks examined, all but Continental

Illinois were large regional banks with a retail orientation. The evidence therefore suggests that large banks

with a retail franchise can better weather a protracted

period of financial deterioration before experiencing

liquidity insolvency. 

Continental Illinois, in contrast, was a wholesale

bank that relied heavily on purchased money, especially foreign deposits. It relied about half as much on domestic funding-measured by domestic deposits as a

percentage of liabilities-as the other banks in the

group (table 5): Continental Illinois funded approximately 34 percent of liabilities with domestic deposits,

whereas the comparable figure for the other banks was

from 45 to 72 percent.

The financial difficulties facing Continental Illinois

surfaced several years before failure. Troubles began

with the collapse of Penn Square, a collapse that

caused Continental Illinois to experience some funding difficulties because it had purchased a large amount

of loan participations from Penn Square.14 But

Continental Illinois was able to replace fleeing domestic deposits with foreign deposits. When rumors of

more substantial problems at the bank surfaced in May

1984, its funding quickly collapsed and an FDICorchestrated bailout was required.

At the time of the bailout, as figure 1 shows,

Continental Illinois still held substantial amounts of

foreign deposits. 0f total deposits of almost $30 billion, insured deposits were believed to be roughly $4.5

billion. Clearly, had the FDIC followed the liquidation

priority later required under national depositor preference, it would have imposed losses on foreign depositors, uninsured depositors, and general creditors and

would not have lost money on this transaction. 

Extrapolating from the data on these six banks, we

can divide large banks into roughly two classes. The

first group has characteristics similar to those of Bank of

New England, MBank, and First City. These "retail"

banks can use their substantial retail funding base to

withstand considerable financial pressure. Even with

depositor preference, creditors of these banks are likely to shift the majority of failure risk to the FDIC.

The second group consists of "wholesale" banks

whose path to failure could more closely approximate

that of Continental Illinois. Since "wholesale" banks

rely more heavily on liabilities that have a lower liquidation priority, liquidity would quickly evaporate in the

face of significantly bad press, although these banks

would be able to withstand a moderate amount of bad

news. In 1991, for example, Citibank, a large wholesale

bank, announced large losses in the first quarter.

Uninsured deposits fell from 12 to 9 percent of liabilities. Citibank, in contrast to Continental, was able to

attract enough foreign deposits to maintain their total

deposit base and avoid liquidity problems. When such

institutions close because of liquidity problems, much

of the risk of financial loss still rests with uninsured and

unsecured creditors, especially under depositor preference.

14 For more detail about Continental Illinois, see FDIC (1997), chap. 7.

Table 5
 

Balance-Sceet Ccaracteristics of Six Large Failed Banks before Failure
 

Deposits ($Millions) and Deposits as a Percentage of Liabilities (%)

Estimated Estimated

Institution Assets Liabilities Total Domestic Foreign Insureda Uninsureda,b

Bank of New England $21,346 $20,264 $15,740 78% $12,865 63% $ 2,875 14% $7,478 35% $7,666 36%

First Republic 25,445 24,262 15,912 66 10,857 45 5,055 21 3,678 15 7,179 30

First City 7,280 6,983 4,355 62 3,809 55 545 8 2,337 40 1,051 18

MBank, Dallas 8,906 8,586 6,801 79 6,232 73 568 7 2,383 27 4,363 50

Southeast 14,578 13,935 10,975 79 9,999 72 976 7 6,378 46 4,597 33

Continental Illinois 44,923 43,162 29,302 68 14,530 34 14,772 34 NA NA NA NA

NA = Not applicable.
 

Note: Merger­adjusted.
 

a Earliest figures available within the two years before failure.
 

b Includes foreign deposits.
 

28
 

 

National Depositor Preference

Figure 2
 

First Republic Bank, Dallas�Balance-Sceet Scifts before Failure
 $Billions 

30 

25 

20 

15 

10 

5 

0 

6/86 9/86 12/86 3/87 6/87 9/87 12/87 3/88 6/88 

Total liabilities 

Total deposits 

Domestic 

deposits 

Estimated insured 

deposits 

Estimated 

uninsured 

deposits 

Failed July 29, 1988 

Adequately 

Capitalized Well-Capitalized Undercap. 

Sign. 

Undercap. Critically Undercapitalized 

Other liabilities Foreign deposits Domestic deposits 

Figure 3 

MBank, Dallas�Balance-Sceet Scifts before Failure
 

$Billions Significantly Sign. Critically 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

Total deposits 

Domestic 

deposits 

Estimated 

uninsured 

deposits 

Estimated 

insured 

deposits 

Undercapitalized Undercapitalized Undercap. Undercap. Undercapitalized 

Total liabilities 

Failed 

March 29, 1989 

12/86 3/87 6/87 9/87 12/87 3/88 6/88 9/88 12/88 3/89 

Other liabilities Foreign deposits Domestic deposits 

29
 

 

 

 

 

 

FDIC Banking Review

Figure 4
 

Bank of New England�Balance-Sceet Scifts before Failure
 $Billions 

12/88 3/89 6/89 9/89 12/89 3/90 6/90 9/90 12/90 

0 

5 

10 

15 

20 

25 

Failed January 6, 1991 

Well-Capitalized Critically Undercapitalized 

Estimated insured deposits 

Estimated uninsured deposits 

Total liabilities 

Total deposits 

Domestic deposits 

Other liabilities Foreign deposits Domestic deposits 

Figure 5
 

Soutceast Bank, Miami�Balance-Sceet Scifts before Failure
 

$Billions Sign. 18 Adequately Capitalized 

16 

Total liabilities 

14 

12 

10 

8 

6 

4 

2 

0 

Estimated uninsured deposits 

Estimated insured deposits 

Total deposits 

Domestic deposits 

Undercapitalized 

Failed September 19, 1991 

Undercap. 

6/89 9/89 12/89 3/90 6/90 9/90 12/90 3/91 6/91 9/91 

Other liabilities Foreign deposits Domestic deposits 

30
 

 

 

National Depositor Preference

Figure 6
 

First City, Houston�Balance-Sceet Scifts before Failure
 

$Billions Significantly 

9/90 12/90 3/91 6/91 9/91 12/91 3/92 6/92 9/92 

0 

1 

2 

3 

4 

5 

6 

7 

8 

Total liabilities 

Total deposits 

Domestic deposits 

Estimated insured deposits 

Estimated uninsured deposits 

Failed October 30, 1992 

Undercap. Undercapitalized Critically Undercapitalized 

Other liabilities Foreign deposits Domestic deposits 

For the 50 largest BIF­insured institutions table 6

ranks the balance­sheet data as a percentage of total liabilities for the top and bottom 10 institutions in the

ranking.15 The majority of the 50 largest institutions,

especially the top ten, have a liability structure similar

to that of the "retail" banks in the failure group. As

mentioned above, their relatively stable funding base

could allow them to weather relatively long periods of

decline before failure. Certainly such a transition period would permit a considerable amount of liability

shifting.

Some of the institutions at the bottom of the list appear to have a more "wholesale" structure. In these

cases the FDIC might be able to benefit substantially

from depositor preference. Yet (as discussed in the

next section) these may be the very institutions most

likely to have some or all of their claims covered in full

because of the "systemic risk" provisions of FDICIA.

FDICIA, Systemic Risk, and National

Depositor Preference

Historically, as shown above, large banks have experienced considerable balance­sheet shifting before failure. It is important to note, however, that these

institutions were operating under a different set of

rules and market perceptions from the ones that exist

today. Not only national depositor preference but also

many other changes were enacted into law in the

1990s, all designed to reduce the exposure of the deposit insurance funds to failed banks. 

FDICIA in particular contained numerous provisions concerning the treatment of financially distressed

and failed banks that have implications for the consequences of national depositor preference. Foremost

among these provisions was prompt corrective action

(PCA), which raised the capital threshold for the determination of equity solvency.16 PCA also made it more

difficult for federal and state regulators to delay closing

capital­deficient institutions. Earlier closure, in turn,

has the potential for reducing some of the liability shifting seen in past failures. 

15 The figures are the sum of balance­sheet items of all of the FDICinsured depository institutions in the bank or thrift holding company as reported on the Call Report. To the extent that transactions

take place between banks within the holding company, the sum

overestimates the amount reported on a consolidated balance

sheet.

16 The PCA provisions of FDICIA define various capital categories

for a bank, ranging from "well­capitalized" to "critically undercapitalized." As a bank's capital level diminishes and it falls into lower capital categories, federal regulators are generally required to

take increasingly stringent action against the institution.

31
FDIC Banking Review

Table 6
 

Sum of Balance Sceets of 50 Largest Holding Companies, December 31, 1998
 

Ranked by Domestic Deposits to Liabilities ($Millions)

Deposits as a Percentage of Liabilities

Rank Holding Company Assets Total Domestic Foreign Insured Uninsureda

1 Union Planters $ 31,549 87% 87% 0% 74% 13%

2 Regions 38,739 85 81 3 61 20

3 First American 20,868 81 79 2 57 21

4 Firstar 40,326 79 78 1 58 20

5 Wells Fargo 195,809 81 77 4 56 21

6 Manufacturers 20,702 78 77 2 57 20

7 Mercantile 36,202 79 77 2 58 19

8 Summit 33,137 76 76 0 57 18

9 U.S. Bancorp 73,470 76 75 1 52 24

10 Marshall & Ilsley 21,557 81 75 6 56 19

41 Astoria $ 20,513 52% 52% 0% 49% 3%

42 California Fed 54,636 50 50 0 47 3

43 Bank of New York 61,343 81 50 32 23 27

44 Northern Trust 28,465 69 42 27 22 21

45 Chase Manhattan 355,483 66 40 26 18 23

46 Republic New York 47,155 78 31 46 24 7

47 State Street 43,184 68 27 41 2 25

48 Bankers Trust 105,844 42 22 20 5 16

49 Citicorp 370,397 66 18 48 11 7

50 J. P. Morgan 175,919 34 5 29 0 5

a Includes foreign deposits.

Some students of the 1980s banking crisis were critical of delays in bank closings, and they attributed

some of the delay to the extent to which large, already

troubled, banks used Federal Reserve discount­window borrowings to stay afloat. Hence, FDICIA restricted the Federal Reserve's ability to lend to

troubled institutions, viewing such lending as an attempt to delay bank closings.

Figures 7-10 show discount­window borrowings relative to total liabilities and total deposits for four of the

six failed banks in our sample.17 Each of these institutions relied on discount­window borrowing, and it

may have extended the life of the institution.

FDICIA also changed the cost test used by the

FDIC to choose the method of failure resolution.

Before FDICIA, the cost test required only that the

chosen resolution method be less costly than a payoff.

FDICIA's "least­cost test" requires that the resolution

method chosen be less costly than all alternative methods. The least­cost test makes it substantially more

difficult for the FDIC to structure resolution transactions in which uninsured depositors are covered in full,

since there will usually be the less­costly alternative

method in which only insured depositors are covered in

full.18

Some argue that the effects of the least­cost test will

be minimal for very large banks-precisely the banks

that offer the largest cost savings to the FDIC from national depositor preference-inasmuch as the test does

not apply if there is a determination of systemic risk. A

systemic­risk determination requires two­thirds of the

members of the FDIC Board of Directors and twothirds of the members of the Board of Governors of the

Federal Reserve System to find that complying with

the least­cost test would have serious adverse effects

on economic conditions or financial stability; if they

make that finding, they forward a written recommen17 Consistent data on discount­window borrowing for CINB and First

City were not available. 

18 For further discussion of the effect of the least­cost test on the

choice of resolution method, see Bovenzi and Muldoon (1990). 

32
 

 

National Depositor Preference

Figure 7
 

First Republic Bank, Dallas�Discount-�indow Borrowings
 

$Billions 

Adequately Sign. Critically 

6/86 9/86 12/86 3/87 6/87 9/87 12/87 3/88 6/88 

0 

5 

10 

15 

20 

25 

30 

FRB borrowings 

Failed July 29, 1988 

Total deposits 

Capitalized Well-Capitalized Undercap. Undercap. Undercapitalized 

Total liabilities 

Other liabilities FRB borrowings Total deposits 

Figure 8

MBank, Dallas�Discount-�indow Borrowings

$Billions Sign. Critically 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

Total liabilities 

Total deposits 

Undercapitalized Significantly Undercapitalized 

Failed March 29, 1989 

FRB borrowings 

Undercap. Undercap. Undercapitalized 

12/86 3/87 6/87 9/87 12/87 3/88 6/88 9/88 12/88 3/89 

Other liabilities FRB borrowings Total deposits 

33
 

 

 

FDIC Banking Review

Figure 9
 

Bank of New England�Discount-�indow Borrowings
 

$Billions 

25 

20 

15 

10 

5 

0 

Well-Capitalized Critically Undercapitalized 

Total deposits 

Failed January 6, 1991 

Total liabilities 

FRB borrowings 

12/88 3/89 6/89 9/89 12/89 3/90 6/90 9/90 12/90 

Other liabilities FRB borrowings Total deposits 

Figure 10

Soutceast Bank, Miami�Discount-�indow Borrowings

$Billions 

18 Adequately Capitalized Undercapitalized 

16 Total liabilities Failed September 19, 1991 

14 

12 

10 

8 

6 

4 

2 

0 

Total deposits 

FRB borrowings 

6/89 9/89 12/89 3/90 6/90 9/90 12/90 3/91 6/91 9/91 

Sign.
 

Undercap.
 

Other liabilities FRB borrowings Total deposits 

34
National Depositor Preference

dation to the Secretary of the Treasury; who, in consultation with the President, must agree before the leastcost test can be waived.

Despite the intentions of Congress when it passed

FDICIA, the least­cost test and the greater complexity

of the systemic­risk determination process might produce additional market anxiety at the onset of future

large­bank failures. Exposed creditors might be more

skittish and therefore more prone to run or seek collateral. Uninsured depositors and unsecured creditors

might move more aggressively to protect themselves.

Thus, financially troubled banks might then face

greater demands for collateral and be exposed to more

aggressive runs.

0n the one hand, such actions by exposed depositors and creditors will certainly cause a troubled institution to close earlier than under past rules. And earlier

closure may cause earlier and more rapid shifting of risk

to the FDIC. Thus, cost savings to the FDIC may end

up being minimal. 0n the other hand, earlier closure

may not give banks time to liquidate high­quality, but

less­liquid, assets, and if higher­quality assets remain in

the bank at the time of failure, the FDIC may lose less

money when resolving a failed bank.

Treatment of Foreign Depositors and

Proposals to Modify Depositor

Preference

Doubts about the cost savings to the FDIC are one

unintended consequence of national depositor preference. There is another, and possibly serious, implication for the FDIC. As noted above, national depositor

preference does not extend to foreign depositors, who

are treated the same as general creditors. This priority

implies that the FDIC can impose losses on foreign depositors. But as Silverberg (1994) noted, if the FDIC

attempts to impose such losses, it may lose control of

the resolution process. If a country attempts to protect

its depositors, it may decide to dispose-under its own

laws-of the assets and liabilities of the domestic

branches of a failed foreign bank (in this case the foreign bank would be a U.S. bank). Seizing such assets

is sometimes called "ring fencing." A country is more

likely to protect its depositors and creditors with ring

fencing if it believes the foreign country (for example,

the United States) does not have a competent liquidation plan. In some countries, ring fencing is required

by law. In this way, domestic depositor preference

complicates the resolution of a large bank with a substantial presence abroad.19

Treating foreign depositors as general creditors increases the chances of ring fencing, but even without

ring fencing, imposing proportionately larger losses on

foreign depositors increases systemic risk and perhaps

generates runs by foreign depositors on other large institutions. If the FDIC reduces the potential for ring

fencing by offering to provide foreign depositors and

creditors with more than would be dictated by receivership recoveries, it would be violating the least­cost

test and would require a systemic­risk determination.

Alternatively, legislative changes could be made so that

foreign deposits were considered "deposits" for preference purposes while remaining uninsured. This

change would decrease both the likelihood of ring

fencing and the need for systemic­risk determinations.

Another way to decrease the incentive for ring fencing would be to enact insured depositor preferencethe same liquidation priority as in the Banking Act of

1933. Under insured depositor preference, insured deposits would receive preference, and uninsured domestic deposits and foreign deposits would be treated

the same as general creditors. Since foreign deposits

(which are not insured) and uninsured domestic deposits would be treated alike, the fairness issue raised

by foreign countries would have less merit.

Even though insured depositor preference has the

advantage of possibly decreasing the incentive for ring

fencing, proposals to enact it have had political opposition. Insured depositor preference would put small

banks at a competitive disadvantage to the extent that

depositors at some large institutions would be perceived as receiving de facto 100 percent coverage (because of the systemic­risk provisions of FDICIA) for

their fninsfred depositors, and these institutions would

therefore be able to attract more depositors.

Insured depositor preference would do more than

decrease the likelihood of ring fencing. It would also

increase market discipline by shifting a greater amount

of failure risk from the FDIC to other market participants. For the 50 largest bank holding companies

ranked by insured deposits to liabilities, table 7 shows

the deposit structure of the top and bottom 10 institutions. The highly wholesale­oriented institutions that

have the smallest proportion of domestic deposits

(table 6) also have the smallest proportion of insured

deposits (table 7). There are also numerous large, re19 It is possible for a bank to change the nature of its foreign­deposit

contracts by making the funds payable in the United States (thereby placing them within the definition of a deposit). Doing so would

generate costs in the form of reserve requirements imposed by the

Federal Reserve and deposit insurance premiums; the net benefits

or costs are difficult to quantify. 

35
FDIC Banking Review

tail­oriented banking organizations that have relatively

low levels of insured deposits. In fact, in three large

banking organizations insured deposits account for less

than 5 percent of total liabilities. Even with the shifting of liabilities, these modest levels of insured deposits imply a larger pool of liabilities to share losses

than is the case under the current system.

Summary and Conclusions

The FDIC's experience with depositor preference

has varied. The agency initially operated under an insured depositor preference mandate but quickly recommended that all deposits have the same liquidation

status as general creditors. This priority system was enacted in 1935 and (except for state­chartered institutions) remained in place until 1993, when Congress

adopted a domestic depositor preference scheme.

Public commentators were generally critical of the

adoption of national depositor preference, particularly

since it was passed with little public debate and discussion. Many large banks have substantial amounts of

foreign deposits and other unsecured liabilities, and

the commentators thought this balance­sheet structure

might have misled federal budget analysts into believing that considerable cost savings were available from

depositor preference. But uninsured depositors and

unsecured creditors of troubled banking institutions always seek to protect themselves. At failure, the

amount of uninsured deposits and unsecured liabilities

is much less than it was in the months or years before

failure.

In any case, given the healthy state of the banking

industry since passage of national depositor preference,

the supervisory and market­discipline changes brought

about by the combination of national depositor preference and FDICIA (1991) remain untested. When a

large bank fails, these revisions will very probably alter

the behavior of market participants in meaningful

ways. Uninsured depositors and unsecured creditors

Table 7
 

Sum of Balance Sceets of 50 Largest Holding Companies, December 31, 1998
 

Ranked by Insured Deposits to Liabilities ($Millions)

Deposits as a Percentage of Liabilities

Rank Holding Company Assets Total Domestic Foreign Insured Uninsureda

1 Union Planters $ 31,549 87% 87% 0% 74% 13%

2 World Savings 31,958 72 72 0 71 1

3 Dime Savings 22,294 66 66 0 63 4

4 Charter 0ne 24,878 66 66 0 62 4

5 Regions 38,739 85 81 3 61 20

6 Huntington 28,271 76 74 2 60 15

7 AmSouth 19,833 73 73 0 58 15

8 Mercantile 36,202 79 77 2 58 19

9 Firstar 40,326 79 78 1 58 20

10 Summit 33,137 76 76 0 57 18

41 Mellon $ 52,354 74% 66% 9% 37% 29%

42 Union Bank 36,428 87 75 12 33 42

43 Republic New York 47,155 78 31 46 24 7

44 Bank of New York 31,343 81 50 32 23 27

45 Northern Trust 28,465 69 42 27 22 21

46 Chase Manhattan 355,483 66 40 26 18 23

47 Citicorp 370,397 66 18 48 11 7

48 Bankers Trust 105,844 42 22 20 5 16

49 State Street 43,184 68 27 41 2 25

50 J. P. Morgan 175,919 34 5 29 0 5

a Includes foreign deposits.

36
National Depositor Preference

will probably be more skittish. They will protect their

interests more actively and thus precipitate a liquidity

failure much more rapidly than has been the case in the

past. They will do this because earlier closures have a

greater potential for leaving foreign depositors and other creditors unprotected, to the benefit of the FDIC.

Another likely consequence of the current depositor

preference system-because this system gives foreign

depositors only the same status as general creditors-is

the greater probability of a systemic­risk determination

in the case of a bank with sizable foreign operations.

For without a systemic­risk determination, the FDIC

would be required to pay domestic depositors in full

before foreign depositors received anything, and placing foreign depositors behind domestic depositors

would create a strong incentive for foreign countries to

intervene in the failure process. In the past, some

countries intervened in the process by structuring their

own liquidation plans for the domestic branches and

operations of a failed foreign institution. This process,

often called "ring fencing," is designed to protect a

country's depositors in foreign banks from loss when

the foreign bank fails. Since the national depositor

preference scheme gives other countries' depositors a

lower priority than U.S. uninsured depositors, other

countries are likely to consider it unfair and be more

willing to engage in ring fencing.

Therefore, a system that gives preference to domestic depositors may not be the best and most effective

form of depositor preference. An alternative would be

to change the statute to grant foreign deposits the same

standing as domestic deposits. Another option, certainly more controversial, would be to move to an insured depositor preference system like the one in

effect from 1933­1935.

Because only relatively small institutions have failed

since the adoption of depositor preference in 1993, we

have a unique opportunity to reopen the depositor

preference debate. 0ther options-either preference

for all depositors, foreign and domestic, or preference

only for insured depositors-should be discussed and

debated as viable alternatives.

37
FDIC Banking Review

BIBLIOGRAPHY
 

Banking Act of 1933. U.S. Public Law 73­66. 73rd Cong., 1st sess., May 17 to June 16, 1933.

Banking Act of 1935. U.S. Public Law 74­305. 74th Cong., 1st sess., April 19 to June 3, 1935.

Bovenzi, John F., and Maureen E. Muldoon. 1990. Failure­Resolution Methods and Policy

Considerations. FDIC Banking Reviee 3, no. 1:1-11.

Federal Deposit Insfrance Act of 1950. U.S. Public Law 81­797. 81st Cong., 2nd sess., September

22, 1950.

Federal Deposit Insurance Corporation (FDIC). 1934. Annfal Report. FDIC.

---. 1983. Deposit Insfrance in a Changing Environment. FDIC.

---. 1984. The First Fifty Years: A History of the FDIC, 1933-1983. FDIC.

---. 1987. Mandate for Change: Restrfctfring the Banking Indfstry. FDIC.

---. 1989. Deposit Insurance for the Nineties: Meeting the Challenge. Unpublished manuscript.

---. 1996. FaileddBank Cost Analysis. FDIC Division of Finance.

---. 1997. History of the Eighties, Lessons for the Fftfre: An Examination of the Banking Crises of

the 1980s and Early 1990s. 2 vols. FDIC.

---. 1998. Managing the Crisis: The FDIC and RTC Experience, 1980-1994. 2 vols. FDIC.

Federal Deposit Insfrance Corporation Improvement Act of 1991 (FDICIA). U.S. Public Law 102­242.

102d Cong., 1st sess., December 19, 1991.

Financial Institftions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). U.S. Public Law 101­

73. 101st Cong., 1st sess., August 9, 1989.

Hirschhorn, Eric, and David Zervos. 1990. Policies to Change the Priority of Claimants: The

Case of Depositor Preference Laws. Jofrnal of Financial Services Research 4:111-25.

Kaufman, George G. 1997. The New Depositor Preference Act: Time Inconsistency in Action.

Managerial Finance 23, no.11:56-63.

Lutton, Thomas, and David Becher. 1994. Depositor Preference. 0ffice of the Comptroller of

the Currency memo dated March 24, 1994. Duplicated.

Omnibfs Bfdget Reconciliation Act of 1993. U.S. Public Law 103­66. 103d Cong., 1st sess., August

10, 1993.

0sterberg, William P. 1996. The Impact of Depositor Preference Laws. Federal Reserve Bank

of Cleveland Economic Reviee 12:1-12.

Silverberg, Stanley C. 1986. A Case for Depositor Preference. FDIC Banking and Economic Reviee

4, no. 4:7-12.

---. 1993. A Case for Broadening the Deposit Insurance Assessment Base. Unpublished

manuscript. Independent Bankers Association of America.

---. 1994. Depositor Preference, Insurance Costs, and the Cost of Supervision. The Golembe

Reports 1994-2.

Thomson, James B. 1994. The National Depositor Preference Law. Federal Reserve Bank of

Cleveland Economic Commentary. February 15, 1-4.

U.S. Department of the Treasury. 1991. Modernizing the Financial System: Recommendations for

Safer, More Competitive Banks. U.S. Department of the Treasury.

38
 

Recent Developments

Recent Developments
 

Affecting Depository
 

Institutions
 

by Lynne Montgomery*
 

REGULATORY AGENCY ACTlON
 

lnteragency Actions

Year 2000 Planning Guidance

Federal banking and thrift regulators issued additional joint guidance on May 7, 1999, in an effort to

help answer frequently asked questions on Year 2000

contingency planning. The release, Additional

Questions and Answers Concerning Year 2000 Business

Resumption Contingency Planning, is intended to supplement Year 2000 guidance issued by regulators

through the Federal Financial Institutions

Examination Council in December 1998. The 1998

guidance said that financial institutions should finish

their business resumption contingency plans (which

are plans to guide institutions in resuming their core

business processes if their computer systems fail) and

design methods to test the plans by June 30, 1999.

The new guidance states that institutions may conduct these tests after June 30, but early enough to

allow ample time to make essential changes and

retest, if necessary. BBR, 5/17/99, p. 878.

Final Rule on Specific Market Risk

The 0ffice of the Comptroller of the Currency

(0CC), the Board of Governors of the Federal

Reserve System, and the Federal Deposit Insurance

Corporation (FDIC) adopted a final rule allowing

banks that meet certain criteria to use their own valuation models to determine how much capital must

be held to protect against specific market risk in their

investment portfolios. In order to determine

whether a bank's internal models are adequate to set

capital levels, regulators will measure the models

against various criteria, such as whether the models

measure risk in a way that adequately explains historical price variations in the institution's investment

portfolio. The final rule, which contains no substantive changes from the interim rule that was published

in the Federal Register on December 30, 1997, is

intended to reduce banks' regulatory burden by ending the requirement that they use two methods to

measure their risk exposure to price fluctuations of

stocks and bonds in their trading portfolios. Banks

whose internal valuation models fail to meet the

rule's minimum adequacy standards will have to continue to hold capital at least equal to half of the specific risk charge calculated under the standardized

approach developed by the international Basel

Committee on Banking Supervision. BBR, 4/5/99, p. 611.

*Lynne Montgomery is a senior financial analyst in the FDIC's Division

of Research and Statistics.

Reference sources: American Banker (AB); The Wall Street Journal (WSJ);

BNA's Banking Report (BBR); and Federal Register (FR).

39
FDlC Banking Review

Joint Working Group to Issue Guidance on

Disclosure of Credit Losses

The federal banking and thrift regulators and the

Securities and Exchange Commission issued a joint

statement on March 10, 1999, announcing plans to

work together to issue guidance on the appropriate

disclosure of credit losses by banks and thrifts. The

agencies plan to set up a Joint Working Group of

agency representatives to understand more about the

procedures and processes of credit loss allowances.

The regulators hope to issue parallel guidance within a year on two issues on credit loss allowances. The

first issue relates to the procedures and processes

necessary for banks to reasonably assess losses inherent in their portfolios and ways to document the

reported loan­loss allowance. The second relates to

appropriate disclosures of loan­loss allowances and

the credit quality of institutions' loan portfolios. The

guidance will also address the need for institutions to

disclose changes in risk factors and asset quality that

affect allowances for credit losses. BBR, 3/15/99.

Federal Deposit lnsurance Corporation

New Insurance Rules for Joint Accounts

and Payable-on-Death Accounts

0n March 23, 1999, the FDIC Board of Directors

approved changes that are intended to simplify the

deposit insurance rules for joint accounts and

payable­on­death accounts. The maximum insurance coverage that a person can obtain for individual

interests in joint accounts at one bank or thrift will

remain at $100,000. However, under the new rules,

the maximum coverage for any joint account owned

by more than one person is expanded from $100,000

for each joint account to $100,000 for each individual

owner. The new rules for payable­on­death accounts

add parents and siblings to the list of "qualifying

beneficiaries," which already includes spouses, children, and grandchildren. BBR, 3/29/99; PR-13-99, FDIC,

3/23/99.

Bank Failures

0n March 26, 1999, the FDIC closed Victory State

Bank in Columbia, South Carolina, and took possession of the bank in its capacity as receiver. The

newly chartered South Carolina Community Bank in

Columbia, South Carolina, assumed the deposits of

Victory State Bank and also purchased $12.2 million

of the failed bank's assets. Victory State Bank's sole

office was re­opened on March 29, 1999, as South

Carolina Community Bank. The FDIC estimates

this will be a no­cost resolution for the Bank

Insurance Fund (BIF). PR-15-99, FDIC, 3/26/99.

0n April 23, 1999, New Mexico's Director of

Financial Institutions closed Zia New Mexico Bank

in Tucumcari, New Mexico, and the FDIC was

named as receiver. All the deposits of Zia New

Mexico Bank were assumed by the First National

Bank of New Mexico in Clayton, New Mexico,

which also purchased $6.0 million of the failed bank's

assets. The FDIC estimates this transaction will cost

the BIF $1.6 million. PR-20-99, FDIC, 4/23/99.

Real-Estate Survey-April 1999

The April 1999 issue of the Survey of Real Estate

Trends reported that the nation's real­estate markets

rebounded in recent months after a slowdown in the

late fall and early winter. The April survey included

an increased number of respondents reporting the

condition of their local housing market as better than

three months earlier. The survey polled 292 examiners and asset managers from federal bank and thrift

regulatory agencies about developments in their local

markets in the preceding three months. The proportion of respondents reporting that housing markets

were on the upswing during the three­month period

increased from 29 percent in January to 48 percent in

April. 0nly 13 percent noted excess supply, down

from 15 percent in January. As for local commercial

real­estate markets, 69 percent of the respondents

characterized supply and demand as in balance.

Higher sales levels and sale prices were also reported

for commercial properties in the April survey.

The national composite index used by the FDIC

to summarize results for both residential and commercial real­estate markets was 69 in April, compared

to 61 in January. Index scores above 50 indicate

improving conditions, while index scores below 50

indicate declining conditions. Survey of Real Estate Trends,

FDIC, April 1999.

40
Recent Developments

Report on Underwriting Practices

The April 1999 issue of the Report on Underwriting

Practices reported a decrease in the occurrence of

risky loan underwriting practices at FDIC­supervised banks during the six months ending March 31,

1999, compared with the previous six­month period

ending September 30, 1998. The FDIC examiners

reported a small proportion of banks with high risk in

current underwriting practices, loan portfolios, and

loan administration. Examiners did note concerns

about the level of "carryover debt" at FDIC­supervised banks actively making agricultural loans.

Carryover debt refers to loans that are not paid off at

the end of the growing season and are subsequently

carried over into the next growing season. The survey of loan underwriting practices is aimed at providing early warnings of potential problems in

underwriting practices at FDIC­supervised, statechartered nonmember banks. The focus of the survey is threefold: material changes in underwriting

standards for new loans, degree of risk in current

practices, and specific aspects of the underwriting

standards for new loans. The April report includes

surveys from 958 FDIC­supervised banks that were

examined during the six months ending March 31,

1999. Report on Underwriting Practices, FDIC, April 1999.

Financial Results for 1998 and FirstQuarter 1999
 

The FDIC reported that the Bank Insurance

Fund (BIF) earned $1.3 billion in 1998 and $244 million in the first quarter of 1999. The Savings

Association Insurance Fund (SAIF) earned $468 million in 1998 and $99 million in the first three months

of 1999. The BIF closed the first quarter of 1999

with a balance of $29.9 billion. The SAIF closed the

quarter with an unrestricted fund balance of $9.0 billion and $978 million in the new SAIF Special

Reserve, which was established on January 1, 1999,

and contains the amount by which the SAIF exceeds

the Designated Reserve Ratio of 1.25 percent.

Revenue for the BIF totaled $2 billion for 1998 and

$438 million for the first quarter of 1999. The fund's

investments in U.S. Treasury securities earned $1.7

billion in interest in 1998 and $429 million during the

first quarter of 1999. Deposit insurance assessments

were $22 million in 1998 and $10 million in the first

quarter of 1999. The SAIF earned $584 million in

revenue during 1998 and $141 million in the first

quarter of 1999. Almost all revenue for both periods

was derived from interest on investments in U.S.

Treasury securities. The low numbers of bank and

thrift failures contributed to the strong financial

results.

During 1998 and the first quarter of 1999, the

FSLIC Resolution Fund (FRF) assets in liquidation

were reduced by $1.4 billion to a balance of $930 million on March 31, 1999. PR-31-99, FDIC, 6/3/99.

Semiannual Agenda of Regulations

The FDIC published its semiannual agenda of

regulations in the Federal Register in May 1999, to

inform the public of the Corporation's regulatory

actions and encourage participation in the rulemaking process. Many of the actions are the result of the

FDIC Board of Director's ongoing efforts to reduce

the regulatory burden on banks, simplify rules,

improve efficiency and comply with the Riegle

Community Development and Regulatory

Improvement Act of 1994. The agenda contains 22

regulatory actions. Four actions have been completed and the remainder are in various stages of the rulemaking process. PR-23-99, FDIC, 5/11/99.

Federal Reserve Board

Vice Chairman Resigns

Federal Reserve Board Vice Chair Alice Rivlin

announced that she plans to resign from the Federal

Reserve Board, effective July 16, 1999. Ms. Rivlin,

who joined the Federal Reserve Board in June 1996,

plans to return to the Brookings Institution and

spend more time with her family. With Ms. Rivlin's

resignation, the seven­member Federal Reserve

Board of Governors now has two vacancies. FRB-PR,

6/3/99; BBR, 6/7/99, p. 1017.

Regulation CC

0n March 23, 1999, the Federal Reserve Board

announced rule changes that will give banks

involved in mergers more time to make software

changes so that the banks can focus on correcting

Year 2000 computer­related problems. The amend41
FDlC Banking Review

ments to Regulation CC affect banks that consummate mergers between July 1, 1998, and March 1,

2000. Banks involved in mergers during this period

will be treated as separate banks for purposes of

Regulation CC until March 1, 2001. Banks involved

in mergers after March 1, 2000, will be subject to the

regulation's normal one­year transition period for

merging banks. FRB-PR, 3/23/99; BBR, 3/29/99.

Office of the Comptroller of the Currency

Information-Sharing Accord

0n June 7, 1999, the 0CC announced that it had

reached an agreement with insurance commissioners

from eight states to exchange information related to

customer complaints about bank sales of insurance

products. The agreement calls for the 0CC and state

authorities to send copies of complaints to each other

and also to communicate on other matters, including

regulatory and policy initiatives. The 0CC and state

commissioners have worked together over the years

on matters of common concern, including consumer

protection. In December 1998, the 0CC signed an

agreement to share information with the 0klahoma

Insurance Department. The eight states involved in

the new agreement are Delaware, Kansas, Kentucky,

Louisiana, Maine, North Carolina, North Dakota,

and Pennsylvania. BBR, 6/14/99, p. 1067.

Federal Housing Finance Board

Mortgage Financing Program

0n March 10, 1999, the Federal Home Loan Bank

of Atlanta announced that it is joining the

FHLBanks of Chicago and Dallas in participating in

the Mortgage Partnership Finance (MPF) program.

The MPF program, which was started as a pilot by

the Chicago FHLBank, provides new competition in

the secondary mortgage market by permitting

FHLBank members to sell loans to the FHLBank

rather than to Fannie Mae or Freddie Mac. BBR,

3/15/99.

Fees Prohibited in Lieu of Stock
 

Redemption
 

The Federal Housing Finance Board adopted an

interim final rule on March 19, 1999, which prohibits

the Federal Home Loan Banks from charging or

accepting a fee instead of redeeming a member's

excess capital stock. The rule was adopted to eliminate a practice under which a FHLBank gave members the option to pay a fee to the FHLBank in lieu

of redeeming each member's capital stock exceeding

115 percent of a member's minimum capital stock as

set by stature. The Finance Board stated that the

FHLBanks are more than adequately capitalized and

they do not need the excess capital stock. In addition, the Finance Board believes that allowing the

payment of such fees would detract from the

agency's ongoing efforts and initiative to ensure that

the FHLBanks carry out their housing and community investment mission. BBR, 3/29/99.

Federal Home Loan Banks' Investments

Limited

0n May 28, 1999, the Federal Housing Finance

Board passed a resolution that would limit the

Federal Home Loan Banks to make only investments that are tied to the system's housing­related

mission. The Federal Home Loan Banks would no

longer be permitted to invest in mortgage­backed

securities purchased on the secondary market. The

resolution was introduced because critics feel that

Federal Home Loan Bank activities have extended

beyond the mission of funding housing and community development. AB, 6/1/99.

National Credit Union Administration

Small-Credit-Union Program

0n March 18, 1999, the board members of the

National Credit Union Administration (NCUA)

agreed to launch a small­credit­union program. The

program covers federal credit unions in three categories: small credit unions, newly chartered credit

unions, and low­income designated credit unions.

The program also allows for regional directors to offer

assistance to federally insured state credit unions

after consultation with state supervisors. The program provides a flexible framework for providing

financial and technical support to those credit unions

that may need some additional assistance to better

serve their members, expand their membership base,

42
Recent Developments

and build capital. Further, the program works toward

future goals by meeting some prompt corrective

action requirements. BBR, 3/22/99, p. 538.

New Insurance Rules for Joint Accounts

0n April 15, 1999, following the action taken by

the FDIC, the NCUA voted to adopt an interim final

rule to simplify insurance regulations on joint ownership accounts. Under the new rule, the maximum

coverage for any joint account owned by more than

one person is expanded from $100,000 for each joint

account to $100,000 for each individual owner.

However, the maximum insurance coverage that a

person can obtain for individual interests in joint

accounts at one bank or thrift will remain at $100,000.

BBR, 4/19/99, p. 715.

Member Business Loan Rule

0n May 19, 1999, the NCUA approved a member

business loan final rule, incorporating loan­limit

provisions required under the Credit Union

Membership Access Act (CUMAA). The CUMAA 

laid out the definition of a member business loan as

"any loan, line of credit, or letter of credit, the properties of which will be used for a commercial, corporate or other business investment property or venture

or agricultural purpose." In addition, the CUMAA

imposed an aggregate limit on a federally insured

credit union's outstanding member business loans of

$50,000. Under the CUMAA and the NCUA's final

rule, loans under $50,000 to credit union members

are not counted as member business loans, with a few

specific exceptions. The final rule states that a federally insured credit union may not grant a member

business loan that would result in an amount outstanding that is higher than 1.75 times the actual net

worth of the credit union or 12.75 percent of the

credit union's assets, whichever is less. BBR, 5/24/99, p.

944.

STATE LEGlSLATlON AND REGULATlON
 

New York

0n April 8, 1999, the New York State Banking

Board approved regulations to remove the ceiling on

the fee that state­chartered banks may charge customers for "bounced" checks. The regulations,

which went into effect on April 28, 1999, remove the

current $15 limit on fees for checks written against

insufficient funds. The state Banking Department 

said the regulations were necessary to keep statechartered banks competitive with federal banks,

which have no limits on the amount they can charge

for insufficient funds. BBR, 4/19/99, p. 707.

Pennsylvania

0n May 27, 1999, Pennsylvania Governor Tom

Ridge nominated former banker David E. Zuern as

the state's top banking regulator. Mr. Zuern would

succeed Banking Secretary Richard C. Rishel. Mr.

Zuern retired last year after a 28­year banking career.

Most recently he was president and chief executive

officer of PNC Bank's northwestern Pennsylvania

operations. Mr. Zuern also headed Governor Ridge's

transition team for banking and insurance in 1994.

AB, 5/28/99.

Texas

0n May 21, 1999, Texas Governor George W. Bush

signed a bill that requires all banks and savings and

loans doing business in Texas but domiciled in other

states to pay corporate franchise taxes in the same

manner as financial institutions domiciled in Texas.

The bill, which becomes effective on January 1,

2000, is aimed at the growing number of banking corporations doing business in Texas that have not been

paying franchise taxes on revenues earned in Texas

because they are domiciled elsewhere. BBR, 6/14/99, p.

1071.

43
FDlC Banking Review

BANK AND THRlFT PERFORMANCE
 

First-Quarter 1999 Results for Commercial

Banks and Savings Institutions

FDIC­insured commercial banks earned a record

$18.0 billion in the first quarter of 1999, which is

$2.1 billion higher than in the first quarter of 1998.

The first quarter was marked by an absence of major

merger­related restructuring expenses at large

banks, which had depressed industry earnings in

recent periods. Large­bank earnings also were

boosted by improvements in international operations and a record quarter for trading income.

Banks' annualized return on assets (R0A) rose to

1.32 percent, compared to 1.11 percent in the fourth

quarter of 1998 and 1.26 percent one year previously. The number of problem banks dropped from 69

in the fourth quarter of 1998 to 64 in the first quarter of 1999, and assets of problem banks were

approximately $4.7 billion at March 31, 1999. There

was one bank failure during the quarter.

FDIC BIF­insured mutual savings institutions

reported profits of $2.7 billion in the first quarter,

which is the third­highest quarterly total in the

industry's history. The higher earnings were made

possible by low expenses for credit losses and strong

growth in interest­earning assets. The industry's

R0A for the first quarter was 0.98 percent, slightly

below the 1.01 percent average in the first quarter of

1998. For the tenth consecutive quarter, no federally insured savings institutions failed. The number

of problem thrifts increased by one institution to 16

at the end of the first quarter. FDIC Quarterly Banking Profile,

First Quarter 1999.

RECENT ARTlCLES AND STUDlES
 

0n April 16, 1999, the Federal Reserve Bank of

Cleveland released a report stating that traditional

financial institutions need to realize specifically what

unbanked low­income individuals need in a financial

institution in order to promote the advantages of

banks compared to nonbank payment­service

providers such as check cashers. The report, entitled

Bringing the Unbanked Onboard, states that 1community organizations need to get involved in promoting

the advantages for building a financial and credit history, as well as in teaching the unbanked how to use

and manage a checking or other transaction account.1

Barbara A. Good, a former payments system specialist for the Federal Reserve, authored the report. BBR,

4/26/99, p. 752.

A paper written by Joanna Stavins of the Federal

Reserve Bank of Boston states that banks could

boost revenue by reducing or eliminating some fees

imposed on checking accounts. Consumers tend to

reduce the amount of cash in their checking accounts

if banks impose per­item fees, charge for the return

of checks, limit the use of tellers, or assess ATM surcharges. The paper, entitled Checking Accounts: What

Do Banks Offer and What Do Consumers Value?, concludes that fees seem to deter bank customers and

induce them to deposit their money elsewhere. As a

result, banks have fewer accounts on which they can

assess fees, leading to lower revenues. AB, 5/28/99.

Nicholas Leung, Jean­Marc Poullet, and Timothy

Savers of McKinsey & Co. write that half of all Asian

banks will be involved in mergers within two years.

The analysts claim that Asian governments are forcing banks to recapitalize quickly, which will force

them to look for outside investors and will lead to

mergers. In their paper, entitled Asian Banking: After

the Storm, they state that when the current Asian crisis has passed, a handful of banks will have emerged

in each market as the leaders. AB, 5/28/99.

44
Recent Developments

lNTERNATlONAL DE�ELOPMENTS
 

European Union

In order to help European Union banking institutions ensure a smooth transition into Year 2000, the

European Union finance ministers declared that

December 31, 1999, will be a banking holiday for all

Euro transactions in the 15 European Union member

states. The finance ministers believe that the shutdown is necessary in order give the financial industry

sufficient time to complete a full back up of all systems before midnight on December 31, 1999. BBR,

4/26/99, p. 769.

The European Commission released a report on

April 13, 1999, stating that the European Union

should not move up the introduction date for Euro

notes and coins to a date earlier than January 1, 2002,

as requested by some member states. Some member

states believe that setting the introduction date earlier than January 1, 2002 would help solidify public

acceptance of the single currency. However, the

Commission concluded that moving the introduction

to an earlier date would pose numerous legal and

technical problems. BBR, 4/19/99, p. 723.

Canada

Effective March 31, 1999, the Canada Deposit

Insurance Corporation (CDIC) adopted a risk­based

premium system that replaced the single premium

rate that has traditionally been charged on deposits.

The new, four­level system is based on assessment of

a deposit­taking institution's risk profile and is

expected to produce substantial premium reductions

for many financial institutions operating in Canada.

The new system establishes four categories of premium rates to be applied to an institution's insured

deposits. The institutions are assigned to a category

on the basis of their rating on the following criteria:

capital adequacy, profitability and asset concentration, regulatory ratings, and adherence to CDIC's

Standards of Sound Business and Financial Practices.

BBR, 3/29/99.

Japan

Under a new approach scheduled to begin in July

1999, Japan's Financial Supervisory Agency (FSA)

will establish a more regular schedule for inspecting

financial institutions, and auditing foreign banks,

brokerages, and insurers. Japanese banks generally

would be inspected every year, but banks that are in

a healthy financial and management condition could

be inspected less frequently, possibly every two or

three years. In addition, the FSA will cooperate far

more closely with the public prosecutors and the

Nation Tax Administration in auditing Japanese and

foreign banks, brokerages, insurers, and other financial­service providers. BBR, 6/7/99, p. 1037.

0n May 14, 1999, Japan's FSA took prompt corrective action against Japanese regional bank Kofuku

Bank Ltd. in response to a sharp drop in the bank's

capital ratio. It was the first time that the FSA has

imposed the tough legal measure on a bank since the

prompt corrective action system was established in

April 1998. The FSA's order requires Kofuku to reinforce its paid­up capital, slash its operations substantially, or terminate its banking business. BBR, 5/24/99, p.

957.

Mexico

Mexico's bank bailout agency, the Instituto para la

Proteccion al Ahorro Banacaris (IPAB), began operations on May 21, 1999. The main functions of the

IPAB will be to administer Mexico's bank protection

fund, conclude efforts to improve the Mexican banking system, and sell nonperforming assets. The IPAB

was established by the Mexican Congress in

December 1998 as an agency designed to replace

F0BAPR0A, an emergency federal deposit insurance fund that was established after the collapse of

the peso at the end of 1994 and early 1995. BBR, 5/17/99,

p. 907.

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