Deposit Insurance: Assessment of Regulators' Use of Prompt Corrective Action Provisions and FDIC's New Deposit Insurance System
Published: 2007-02-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Federal Deposit Insurance Reform Conforming Amendments Act of 2005 required GAO to report on the federal banking regulators' administration of the prompt corrective action (PCA) program under section 38 of the Federal Deposit Insurance Act (FDIA). Congress created section 38 as well as section 39, which required regulators to prescribe safety and soundness standards related to noncapital criteria, to address weaknesses in regulatory oversight during the bank and thrift crisis of the 1980s that contributed to deposit insurance losses. The 2005 act also required GAO to report on changes to the Federal Deposit Insurance Corporation's (FDIC) deposit insurance system. This report (1) examines how regulators have used PCA to resolve capital adequacy issues at depository institutions, (2) assesses the extent to which regulators have used noncapital supervisory actions under sections 38 and 39, and (3) describes how recent changes to FDIC's deposit insurance system affect the determination of institutions' insurance premiums. GAO reviewed regulators' PCA procedures and actions taken on a sample of undercapitalized institutions. GAO also reviewed the final rule on changes to the insurance system and comments from industry and academic experts.
section_title: What GAO Found
paragraphs: In recent years, the financial condition of depository institutions generally has been strong, which has resulted in the regulators' infrequent use of PCA provisions to resolve capital adequacy issues of troubled institutions. Partly because they benefited from a strong economy in the last decade, banks and thrifts in undercapitalized and lower capital categories decreased from 1,235 in 1992, the year regulators implemented PCA, to 14 in 2005, and none failed from June 2004 through January 2007. For the banks and thrifts GAO reviewed, regulators generally implemented PCA in accordance with section 38. For example, regulators identified when institutions failed to meet minimum capital requirements, required them to implement capital restoration plans or corrective actions outlined in enforcement orders, and took steps to close or require the sale or merger of those institutions that were unable to recapitalize. Although regulators generally used PCA appropriately, capital is a lagging indicator and thus not necessarily a timely predictor of problems at banks and thrifts. In most cases GAO reviewed, regulators had responded to safety and soundness problems in advance of a bank or thrift's decline in required PCA capital levels. Under section 38 regulators can take noncapital supervisory actions to reclassify an institution's capital category or dismiss officers and directors from deteriorating institutions, and under section 39 regulators can require institutions to implement plans to address deficiencies in their compliance with regulatory safety and soundness standards. Regulators generally have made limited use of these authorities, in part because they have chosen other informal and formal actions to address problems at troubled institutions. According to the regulators, other tools, such as cease-and-desist orders, may provide more flexibility than those available under sections 38 and 39 because they are not tied to an institution's capital level and may allow them to address more complex or multiple deficiencies with one action. Regulators' discretion to choose how and when to address safety and soundness weaknesses is demonstrated by their limited use of section 38 and 39 provisions and more frequent use of other informal and formal actions. Recent changes to FDIC's deposit insurance system tie the premiums a bank or thrift pays into the insurance fund more directly to the estimated risk the institution poses to the fund. In the revised system, FDIC generally (1) differentiates between larger institutions with current credit agency ratings and $10 billion or more in assets and all other, smaller institutions and (2) requires all institutions to pay premiums based on their individual risk. Most bankers, industry groups, and academics GAO interviewed and many of the organizations and individuals that submitted comment letters to FDIC on the new system generally supported making the system more risk based, but also had some concerns about unintended effects. FDIC and the other federal banking regulators intend to monitor the new system for any adverse impacts.

section_title: Letter
paragraphs: With the failure of more than 2,900 federally insured banks and thrifts in  the 1980s and early 1990s, federal regulators were criticized for failing to  take timely and forceful action to address the causes of these failures and  prevent losses to the deposit insurance fund and taxpayers. In response to  the federal banking regulators’ failure to take appropriate action, Congress  passed the Federal Deposit Insurance Corporation Improvement Act of  1991 (FDICIA), implementing significant changes to the way banking  regulators supervise the nation’s depository institutions. FDICIA created  two new sections in the Federal Deposit Insurance Act (FDIA)—sections  38 and 39—that required the federal banking regulators to create a two- part framework to supplement their existing supervisory authority to  address capital deficiencies and unsafe or unsound conduct, practices, or  conditions. The addition of sections 38 and 39 to FDIA were intended to  improve the ability of regulators to identify and promptly address  deficiencies at an institution to better safeguard the deposit insurance  fund. Specifically, section 38 requires regulators to classify depository  institutions into one of five capital categories based on their level of  capital—well capitalized, adequately capitalized, undercapitalized,  significantly undercapitalized, and critically undercapitalized—and take  increasingly severe actions, known as prompt corrective action (PCA), as  an institution’s capital deteriorates. Section 38 primarily focuses on  capital as an indicator of trouble, thus the supervisory actions authorized  under it are almost exclusively designed to address an institution’s  deteriorating capital level (for example, requiring undercapitalized  institutions to implement capital restoration plans). However, section 38  also authorizes noncapital supervisory actions (for example, removing  officers and directors or downgrading an institution’s capital level).  Section 39 required the banking regulators to prescribe safety and  soundness standards related to noncapital criteria, including operations  and management; compensation; and asset quality, earnings, and stock  valuation, and allows the regulators to take action if an institution fails to  meet one or more of these standards. Since the passage of FDICIA, banks  and thrifts have benefited from a strong economy, but this has not  diminished the importance of the need for regulators to take early and  forceful action to address capital and noncapital deficiencies.
FDICIA also granted the Federal Deposit Insurance Corporation (FDIC)  the authority to establish and maintain a system—the deposit insurance  system—to assess the relative risk of federally insured banks and thrifts  and charge them premiums based on that risk. In February 2006, Congress  granted FDIC the authority to make substantive changes to the deposit  insurance system, including the way the regulator assesses risk and  assigns premiums. FDIC issued its final rule implementing changes in  November 2006.
This report responds to the mandate contained in section 6 of the Federal  Deposit Insurance Reform Conforming Amendments Act of 2005 requiring  the Comptroller General to report on issues relating to the federal banking  regulators’ administration of the PCA program under section 38 of FDIA as  well as various aspects of FDIC’s deposit insurance system. Because the  banking regulators also monitor the safety and soundness of depository  institutions using criteria other than capital levels, this report also includes  a review of the federal banking regulators’ use of safety and soundness  standards under section 39. Specifically, this report (1) describes trends in  the financial condition of banks and thrifts and federal regulators’  oversight of these institutions since the passage of FDICIA, (2) evaluates  how federal regulators have used PCA to resolve capital adequacy issues  at the institutions they regulate, (3) evaluates the extent to which federal  regulators have used the noncapital supervisory actions of sections   38 and 39 to address weaknesses at the institutions they regulate, and   (4) describes FDIC’s deposit insurance system and how recent changes to  the system affect the determination of institutions’ risk and insurance  premiums.
To address these objectives, we reviewed relevant laws, regulations, and  regulators’ policies and procedures and interviewed officials from the four  federal banking regulators—FDIC, the Board of Governors of the Federal  Reserve System (Federal Reserve), the Office of the Comptroller of the  Currency (OCC), and the Office of Thrift Supervision (OTS)—as well as  industry officials and academics. We also reviewed our previous reports  on PCA. To describe trends in the financial condition of banks and thrifts  and regulators’ oversight of these institutions since the passage of FDICIA,  we reviewed relevant industry reports and analyses. We also analyzed  regulator and industry data to determine, among other things, the number  of well-capitalized, adequately capitalized, and undercapitalized  institutions and the number of institutions appearing on the problem  institutions list since 1992, the year regulators implemented FDICIA. To  assess how federal regulators have used PCA to resolve capital adequacy  issues at the institutions they regulate, we reviewed section 38 and its  implementing regulations, as well as regulators’ policies and procedures.  We also examined reports of examination, informal and formal  enforcement actions, and institution-regulator correspondence for a  nonprobability sample of 24 institutions from a population of 157  institutions that fell below one of the three lowest PCA capital thresholds  at least once from 2001 through 2005. We chose this period for review  based on the availability of examination- and enforcement-related  documents and to reflect the most current policies and procedures used  by the regulators. The sample reflects a mix of institutions regulated by  each of the four regulators as well as a mix of the three lowest PCA capital  categories. In 6 of these 24 cases, regulators did not implement PCA  because they determined that it was not warranted. In addition, we  reviewed the material loss reviews of all banks and thrifts that failed from  1992 through 2005 and in which the primary regulator implemented PCA to  address capital adequacy issues. To determine the extent to which  federal regulators have used the noncapital supervisory actions of sections  38 and 39 to address weaknesses at the institutions they regulate, we  reviewed regulators’ policies and procedures related to sections  38(f)(2)(F) and 38(g) (the provisions for dismissal of officers and directors  and reclassification of a capital category, respectively) and section 39, as  well as data on the number of times and for what purposes they used these  noncapital authorities. To provide context on the extent of regulators’ use  of these noncapital provisions, we also obtained data on the number of  times regulators used their authority under section 8(e) of FDIA to remove  officers and directors from office and section 8(b) to enforce compliance  with safety and soundness standards. Finally, to describe how changes in  FDIC’s deposit insurance system affect the determination of institutions’  risk and insurance premiums, we reviewed FDIC’s notice of proposed rule  making on deposit insurance assessments, selected comments to the  proposed rule, and FDIC’s final rule on deposit insurance assessments.  We also interviewed representatives of five depository institutions (three  large and two small) and two trade groups representing large and small  institutions and two academics to obtain their views on the impact of  FDIC’s changes to the system. Appendix I contains a more detailed  description of our scope and methodology. We conducted our work in  Washington, D.C., and Chicago from March 2006 through January 2007 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Four federal banking regulators—FDIC, the Federal Reserve, OCC, and  OTS—oversee the nation’s banks and thrifts to ensure they are operating  in a safe and sound manner. The failure of more than 2,900 depository  institutions during the 1980s and early 1990s led to the passage of FDICIA,  which amended FDIA to require regulators to take action against  institutions that failed to meet minimum capital levels and granted  regulators several authorities to address noncapital deficiencies at the  institutions they regulate. FDICIA also required FDIC to establish a system  to assess the risk of depository institutions insured by the deposit  insurance fund.
subsections: section_title: Federal Regulation of Banks and Thrifts
paragraphs: FDIC insures the deposits of all federally insured depository institutions,  generally up to $100,000 per depositor, and monitors their risk to the  deposit insurance fund. In addition, FDIC is the primary regulator for  state-chartered nonmember banks (that is, state-chartered banks that are  not members of the Federal Reserve System), the Federal Reserve is the  primary regulator for state-chartered member banks (state-chartered  banks that are members of the Federal Reserve System) and bank holding  companies, OCC is the primary regulator of federally chartered banks, and  OTS is the primary regulator of federally and state-chartered thrifts and  thrift holding companies.
Federal regulators have defined several categories of risk to which  depository institutions are exposed—credit risk, compliance risk, legal  risk, liquidity risk, market risk, operational risk, reputational risk, and  strategic risk (see table 1).
Banks and thrifts, in conjunction with regulators, must continually manage  risks to ensure their safe and sound operation and protect the well-being  of depositors—those individuals and organizations that act as creditors by  “loaning” their funds in the form of deposits to institutions to engage in  lending and other activities. Regulators are responsible for supervising the  activities of banks and thrifts and taking corrective action when these  activities and their overall performance present supervisory concerns or  have the potential to result in financial losses to the insurance fund or  violations of law. Losses to the insurance fund may occur when an  institution does not have sufficient assets to reimburse customers’ insured  deposits and FDIC’s administrative expenses in the event of closure or  merger.
Regulators assess the condition of banks and thrifts through off-site  monitoring and on-site examinations. Examiners use Reports of Condition  and Income (Call Report) and Thrift Financial Report data to remotely  assess the financial condition of banks and thrifts, respectively, and to  plan the scope of on-site examinations. As part of on-site examinations,  regulators more closely assess institutions’ exposure to risk and assign  institutions ratings, known as CAMELS ratings, that reflect their condition  in six areas: capital, asset quality, management, earnings, liquidity, and  sensitivity to market risk. Each component is rated on a scale of 1 to 5,  with 1 the best and 5 the worst. The component ratings then are used to  develop a composite rating also ranging from 1 to 5. Institutions with  composite ratings of 1 or 2 are considered to be in satisfactory condition,  while institutions with composite ratings of 3, 4, or 5 exhibit varying levels  of safety and soundness problems. Also as part of the examination and  general supervision process, regulators may direct an institution to  address issues or deficiencies within specified time frames.
When regulators determine that a bank or thrift’s condition is  unsatisfactory, they may take a variety of supervisory actions, including  informal and formal enforcement actions, to address identified  deficiencies and have some discretion in deciding which actions to take.  Regulators typically take progressively stricter actions against more  serious weaknesses. Informal actions generally are used to address less  severe deficiencies or when the regulator has confidence that the  institution is willing and able to implement changes. Informal actions  include, for example, commitment letters detailing an institution’s  commitment to undertake specific remedial measures, board resolutions  adopted by the institution’s board of directors at the request of its  regulator, and memorandums of understanding. Informal actions are not  public agreements (meaning, regulators do not make them public through  their Web sites or other channels) and are not enforceable by the  imposition of sanctions. In comparison, formal enforcement actions are  publicly disclosed by regulators and enforceable and are used to address  more severe deficiencies or when the regulator has limited confidence in  an institution’s ability to implement changes. Formal enforcement actions  include, for example, PCA directives, cease-and-desist orders under  section 8(b) of FDIA, removal and prohibition orders under section 8(e) of  FDIA, civil money penalties, and termination of an institution’s deposit  insurance.
All four regulators have policies and procedures that describe for  examiners the circumstances under which they should recommend the use  of informal and formal enforcement actions to address identified  deficiencies. Each federal banking regulator also has established a means  through which senior management of the applicable federal regulator  reviews all enforcement recommendations to ensure that the proposed  actions are the best and most efficient means to bring an institution back  into compliance with applicable laws, regulations, and best practices.
section_title: Capital and Noncapital Actions of FDIA
paragraphs: Section 38 of FDIA requires regulators to categorize depository  institutions into five categories on the basis of their capital levels.  Regulators use three different capital measures to determine an  institution’s capital category: (1) a total risk-based capital measure, (2) a  tier 1 risk-based capital measure, and (3) a leverage (or non-risk-based)  capital measure (see table 2). To be considered well capitalized or  adequately capitalized, an institution must meet or exceed all three ratios  for the applicable capital category. Institutions are considered  undercapitalized or worse if they fail to meet just one of the ratios  necessary to be considered at least adequately capitalized. For example,  an institution with 9 percent total risk-based capital and 6 percent tier 1  risk-based capital but only 3.5 percent leverage capital would be  undercapitalized for PCA purposes.
Under section 38, regulators must take increasingly severe supervisory  actions as an institution’s capital level deteriorates. For example, all  undercapitalized institutions are required to implement capital restoration  plans to restore capital to at least the adequately capitalized level, and  regulators are generally required to close critically undercapitalized  institutions within a 90-day period. Section 38 allows an exception to the  90-day closure rule if both the primary regulator and FDIC concur and  document why some other action would better achieve the purpose of  section 38—resolving the problems of institutions at the least possible  long-term cost to the deposit insurance fund.
Resolving failed or failing institutions is one of FDIC’s primary  responsibilities under PCA. In selecting the least costly resolution  alternative, FDIC’s process is to compare the estimated cost of  liquidation—basically, the amount of insured deposits paid out minus the  net realizable value of an institution’s assets—with the amounts that  potential acquirers bid for the institution’s assets and deposits. FDIC   has resolved failed or failing institutions using three basic methods:   (1) directly paying depositors the insured amount of their deposits and  disposing of the failed institution’s assets (depositor payoff and asset  liquidation); (2) selling only the institution’s insured deposits and certain  other liabilities, with some of its assets, to an acquirer (insured deposit  transfer); and (3) selling some or all of the failed institution’s deposits,  certain other liabilities, and some or all of its assets to an acquirer  (purchase and assumption). Within this third category, many variations  exist based on specific assets that are offered for sale. For example, some  purchase and assumption resolutions also have included loss-sharing  agreements—an arrangement whereby FDIC, in order to sell certain assets  with the intent of limiting losses to the deposit insurance fund, agrees to  share with the acquirer the losses on those assets.
Section 38 also authorizes several non-capital-based supervisory actions  designed to allow regulators some flexibility in achieving the purpose of  section 38. Specifically, under section 38(g) regulators are permitted to  reclassify or downgrade an institution’s capital category to apply more  stringent operating restrictions or requirements if they determine, after  notice and opportunity for a hearing, that an institution is in an unsafe and  unsound condition or engaging in an unsafe or unsound practice. Under  section 38(f)(2)(F) regulators can require an institution to make  improvements in management, for example, by dismissing officers and  directors who are not able to materially strengthen an institution’s ability  to become adequately capitalized.
Section 39 directs regulatory attention to noncapital areas of an  institution’s operations and activities in three main safety and soundness  areas: operations and management; compensation; and asset quality,  earnings, and stock valuation. As originally enacted under FDICIA, section  39 required regulators to develop and implement standards in these three  areas, as well as develop quantitative standards for asset quality and  earnings. However, in response to concerns about the potential regulatory  burden of section 39 on banks and thrifts, section 318 of the Riegle  Community Development and Regulatory Improvement Act of 1994  amended section 39 to allow the standards to be issued either by  regulation (as originally specified in FDICIA) or by guideline and  eliminated the requirement to establish quantitative standards for asset  quality and earnings. The regulators chose to prescribe the standards  through guideline rather than regulation, essentially providing them with  flexibility in how and when they would take action against institutions that  failed to meet the standards. Under section 39, if a regulator determines  that an institution has failed to meet a prescribed standard, the regulator  may require that the institution file a safety and soundness plan specifying  the steps it will take to correct the deficiency. If the institution fails to  submit an acceptable plan or fails to materially implement or adhere to an  approved plan, the regulator must require the institution, through the  issuance of a public order, to correct identified deficiencies and may take  other enforcement actions pending the correction of the deficiency.
section_title: Deposit Insurance System
paragraphs: In addition to adding sections 38 and 39 to FDIA to address capital  inadequacy and safety and soundness problems at depository institutions,  FDICIA also required FDIC to establish a system—the deposit insurance  system—to assess the risk of federally insured depository institutions and  charge premiums to finance a deposit insurance fund meant to protect  depositors in the event of future bank and thrift failures.
At the urging of FDIC, in February 2006 Congress enacted legislation  granting the regulator authority to make substantive changes to the  deposit insurance system, including the way it assesses the risk of  institutions and determines their premiums. In July 2006, FDIC issued its  proposed rule outlining proposed changes to the deposit insurance system  and opened a public comment period. FDIC adopted a final rule in  November 2006. Recalculated premiums and other changes reflected in the  final rule were effective January 1, 2007. As of September 30, 2006, FDIC  insured over 60 percent of all domestic deposits, totaling more than   $4 trillion.
section_title: Since the Enactment of FDICIA, the Financial Condition of Depository Institutions Has Been Strong and Regulators’ On-site Monitoring Has Been More Frequent
paragraphs: The nation’s banks and thrifts have benefited from a strong economy since  1992—as demonstrated by steady increases in several of the industry’s  primary performance indicators and growing numbers of institutions  meeting or exceeding minimum capital levels. For example, in 2005, the  industry reported record total assets ($10 trillion in 2005) and net income  ($133 billion in 2005) (see fig. 1). Similarly, the industry’s two primary  indicators of profitability—returns on assets and equity—have improved  since 1992 and remain near record highs.
As a result of institutions’ overall strong financial performance, few have  failed to meet minimum capital requirements since 1992, the year  regulators implemented PCA. The percentage of well-capitalized  institutions has increased from 93.99 percent in 1992 to 99.71 percent in  2005, while the percentage of undercapitalized and lower-rated institutions  generally has declined (see fig. 2). For example, the percentage of  significantly undercapitalized institutions declined from 2.74 percent (394  institutions) to 0.06 percent (5 institutions) in this period, while the  percentage of critically undercapitalized institutions fell from 1.64 percent  to 0.01 percent (236 to 1).
Further, the percentage of institutions carrying capital in excess of the  well-capitalized leverage capital minimum (that is, 5 percent or more of  leverage capital) also increased from 84 percent of all reporting  institutions in 1992 to 94 percent in 2005. The percentage of institutions  carrying at least two times as much capital (200 percent or more of the  well-capitalized leverage capital minimum) increased from 25 percent to  41 percent over the period.
According to regulators, the improved financial condition of banks and  thrifts may have contributed to the sharp decline in the number of  problem institutions (those with composite CAMELS ratings of 4 or 5),  from 1,063 in 1992 to 74 in 2005 (see fig. 3).
Similarly, regulators said that institutions’ improved financial condition  may have also contributed to the significant decline in the number of  failures and losses to the insurance fund since 1992 (see fig. 4). From   1992 through 2004, the number of failed banks and thrifts fell from 180  (with estimated losses to the insurance fund of $7.3 million) to 4 (with   no estimated losses). No bank or thrift failed from June 2004 through   January 2007.
In addition, regulators’ on-site presence at banks and thrifts increased  beginning in the early 1990s, in part as a result of reforms enacted as a part  of FDICIA that required regulators to conduct full-scope, on-site  examinations for most federally insured institutions at least annually to  help contain losses to the deposit insurance fund. Historical data show  that the interval between full-scope, on-site examinations for all  institutions peaked in 1986 when it reached 609 days. Subsequent to the  enactment of FDICIA in December 1991, the average interval between  examinations for all institutions declined to 373 days in 1992. Based on  information we obtained from all four regulators, the average interval  between examinations for all institutions generally has remained from 12  to 18 months since 1993 (the year after FDICIA requirements were  implemented) and in many instances has been even shorter, especially for  problem institutions.
section_title: Regulators Used PCA Appropriately in Cases We Reviewed and Other Enforcement Actions Generally Preceded Declines in These Institutions’ PCA Capital Categories
paragraphs: For the sample of banks and thrifts we reviewed, we found that regulators  generally implemented PCA in accordance with section 38. For example,  when institutions failed to meet minimum capital requirements, regulators  required them to submit capital restoration plans or imposed restrictions  through PCA directives or other enforcement actions. Regulators generally  agreed that capital is a lagging indicator of poor performance and  therefore other measures are often used to address deficiencies upon  recognition of an institution’s troubled status. This contention was  supported by the fact that in a majority of the cases we reviewed,  institutions had one or more informal or formal enforcement actions in  place prior to becoming undercapitalized. Most of the material loss  reviews conducted by IGs also found that regulators appropriately used  PCA provisions in most cases, although in two reviews they found that  regulators could have used PCA sooner.
subsections: section_title: Regulators Used PCA Appropriately to Resolve Capital Problems at Banks and Thrifts We Reviewed
paragraphs: Based on a sample of cases, we found that regulators generally acted  appropriately to address problems at institutions that failed to meet  minimum capital requirements by taking increasingly severe enforcement  actions as these institutions’ capital deteriorated, as required by section  38.
subsections: section_title: PCA Requires Regulators to Take Specific Actions When Capital Declines
paragraphs: Institutions that fail to meet minimum capital levels face several  mandatory restrictions or requirements under section 38 (see fig. 5).  Specifically, section 38 requires an undercapitalized institution to submit a  capital restoration plan detailing how it is going to become adequately  capitalized. When an institution becomes significantly undercapitalized,  regulators are required to take more forceful corrective measures,  including requiring the sale of equity or debt, or under certain  circumstances requiring an institution to be acquired by or merged with  another institution; restricting otherwise allowable transactions with  affiliates; and restricting the interest rates paid on deposits. In addition to  these actions, regulators also may impose other discretionary restrictions  or requirements outlined in section 38 that they deem appropriate. After  an institution becomes critically undercapitalized, regulators have 90 days  to either place the institution into receivership or conservatorship (that is,  close the institution) or to take other actions that would better prevent or  reduce long-term losses to the insurance fund. Regulators also have some  discretion in how they enforce PCA restrictions and requirements—they  may issue a PCA directive (a formal action that requires an institution to  take one or more specified actions to return to required minimum capital  standards) or delineate the restrictions and requirements in a new or  modified enforcement order, such as a section 8(b) cease-and-desist order.
For the cases we reviewed, consistent with our 1996 report, we found that  regulators generally implemented PCA in accordance with section 38, the  implementing regulations, and their policies and procedures. Regulators  used PCA to address capital problems at 18 of 24 institutions we sampled  from among those that fell below one of the three lowest PCA capital  thresholds (that is, undercapitalized, significantly undercapitalized, or  critically undercapitalized based on Call or Thrift Financial Report data).  (See table 3.)
In each of the 18 cases in which regulators used PCA to address capital  deficiencies, the relevant regulator identified the institution as having  fallen below one of the three lowest PCA capital thresholds and in most  cases required the institution to address deficiencies through a capital  restoration plan or a PCA directive or other enforcement order.
Regulators’ use of PCA is illustrated by the following examples:    From the end of March 2002 to the end of June 2002, Rock Hill Bank and  Trust’s capital level declined from well capitalized to critically  undercapitalized. In response, FDIC issued a notice informing the bank of  the restrictions applicable to critically undercapitalized institutions under  section 38. Within approximately 2 months of first becoming critically  undercapitalized, the bank entered into a purchase and assumption  agreement with another institution.
Federal Reserve examiners required Federal Reserve Open Bank 2 to  submit a capital restoration plan more than a year and a half prior to the  bank’s failure to meet minimum capital requirements. Federal Reserve  examiners, prepared to issue a PCA directive when the bank’s capital fell  to significantly undercapitalized in March 2005, noted in a June 2005  report of examination that the bank had taken steps to raise its capital  level to undercapitalized, and then issued a PCA directive requiring the  bank to submit a capital restoration plan. By September 2005, the bank  was well capitalized by PCA standards.
OCC examiners notified First National Bank (Lubbock) of its critically  undercapitalized status shortly after the closing date of the bank’s June 30,  2003, Call Report filing. In November 2003, the bank was sold to a bank  holding company and recapitalized. Concurrent with the bank’s June 30,  2004, Call Report filing date, OCC conducted a full-scope examination and  found the bank to be critically undercapitalized and directed it to file a  capital restoration plan. The bank merged into an affiliate in early 2005, in  accordance with its capital restoration plan.
After Enterprise FSB’s capital level declined to undercapitalized in  September 2001, OTS issued a PCA directive that required the institution  to submit a capital restoration plan and make arrangements to sell or  merge with another institution. On several occasions, OTS modified its  original PCA directive to allow additional time to process the institution’s  merger application. With the exception of one quarter in which Enterprise  FSB’s capital level increased to well capitalized, the institution remained  undercapitalized until the merger was completed in early 2003.
Regulators said that PCA was most effective when it was used to close or  require the sale or merger of institutions as a means of minimizing or  preventing losses to the insurance fund. Fifteen of the 18 institutions we  reviewed were able to recapitalize or merged or closed without losses to  the insurance fund. The remaining three institutions failed with losses to  the insurance fund: Pulaski Savings Bank ($1 million), New Century Bank  ($5 million), and Southern Pacific Bank ($93 million). The failure of  Southern Pacific Bank resulted in material losses to the insurance fund. In  its material loss review for the bank, the FDIC IG noted that even though  FDIC examiners applied PCA in accordance with regulatory guidelines,  other factors, including the bank’s failure to abide by FDIC  recommendations related to the administration of its loan program,  resulted in an overstatement of both net income and capital and limited  PCA’s effectiveness in minimizing losses to the insurance fund. In our  review of FDIC’s reports of examination and other information for the  bank, we found that FDIC examiners continually informed the bank of its  capital status and made repeated requests to management to recapitalize.  However, the bank’s reported capital level never fell to critically  undercapitalized—the point at which FDIC has the authority to close an  institution under section 38.
In 6 of the 24 sampled cases we reviewed, we determined that use of PCA  was not required to address declines in capital reported on quarterly Call  and Thrift Financial Reports (see table 4).
section_title: Regulators Used Other Enforcement Actions to Address Deficiencies in Sampled Institutions Prior to Declines in Their PCA Capital Categories
paragraphs: Although PCA requires regulators to take regulatory action when an  institution fails to meet established minimum capital requirements, capital  is a lagging indicator and thus not necessarily a timely predictor of  problems at banks and thrifts. Although capital is an essential and  accepted measure of an institution’s financial health, it does not typically  begin to decline until an institution has experienced substantial  deterioration in other areas, such as asset quality and the quality of bank  management. As a result, regulatory actions focused solely on capital may  have limited effects because of the extent of deterioration that may have  already occurred in other areas. All four regulators generally agreed that  by design, PCA is not a tool that can be used upon early recognition of an  institution’s troubled status—in all of the cases we examined, regulators  took steps, in addition to PCA, to address institutions’ troubled conditions.
For example, 12 of the 18 banks and thrifts subject to PCA that we  examined experienced a decline in their CAMELS ratings to composite  ratings of 4 or 5 prior to or generally concurrent with becoming  undercapitalized. CAMELS ratings measure an institution’s performance in  six areas—capital, asset quality, management, earnings, liquidity, and  sensitivity to market risk. These ratings are a key product of regulators’  on-site monitoring of institutions, providing information on the condition  and performance of banks and thrifts, and can be useful in predicting their  failure. The FDIC IG found a similar trend among the banks it examined as  part of an evaluation of FDIC’s implementation of PCA.
All of the 18 institutions we examined also appeared on at least one of  three regulator watch lists—the FDIC problem institutions list, the FDIC  resolution cases list, and the FDIC projected failure list—prior to or  concurrent with becoming undercapitalized (see fig. 6). Regulators use  these and their own watch lists to monitor the status of troubled  institutions and, in some cases, ensure their timely resolution (that is,  facilitating the merger or closure of institutions to prevent losses to the  insurance fund); the lists were another means through which regulators  monitored and addressed problems or potential problems at the 18  institutions prior to declines in PCA capital categories.
Consistent with banks and thrifts exhibiting declining CAMELS ratings and  appearing on one or more watch lists prior to or concurrent with  becoming undercapitalized, at least 15 of the 18 banks and thrifts that we  reviewed had informal or formal enforcement actions in place prior to  becoming undercapitalized. Although we did not examine the  effectiveness of these prior actions in addressing deficiencies, the  following examples illustrate the types and numbers of enforcement  actions regulators took at some of the institutions in our sample.
Although FDIC Open Bank 1 and FDIC examiners disagreed over the  bank’s capital status, FDIC required the bank’s board of directors to  execute a board resolution to address certain safety and soundness  deficiencies identified as part of an examination (see fig. 7). When the  bank failed to adequately address the identified deficiencies, FDIC issued  a cease-and-desist order.
When New Century Bank opened in July 1999, the Federal Reserve, the  state regulator, and FDIC all required the bank to maintain capital in  excess of the PCA well-capitalized minimums to obtain a state charter and  FDIC insurance (see fig. 8). Throughout its existence, the bank not only  failed to maintain these capital levels, but also failed to remain adequately  capitalized by PCA standards. The Federal Reserve attempted to address  these capital and other safety and soundness deficiencies through PCA  directives and other formal enforcement orders. When the bank proved  incapable of maintaining minimum capital levels, the state regulator closed  it and appointed FDIC as receiver.
OCC examiners identified Compubank as posing serious safety and  soundness concerns related to earnings when the bank was well  capitalized by PCA standards (see fig. 9). The bank had high operating  losses because of high overhead expenses caused by expanding operations  in anticipation of high growth. As a result, OCC required the bank to enter  into a written agreement, which stipulated that the bank implement a  capital restoration plan and develop a contingency plan to sell, merge, or  liquidate. Five months later, the bank reported that it was critically  undercapitalized by PCA standards. The bank began the self-liquidation  process and closed in June 2002.
Approximately 5 months before Georgia Community Bank became  undercapitalized, OTS and the institution entered into a supervisory  agreement in response to regulator concerns about the institution’s asset  quality and management (see fig. 10). When the institution reported it was  significantly undercapitalized, OTS issued a PCA directive; however, the  institution was unable to recapitalize and as a result, it merged into  another institution in July 2005.
section_title: Most Material Loss Reviews Also Found Appropriate Use of PCA, but Some Reviews Found Regulators Could Have Used PCA Sooner
paragraphs: We also reviewed material loss reviews of all institutions that failed with  material losses to the insurance fund—losses that exceed $25 million or 2  percent of an institution’s assets, whichever is greater—from 1992 through  2005 and in which regulators used PCA to address capital problems (see  table 5). In 12 of these 14 cases, the relevant IG found that PCA was  applied appropriately—meaning that when institutions failed to meet  minimum capital requirements, regulators required that they submit  capital restoration plans and adhere to restrictions and requirements in  PCA directives or other enforcement orders.
Regulators appropriate use of PCA in institutions that failed with material  losses are demonstrated by the following examples:    According to the FDIC IG’s material loss review on Connecticut Bank of  Commerce, FDIC used enforcement actions other than PCA directives to  address the bank’s capital and other problems. Connecticut Bank of  Commerce experienced capital deficiencies from 1991 through 1996 as a  result of its poor asset quality. The bank operated under several cease-and- desist orders (1991, 1993, and 2001) and a memorandum of understanding,  each of which contained requirements that the bank hold capital in excess  of the required PCA minimums. Upon the detection of fraud in April 2002,  the bank’s capital was immediately exhausted and it became critically  undercapitalized. On June 25, 2002, FDIC issued a PCA directive ordering  the dismissal of the bank’s chairman and president. On June 26, 2002, the  Banking Commissioner for the State of Connecticut declared Connecticut  Bank of Commerce insolvent, ordered it closed, and appointed FDIC as  receiver.
Prior to the implementation of legislation implementing PCA, Federal  Reserve examiners attempted to restore Pioneer Bank to a safe and sound  operating condition through written agreements entered into in 1986 and  1991. Despite these enforcement actions, the bank’s condition continued  to deteriorate and in June 1994, the Federal Reserve issued a PCA  directive requiring Pioneer Bank to become adequately capitalized though  the sale of stock or to be acquired by or merge into another institution.  When the bank was unable to comply with the terms of the PCA directive,  the California State Banking Department issued a capital impairment order  on July 6, 1994, and closed the bank on July 8, 1994. In its material loss  review of Pioneer Bank, the Federal Reserve IG concluded that the level of  supervisory actions taken by the Federal Reserve was within the range of  acceptable actions for the problems the bank experienced.
In October 2001, NextBank’s capital level dropped from well capitalized to  significantly undercapitalized based on findings from an examination  conducted by OCC’s Special Supervision and Fraud Division. The  Department of the Treasury (Treasury) IG noted in its material loss review  that the bank was at that point automatically subject to restrictions under  PCA. In November 2001, OCC issued a PCA directive requiring the bank,  among other things, to develop a capital restoration plan; file amended  Call Reports; restrict new credit card account originations to prime  lenders; and restrict asset growth, management fees, and brokered  deposits. By December 2001, NextBank advised OCC that it would not be  able to address its capital deficiency. In January 2002, NextBank and its  parent company took steps to liquidate the bank. OCC appointed FDIC as  receiver on February 7, 2002. While the Treasury IG did not find fault with  OCC’s use of PCA to address NextBank’s capital deficiencies, it found that  PCA’s effectiveness in NextBank’s situation was difficult to assess given  the short amount of time that passed between when the bank’s capital  declined below PCA minimum requirements and when the bank failed.
In two cases, the relevant IG determined that the regulator’s use of PCA  was not appropriate—First National Bank of Keystone (Keystone) and  Superior Bank, regulated by OCC and OTS, respectively. In both cases, the  Treasury IG found that the regulator failed to identify the institution’s true  financial condition in a timely manner and thus could not apply PCA’s  capital-based restrictions because the institution’s reported capital levels  met or exceeded the minimum required levels. Because PCA was not  implemented timely in these cases, it was not effective in containing losses  to the deposit insurance fund.
According to the Treasury IG, Keystone’s operating strategy entailed  growth into the high-risk areas of subprime lending and selling loans for  securitization. The bank’s growth in these areas occurred without  adequate management systems and controls, and inaccurate financial  records masked the bank’s true financial condition. At the time of the  bank’s failure, allegations of fraud were under investigation. In its material  loss review of the bank, the IG noted that if OCC had reclassified the  bank’s capital category from well capitalized to adequately capitalized  following an examination in late 1997, OCC could have restricted the  bank’s use of brokered deposits and applied certain interest-rate  restrictions in an effort to curb the bank’s growth 6 months before its  capital levels showed serious signs of decline. Instead, these restrictions  were not put in place until June 1998 when OCC required the bank to  adjust its reported capital based on examination findings—this adjustment  resulted in a downgrade in the bank’s capital category from well  capitalized to undercapitalized and trigged PCA restrictions. Despite this  finding, the IG noted that it was unclear whether reclassification would  have actually had its desired effect—after the restrictions were trigged in  June 1998, the bank continued to intentionally violate them.
The Treasury IG’s material loss report on Superior Bank notes that while  the immediate causes of the bank’s insolvency in 2001 appeared to be  improper accounting and inflated valuations of residual assets, the causes  could be attributed to a confluence of factors going back as early as 1993,  including asset concentration, rapid growth into a new high-risk activity,  deficient risk management systems, liberal underwriting of subprime  loans, unreliable loan loss provisioning, economic factors affecting asset  valuation, and lack of management response to supervisory concerns.  Our 2002 testimony on the failure of Superior Bank and the IG’s material  loss review suggested that had OTS acknowledged problems at Superior  Bank when examiners became aware of them in 1993, PCA would have  been triggered sooner and might have slowed the bank’s growth and  contained its losses to the deposit insurance fund. The IG further noted  that OTS’s delayed detection of so many critical problems suggests that  the advantage of PCA as an early intervention tool depends as much on  timely supervisory detection of actual, if not developing, problems as it  does on capital.
section_title: Regulators Have Made Limited and Targeted Use of the Noncapital Supervisory Actions Available under Sections 38 and 39
paragraphs: Under section 38 regulators have the ability to reclassify an institution’s  capital category and dismiss officers and directors from deteriorating  banks and thrifts. However, regulators have made limited use of these  authorities, preferring instead to use moral suasion (as part of or separate  from the examination process) or other enforcement actions to address  deficiencies. Under section 39, regulators can require institutions to  implement plans to address deficiencies in their compliance with  regulatory safety and soundness standards. Regulators have used section  39 with varying frequency to address noncapital deficiencies; however,  those that use the provision use it to address targeted deficiencies, such as  noncompliance with certain laws or requirements, and when an  institution’s management generally is willing and able to comply with  required corrective actions.
subsections: section_title: Regulators Prefer to Use Other Informal and Formal Enforcement Powers over PCA’s Reclassification and Dismissal Authorities
paragraphs: In addition to their authority under PCA to reclassify an institution’s PCA  capital category or require improvements in management at significantly  undercapitalized institutions, regulators also can use other means—such  as moral suasion or more formal enforcement actions—to address  deficiencies or effect change at an institution. Under section 38(g),  regulators have the authority to reclassify or downgrade an institution’s  PCA capital category to apply PCA restrictions and requirements in  advance of a decline (or further decline) in capital if the regulator  determines that the institution is operating in an unsafe or unsound  manner or engaging in an unsafe or unsound practice. Regulators also  may treat an undercapitalized institution as if it were significantly  undercapitalized if they determine that doing so is “necessary to carry out  the purpose” of PCA. In practice, this means that regulators may, in certain  circumstances, treat a well-capitalized institution as if it were adequately  capitalized, an adequately capitalized institution as if it were  undercapitalized, and an undercapitalized institution as if it were  significantly undercapitalized. Regulators are prohibited from reclassifying  or downgrading an institution more than one capital category and cannot  downgrade a significantly undercapitalized institution to critically  undercapitalized. Regulators also may require improvements in the  management of a significantly undercapitalized institution—for example,  through the dismissal of officers and directors. This provision can be used  alone or in conjunction with the reclassification provision. In the latter  case, a regulator can require the dismissal of officers and directors from  an undercapitalized institution.
All four regulators said that they generally prefer other means of  addressing problems to PCA. According to the regulators, the authority to  reclassify an institution’s capital category is of limited use on its own  because regulators’ ability to address both noncapital (such as  management) and capital deficiencies through other informal and formal  enforcement actions prior to a decline in capital effectively negates the  need to reclassify an institution to apply operating restrictions or  requirements. Regulators’ use of section 38’s reclassification authority is  consistent with their views on it—since 1992, FDIC, the Federal Reserve,  and OTS have never reclassified an institution’s capital category. OCC has  used the authority twice.
All four regulators said that section 38’s dismissal authority under section  38(f)(2)(F) is valuable as a deterrent and a potential tool, despite their  infrequent use of it—FDIC has used the authority six times since 1992 and  OCC once; the Federal Reserve and OTS have never used the authority.  They said that the PCA authority occupies the middle ground between  moral suasion and the removal and prohibition authority under section  8(e) of FDIA. According to the regulators, the first step in confronting  problem officers and directors is moral suasion—that is, reminding the  board of directors that it has an obligation to ensure that the institution is  competently managed. In many cases, we were told that this reminder  often is enough to force the resignations of problem individuals.  Dismissal under section 38 represents a “middle of the road” option—it  results in a ban from serving as an officer or director in the institution in  question. In order to be reinstated, the dismissed individual must  demonstrate that he or she has the capacity to materially strengthen the  institution’s ability to become adequately capitalized or correct unsafe or  unsound conditions or practices. Regulators also have a more severe  option—removal under section 8(e), which results in an industrywide  prohibition and consequently, requires proof of a high degree of  misconduct or malfeasance. Data show that regulators have used section  8(e) with some regularity (see fig. 11). The regulators said that if an  individual’s misconduct rises to the level required to support removal and  prohibition under section 8(e), use of that authority generally is preferable  to dismissal under section 38.
The regulators also noted that moral suasion and section 8(e) are not  necessarily capital based, meaning that both can be used at times when  PCA cannot. The regulators acknowledged that section 38 permits them to  reclassify an institution’s capital category to dismiss an officer or director;  however, they said that because section 38 only allows them to dismiss  individuals from institutions that are undercapitalized or worse by PCA  standards, the tool generally is not available to them in these good  economic times when all or most of the institutions they regulate are well  capitalized. OCC was of the view that section 38’s dismissal authority  could be more useful if it were uncoupled from capital and instead  triggered by less-than-satisfactory ratings in the management component  of the CAMELS rating. In particular, OCC officials said that linking the  authority to the CAMELS rating could provide regulators with the  authority to dismiss individuals who did not meet the criteria for removal  and prohibition under section 8(e) and from institutions with boards that  were unresponsive to regulators’ moral suasion.
section_title: Regulators Use Section 39 to Address Targeted Safety and Soundness Deficiencies
paragraphs: Changes to section 39 in 1994 gave regulators considerable flexibility over  how and when to use their authority under the section to address safety  and soundness deficiencies at the institutions they regulate. Like section  38’s dismissal authority, section 39 represents a “middle of the road”  option between informal enforcement actions (such as a commitment  letter) and formal enforcement actions (such as a cease-and-desist order).  In varying degrees, they have used section 39 to address deficiencies in the  three broad categories defined under the section: operations and  management; compensation; and asset quality, earnings, and stock  valuation (see fig. 12). Finally, regulators said that they prefer to use  section 39 when regulators are certain that management is willing and able  to address identified deficiencies, even if management has not been  responsive to informal regulatory criticisms in the past. For example,  FDIC, OCC, and OTS have all used section 39 to require institutions to  achieve compliance with Year 2000 (Y2K) or Bank Secrecy Act (BSA)  requirements (both of which relate to institutions’ operations).
Officials from the Federal Reserve told us that they use memorandums of  understanding in the same way that the other three regulators use section  39—that is, to address targeted deficiencies at institutions that are willing  and able to make required changes.
According to the regulators, formal enforcement actions, such as section  8(b) cease-and-desist orders or written agreements, are better reserved for  institutions that have multiple or complex problems and in cases where  management is unable to define what steps must be taken to address  problems independent of the regulator or is unwilling to take action. Since  1995 (the year regulators issued the section 39 guidelines), regulators have  made frequent use of section 8(b) of FDIA to address problems associated  with operations and management; compensation; and asset quality,  earnings, and stock valuation. From 1995 through 2005, FDIC and the  Federal Reserve issued 288 and 98 cease-and-desist orders or written  agreements, respectively, to address deficiencies in these three areas. OTS  issued 47 cease-and-desist orders related to deficiencies in operations.
section_title: FDIC Has More Tightly Linked Deposit Insurance Premiums to Institutional Risk, but Some Expressed Concerns about Certain Aspects of the New System
paragraphs: Under authority provided by the Federal Deposit Insurance Reform Act of  2005, FDIC now prices its deposit insurance more closely to the risk FDIC  officials judge an individual bank or thrift presents to the insurance fund.  To do this, FDIC has created a system in which it evaluates a number of  financial and regulatory factors specific to an individual bank or thrift.  This replaces a system that was also risk based, but which differentiated  risk less finely. Industry officials and academics to whom we spoke and  selected organizations that submitted comment letters to FDIC generally  supported the concept of the new system. However, several voiced  concern about what they saw as the new system’s subjectivity and  complexity and questioned whether the new system might produce  unintended consequences, including upsetting relations between bankers  and their regulators.
subsections: section_title: Changes to FDIC’s Deposit Insurance System More Closely Tie Premiums to the Risk Institutions Present to the Deposit Insurance Fund, but Stop Short of Completely Risk- Based Pricing
paragraphs: FDIC’s recent changes to the deposit insurance system more closely tie an  individual bank or thrift’s deposit insurance premium to the risk it  presents to the insurance fund. In general, FDIC does this by considering  three sets of factors—supervisory (CAMELS) ratings and financial ratios  or credit agency ratings—while also distinguishing between large  institutions with credit agency ratings and all other institutions. However,  the system stops short of completely risk-based pricing.
subsections: section_title: Old System Relied on Two Factors to Determine Risk and Premiums
paragraphs: FDIC’s previous method for determining premiums relied on two factors— capital levels and supervisory ratings—to determine institutions’ risk and  premiums. FDIC established three capital groups—termed 1, 2, and 3 for  well-capitalized, adequately capitalized, and undercapitalized institutions,  respectively—based on leverage ratios and risk-based capital ratios.  Three supervisory groups—termed A, B, and C—reflected, respectively,  financially sound institutions with only a few minor weaknesses;  institutions with weaknesses, which if not corrected could result in  significant deterioration and increased risk of loss to the insurance fund;  and institutions that pose a substantial probability of loss to the insurance  fund unless effective corrective action is taken. Based on its capital levels  and supervisory ratings, an institution fell into one of nine risk categories  (see table 6). However, the vast majority of institutions—95 percent at  year-end 2005—fell into category 1A, even though, according to FDIC  officials, there were significant differences among individual institutions’  risk profiles within the category.
Further, according to FDIC, in 2005, 95 percent of institutions did not pay  premiums into the insurance fund because the agency was barred from  charging premiums to well-managed and well-capitalized institutions when  the deposit insurance fund was at or above its designated reserve ratio,  and was expected to remain there. Because nearly all institutions paid  the same rate under the old system, lower-risk institutions effectively  subsidized higher-risk institutions.
section_title: The New System Links Risk and Premiums More Closely
paragraphs: To tie institutions’ insurance premiums more directly to the risk each  presents to the insurance fund, FDIC created a system that generally   (1) differentiates between large and small institutions, specifically  between institutions with current credit agency ratings and $10 billion or  more in assets and all other institutions; (2) for institutions without credit  agency ratings, forecasts the likelihood of a decline in financial health  (referred to throughout this report as the general method); (3) for  institutions with credit agency ratings, uses those ratings, plus potentially  other financial market information, to evaluate institutional risk (referred  to throughout this report as the large-institution method); and (4) requires  all institutions to pay premiums based on their individual risk.
Premiums under the general method and the large-institution method are  calculated differently, based on the availability of relevant information for  institutions in each category. The general method uses two sources of  information as inputs to a statistical model designed to predict the  probability of a downgrade in an institution’s CAMELS rating: (1) financial  ratios (such as an institution’s capital, past-due loans, and income) and   (2) CAMELS ratings. According to FDIC officials, little other information is  readily available to assess risk for these institutions. However, FDIC data  show that the higher on the CAMELS scale institutions are rated, the  higher the rate of failure—the 5-year failure rate is 0.39 percent for  CAMELS 1-rated banks, 3.84 percent for 3-rated banks, and 46.92 percent  for 5-rated banks—thus making CAMELS ratings and financial ratios a  reasonable basis for assessing risk.
The large-institution method also uses CAMELS ratings. But rather than  employ financial ratios, it incorporates market-based information—credit  agency ratings of an institution’s debt offerings. FDIC officials told us that  incorporating debt ratings provides a fuller, market-based picture of an  institution’s condition than do financial ratios. For example, some large  institutions concentrate in certain activities, such as transactions  processing or credit cards, while others provide more general services.  According to FDIC officials, financial ratios may not adequately  distinguish among such different activities. Also, credit ratings determine  how much institutions must pay to obtain funds in capital markets—well- rated banks and thrifts will pay less, while institutions the market judges  as riskier will pay more. Thus, according to FDIC officials, it makes sense  to align premiums with these market-based funding costs. In addition to its  ability to use the CAMELS and credit ratings, FDIC also has the flexibility  to adjust premiums for large institutions up to 0.5 basis points up or down  based on other relevant information (such as market analyst reports,  rating-agency watch lists, and rates paid on subordinated debt) as well as  stress considerations (such as how an institution would be expected to  react to a sudden and significant change in interest rates). If a large  institution does not have an available credit agency rating, its premium is  calculated according to the general method.
The new insurance system places banks and thrifts into one of four risk  categories, each of which has a corresponding premium or range of  premiums. These “base rate” premiums range from 2 to 4 basis points for  banks and thrifts in the best-rated category, risk category I, to 40 basis  points for institutions in the bottom category, risk category IV (see table  7). Thus, for example, under the base rate schedule the riskiest  institutions (risk category IV) pay a premium rate 20 times greater than the  best-rated banks and thrifts (minimum rate, risk category I). Even within  the best category, riskier institutions pay twice the rate paid by the safest  banks and thrifts, reducing the tendency for subsidies under the old  system. The same premium schedule applies to all institutions, regardless  of their premium assessment method.
Under the new system, FDIC has limited authority, without resorting to  new rule making, to vary premiums from the base rates as necessary and  appropriate. For assessments beginning in 2007, FDIC has used this  flexibility to increase premiums by 3 basis points over the base rates.  Thus, the current rate for risk category I is 5 to 7 basis points, rather than 2  to 4 basis points; for risk category II, the premium is 10 basis points; for  risk category III, the premium is 28 basis points; and for risk category IV,  the premium is 43 basis points. According to FDIC, the increase in  premiums for 2007 was necessary because of strong growth in insured  deposits and the availability of premium credits to many institutions under  the terms of the Federal Deposit Insurance Reform Act of 2005.
In general, to set the premium rates for each of the four risk categories,  FDIC officials told us they considered both what the differences should be  in premiums among risk categories and, taking those differences into  account, the level at which the premiums should be established.  Considering the two together, the goal was to create a schedule of rates  with the best chance of maintaining the insurance fund with a designated  reserve ratio from 1.15 percent to 1.35 percent of insured deposits, with  the former representing the required minimum under the Federal Deposit  Insurance Reform Act of 2005, and the latter being the level at which  mandated rebates of premiums to banks and thrifts must begin. FDIC  officials told us they established the level of premiums based on four  factors: (1) historical data on insurance losses, (2) FDIC operating  expenses, (3) projected interest rates and their effect on FDIC investment  portfolio income, and (4) expected growth of insured deposits.
section_title: While Focusing More on Risk, the New System Stops Short of Completely Risk-Based Pricing
paragraphs: Although the new system ties premiums more specifically to the risk an  individual institution presents to the insurance fund, it does not represent  completely risk-based pricing. As a result, some degree of cross-subsidy  still exists in the new system. In particular, as estimated by FDIC,  institutions in risk category IV would need to pay premiums of about 100  basis points to cover the expected losses of the group. However, FDIC has  chosen to set the base rate premium for these banks and thrifts at 40 basis  points, or 60 percent below the indicated premium. In doing so, FDIC  officials told us they sought to address long-standing concerns of the  industry, regulators, and others that premiums should not be set so high as  to prevent an institution that is troubled and seeking to rebuild its health  from doing so. In contrast, some have suggested that capping premiums to  address such concerns ultimately may cost the insurance fund more in the  long run—lower premiums for riskier institutions may allow them to  remain open longer, resulting in greater losses if and when they eventually  fail. FDIC officials said that the number of institutions in category IV is  small and thus the trade-off between lower premiums for troubled  institutions and potentially larger losses later is not significant. Further,  they said that the 40 basis point base rate applicable to the highest risk  institutions represents a sizable increase over the assessment rate for  these institutions under the previous system.
Another way FDIC’s new premium pricing system stops short of being  completely risk based is that it does not take into account “systemic risk.”  In a fully risk-based system, premiums would be set to reflect two major  components: expected losses plus a premium for systemwide risk of  failure or default. According to academics we spoke to, FDIC’s new  system reflects the first component, but not the second. Incorporating the  notion of systemic risk into the premium calculation would acknowledge  that failure of some banks could have repercussions to the financial  system as a whole and that such failures are more likely during economic  downturns. FDIC officials told us that the new system does not reflect  systemic risk for several reasons. First, there is an alternative mechanism  for capturing what is effectively a systemic risk premium. Second, FDIC  officials said that charging an up-front premium for systemic risk could  prevent institutions from getting the best premium rate on the basis of  their size, which is not permitted under the 2005 Federal Deposit  Insurance Reform Act. And finally, FDIC officials said that FDIC has  other sources of financing available to address losses resulting from large- scale failures, including borrowing from the industry, a $30 billion line of  credit with Treasury, and the ability to borrow from the Federal Financing  Bank and the Federal Home Loan Bank system.
section_title: Industry Officials and Academics Generally Support the New System, but Have Voiced Concerns about Certain Aspects
paragraphs: In our review of selected comments to FDIC’s proposed rule and  interviews with bankers, industry trade groups, and academics, we found  that the industry generally supported the concept of a more risk-based  insurance premium system. However, several of those to whom we spoke  and many organizations that submitted comments to FDIC raised several  concerns about the new system. First, many said that the new system  places too much weight on subjective factors, which could result in  incorrect assessments of institutions’ actual risk. Specifically, officials  from two trade associations and one small bank who we interviewed  questioned the inclusion of, or the weight given to, the management  component of the CAMELS ratings. One considered this component to be  the most subjective of the CAMELS component areas. Six additional  organizations noted in comment letters their concern with FDIC’s plan to  assign different weights to the CAMELS components, noting in at least one  case that FDIC had provided no evidence to support using a weighted  rating in place of the composite rating. FDIC officials said that the weights  were set in consultation with the other federal banking regulators and  represent the relative importance of each component as it pertains to the  risk an institution presents to the insurance fund. Specifically, FDIC  officials said that asset quality, management, and capital are often key  factors in an institution’s failure and any subsequent losses to the  insurance fund, and thus warrant more consideration than other factors in  the calculation of risk.
Similarly, in comment letters to FDIC, five large banks, three trade groups,  and one financial services company expressed concern with the part of the  rule that gives FDIC flexibility to adjust large institutions’ premiums up or  down based on other information, including other market information and  financial performance and conditions measures (such as market analyst  reports, assessments of the severity of potential losses, and stress factors).  All of these organizations cautioned that to do so would undermine the  assessments of institutions’ primary regulators regarding their  performance and health (as expressed in CAMELS ratings, a primary  component of FDIC’s system). According to FDIC, this authority to adjust  ratings in consultation with other federal regulators is necessary to ensure  consistency, fairness, and the consideration of all available information.  FDIC officials said that the agency plans to clarify its processes for making  any adjustments to ensure transparency and plans to propose and seek  comments on additional guidelines for evaluating whether premium  adjustments are warranted and the size of the adjustments.
Related to these concerns, officials from one large bank, one small bank,  and one trade association and one of the academics with whom we spoke  said that FDIC’s new system is overly complicated and that it might not be  readily apparent to bank or thrift management how activities at their  respective institutions could affect the calculation of their insurance  premiums. Seven others expressed similar concerns in comment letters to  FDIC. In its final rule, FDIC stated that while the pricing method is  complex, its application is straightforward. For example, if an institution’s  capital declines, its premium will likely increase. Further, FDIC officials  said that the FDIC Web site contains a rate calculator that allows an  institution to determine its premium and to simulate how a change in the  value of debt ratings, supervisory ratings, or financial ratios would affect  its premium.
Officials we interviewed from all three of the large banks said that the  level and range of premiums for top-rated institutions generally was too  high, given the actual risk they believe their institutions pose to the  insurance fund. Officials from one large bank and one trade association  we spoke with said that the best-rated banks and thrifts should pay no  premiums, or that the base rate range of premiums should be reduced  from 2 to 4 to 1 to 3 basis points. An additional nine organizations  supported similar changes in their comment letters. Risk category I, the  top-rated premium category, accounts for the majority of total deposits,  meaning that even small changes in premium assessment rates could  produce a significant difference in revenue to the insurance fund, and  hence assessments to the industry. FDIC officials said that the 2 to 4 basis  point spread is more likely to satisfy the insurance fund’s long-term  revenue needs than a 1 to 3 basis point spread. FDIC officials also said that  FDIC could, based on authority in the final rule, reduce rates below the  current base rate “floor” of 2 to 4 basis points if the agency determined  that such a reduction was warranted.
Further, one bank official we spoke to said that the new system was  incorrectly based in the idea of institutions failing, rather than on the more  nuanced notion of actual losses expected to be suffered by the deposit  insurance fund if failures occurred. As a result, he said, FDIC failed to give  appropriate credit to how large banks handle risk. Three organizations  that submitted comments on FDIC’s new system supported this notion,  saying that FDIC should not assess premiums on all domestic deposits  because losses suffered by uninsured depositors should impose no burden  on the insurance fund—the magnitude of any loss would be lessened to  the extent that depositors in foreign branches, other uninsured depositors,  general creditors, and holders of subordinated debt absorbed such losses.  FDIC officials, citing research the agency has done on failures and losses,  said that the differences in rates and categories were empirically based,  and thus adequately reflected all institutions’ risk. Further, FDIC officials  said that loss severity is one of the many factors the agency is permitted to  consider as part of its assessment of the risk of large institutions.
Officials from the two small banks, one large bank, and both industry  trade groups and the academics with whom we spoke questioned FDIC’s  choice on initial placement of institutions into risk categories. Because  most institutions are now healthy, FDIC placed them into the best-rated  premium category, risk category I, for which base rate premium charges  range from 2 to 4 basis points. Within this top-rated category, FDIC  initially assigned approximately 45 percent of institutions to receive the  minimum rate of 2 basis points, and 5 percent of institutions to receive the  highest rate of 4 basis points. The remainder fell in the middle of the range.  These officials and academics generally agreed that FDIC should establish  risk criteria, and then assign institutions to appropriate groups based on  those criteria, rather than start with a predetermined distribution in mind.  Three additional organizations expressed similar concerns in comment  letters to FDIC. Further, officials from the other two large banks with  whom we spoke said that given the economic good times and institutional  good health, the 45 percent of institutions with the lowest rate was too  small a grouping and, as a result, healthy institutions arbitrarily would be  bumped into higher premiums. FDIC officials said that based on the  agency’s experience, a range of 40 to 50 percent appeared to be a natural  breaking point in the distribution of institutions by risk, and that over  time, the percentage of institutions assigned the lowest premium in the  top-rated category may vary.
Some also thought the new system had the potential to create tension or  discourage cooperative relations between bank management and federal  examiners. Under the old system, there was no difference in premiums for  well-capitalized, 1-rated institutions and well-capitalized 2-rated  institutions. However, under the new system, such a difference could lead  to higher premiums because CAMELS ratings are factored into premium  calculations. As a result, according to officials we interviewed from one  trade group, management might be less willing to discuss with examiners  issues or problems that could prompt a lower rating, although raising and  resolving such problems ultimately might be good for both the institution  and the insurance fund. FDIC officials acknowledged the concern, and  said that FDIC and the other federal regulators plan to monitor the new  system for adverse effects. However, they said that it was important to  include CAMELS ratings in the assessment of risk because the ratings  provide valuable information about institutions’ financial and operational  health.
Finally, officials from one trade association and one of the large banks  with whom we spoke also expressed concern that regional or smaller  institutions could be disadvantaged under the new system. Officials from  two credit rating agencies echoed this view, saying that larger, more  diverse institutions (by virtue of factors such as revenue, geography, or  range of activities) typically have steadier income, which increases  security and decreases risk. In contrast, regional or smaller institutions  can have geographic or line-of-business concentrations in their lending  portfolios that could hurt supervisory or credit ratings, leading to higher  deposit insurance premiums. FDIC said that while size or geography could  affect an institution’s risk profile, management could offset that risk by  maintaining superior earnings or capital reserves, requiring higher  collateral requirements on loans, or using hedging vehicles.
FDIC officials told us that the agency plans to monitor the new deposit  insurance system to ensure its proper functioning and the fair treatment of  the institutions that pay premiums into the deposit insurance fund. For  example, in addition to assessing whether the new system creates friction  between examiners and bank and thrift management, as discussed above,  FDIC officials also said that the agency will, among other things, assess  over time whether the percentage of institutions paying the lowest rate in  risk category I—those receiving the best premium rate—should be  increased and whether different financial ratios should be considered in  the calculation of premiums.
section_title: Agency Comments
paragraphs: We provided FDIC, the Federal Reserve, OCC, and OTS with a draft of this  report for their review and comment. In written comments, the Federal  Reserve concurred with our findings related to PCA. These comments are  reprinted in appendix II. The Federal Reserve noted that PCA has  substantively enhanced the agency’s authority to resolve serious problems  expeditiously and that PCA has generally worked effectively in the  problem situations where its use became applicable. In addition, FDIC, the  Federal Reserve, and OCC provided technical comments, which we  incorporated as appropriate.
We are sending copies of this report to the Chairmen of the Federal  Deposit Insurance Corporation and the Board of Governors of the Federal  Reserve System, the Comptroller of the Currency, the Director of the  Office of Thrift Supervision, and interested congressional committees. We  will also make copies available to others upon request. In addition, the  report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions concerning this report, please  contact me at (202) 512-8678 or at jonesy@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. Key contributors to this report are listed in  appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report were to (1) describe trends in the financial  condition of banks and thrifts and federal regulators’ oversight of these  institutions since the passage of the Federal Deposit Insurance  Corporation Improvement Act of 1991 (FDICIA), (2) evaluate how federal  regulators used the capital or prompt corrective action (PCA) provisions  of FDICIA to resolve capital adequacy issues at the institutions they  regulate, (3) evaluate the extent to which federal regulators use the  noncapital provisions of FDICIA to identify and address weaknesses at the  institutions they regulate, and (4) describe the Federal Deposit Insurance  Corporation’s (FDIC) deposit insurance system and how recent changes to  the system affect the determination of depository institutions’ risk and  insurance premiums. Our review focused on FDIC, the Board of  Governors of the Federal Reserve System (Federal Reserve), the Office of  the Comptroller of the Currency (OCC), and the Office of Thrift  Supervision (OTS) and was limited to depository institutions.
To describe trends in the financial condition of banks and thrifts, we  summarized financial data (including total assets, net income, returns on  assets, returns on equity, the number of problem institutions, and the  number of bank and thrift failures) from 1992, the year FDICIA was  implemented, through 2005. We obtained this information from FDIC  Quarterly Banking Reports, which publish industry statistics derived from  Reports on Condition and Income (Call Report) and Thrift Financial  Reports. All banks and thrifts must file Call Reports and Thrift Financial  Reports, respectively, with FDIC every quarter. We also analyzed Call and  Thrift Financial Report data for 1992 through 2005 that FDIC provided to  determine (1) the number of well-capitalized, adequately capitalized,  undercapitalized, significantly capitalized, and critically undercapitalized  depository institutions from 1992 through 2005 and (2) the amount of  capital well-capitalized banks and thrifts carried in excess of the well- capitalized leverage capital minimum for each year from 1992 through  2005. We chose to use Call and Thrift Financial Report data because the  data are designed to provide information on all federally insured  depository institutions’ financial condition, and FDIC collects and reports  the data in a standardized format. We have tested the reliability of FDIC’s  Call and Thrift Financial Report databases as part of previous studies and  found the data to be reliable. In addition, we performed various electronic  tests of the specific data extraction we obtained from FDIC and  interviewed FDIC officials responsible for providing the data to us. Based  on the results of these tests and the information we obtained from FDIC  officials, we found these data to be sufficiently reliable for purposes of this  report.
To describe federal regulators’ oversight of banks and thrifts since the  passage of FDICIA, we reviewed the provisions of the Federal Deposit  Insurance Act (FDIA) requiring regulators to conduct annual, on-site, full- scope examinations of depository institutions as well as several GAO and  industry reports discussing the federal regulators’ oversight of depository  institutions prior to the failures of the 1980s and early 1990s and after the  enactment of FDICIA, including their use of PCA to address capital  deficiencies. We also obtained data from each of the four federal  regulators on the interval between examinations for each year, from 1992  through 2005. We interviewed officials from FDIC, the Federal Reserve,  OCC, and OTS to assess the reliability of these data. Based on their  responses to our questions, we determined these data to be reliable for  purposes of this report.
To determine how federal regulators used PCA to address capital  adequacy issues at the institutions they regulate, we reviewed section 38 of  FDIA, related regulations, regulators’ policies and procedures, and past  GAO reports on PCA to determine the actions regulators are required to  take when institutions fail to meet minimum capital requirements. We  then analyzed Call and Thrift Financial Report data to identify all banks  and thrifts that were undercapitalized, significantly undercapitalized, or  critically undercapitalized (the three lowest PCA capital categories) during  at least one quarter from 2001 through 2005. We chose this period for  review based on the availability of examination- and enforcement-related  documents and to reflect the regulators’ most current policies and  procedures. From the 157 institutions we identified as being  undercapitalized or lower from 2001 to 2005, we selected a nonprobablity  sample of 24 institutions, reflecting a mix of institutions supervised by  each of the four regulators and institutions in each of the three lowest PCA  capital categories. We reviewed their reports of examination, informal and  formal enforcement actions, and institution-regulator correspondence for  a period covering four quarters prior to and four quarters following the  first and last quarters in which each institution failed to meet minimum  capital requirements to determine how regulators used PCA to address  their capital deficiencies. As discussed above, we have tested the  reliability of Call and Thrift Financial Report data and found the data to be  reliable. To supplement our sample, we also reviewed material loss  reviews from 14 banks and thrifts that failed with material losses from  1992 through 2005 and in which regulators used PCA to address capital  deficiencies. Because of the limited nature of our sample, we were unable  to generalize our findings to all institutions that were or should have been  subject to PCA since 1992.
To determine the extent to which federal regulators have used the  noncapital supervisory actions of sections 38 and 39 of FDIA to address  weaknesses at the institutions they regulate, we reviewed regulators’  policies and procedures related to sections 38(f)(2)(F) and 38(g)—the  provisions for dismissal of officers and directors and reclassification of a  capital category, respectively—and section 39, which gives regulators  authority to address safety and soundness deficiencies. We analyzed  regulator data on the number of times and for what purposes the  regulators used these noncapital authorities. To provide context on the  extent of regulators’ use of these noncapital provisions, we also obtained  data on the number of times regulators used their authority under section  8(e) of FDIA to remove officers and directors from office and section 8(b)  of FDIA to enforce compliance with safety and soundness standards.  Based on regulators’ responses to our questions related to these data, we  determined the data to be reliable for purposes of this report.
Finally, to describe how changes in FDIC’s deposit insurance system affect  the determination of institutions’ risk and insurance premiums, we  reviewed FDIC’s notice of proposed rule making on deposit insurance  assessments, selected comments to the proposed rule, and FDIC’s final  rule on deposit insurance assessments. We also interviewed  representatives of three large institutions, two small institutions, and two  trade groups representing large and small institutions and two academics  to obtain their views on the impact of FDIC’s changes to the system. We  selected the large institutions based on geographic location and size and  the small institutions based on input from the Independent Community  Bankers Association on which of its member organizations were familiar  with FDIC’s proposed changes to the deposit insurance system. We also  interviewed officials from two credit rating agencies on the factors— financial, management, and operational—they consider when rating  institutions’ debt offerings.
We conducted our work in Washington, D.C., and Chicago from March  2006 through January 2007 in accordance with generally accepted  government auditing standards.
section_title: Appendix II: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Kay Kuhlman, Assistant Director;  Gloria Hernandez-Saunders; Wil Holloway; Tiffani Humble; Bettye  Massenburg; Marc Molino; Carl Ramirez; Omyra Ramsingh; Barbara  Roesmann; Cory Roman; and Christopher Schmitt made key contributions  to this report.