Bank Regulation: Lessons Learned and a Framework for Monitoring Emerging Risks and Regulatory Response
Published: 2015-06-25T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Weakness in federal oversight was one of many factors that contributed to the size of federal losses and the number of bank failures in banking-related crises over the past 35 years—including the 1980s thrift and commercial bank crises and the 2007–2009 financial crisis. Resolving the failures of banks and thrifts due to these crises resulted in estimated costs to federal bank and thrift insurance funds over $165 billion, as well as other federal government costs, such as taxpayer-funded assistance during the financial crises.
Ongoing monitoring of banking regulators' efforts to identify and respond to emerging threats to the banking system can provide a starting point for identifying opportunities for more targeted and frequent assessments of these efforts. This report (1) discusses regulatory lessons learned from these past crises and (2) offers a framework that GAO and other oversight bodies, such as inspectors general, can use to provide continuous future oversight of regulatory responses to emerging risks.
To do this work, GAO reviewed its prior studies and those of federal banking regulators, the regulators' inspectors general, and academics that evaluated regulators' efforts to identify and respond to risks that led to bank failures in past crises. In developing an oversight framework, GAO reviewed frameworks for monitoring domestic and global financial systems to identify key areas in which risks to banks can arise. GAO interviewed regulators to identify supervisory actions that can be used to respond to emerging risks.
section_title: What GAO Found
paragraphs: Past banking-related crises highlight a number of regulatory lessons learned. These include the importance of
Early and forceful action. GAO's past work on failed banks found that regulators frequently identified weak management practices that involved the banks in higher-risk activities early on in each crisis, before banks began experiencing declines in capital. However, regulators were not always effective in directing bank management to address underlying problems before bank capital began to decline and it was often too late to avoid failure. For example, examiners did not always press bank management to address problems promptly or issue timely enforcement actions.
Forward-looking assessments of risk. The crises revealed limitations in key supervisory tools for monitoring and addressing emerging risks. During examinations, examiners did not always incorporate forward-looking information when assigning supervisory ratings based on banks' exposure to risk. For example, ratings did not consistently reflect factors such as poor risk-management practices that while not causing losses in the short term, caused losses in the long term.
Considering risks from the broader financial system. The 2007–2009 financial crisis demonstrated that risks to bank safety and soundness could not be assessed by looking only at the performance and activities of individual banks or groups of banks. Rather, regulators must look across the financial system to identify emerging risks.
In response to these lessons learned, regulators said they have taken a number of steps intended to improve their ability to identify and respond to emerging risks—including instituting more granular tracking of bank compliance with examination recommendations to address emerging problems in a timely manner; incorporating more forward-looking elements into supervisory tools; and participating in systemic risk-monitoring efforts as members of Financial Stability Oversight Council. GAO and others have begun to review some of these initiatives.
GAO has incorporated the regulatory lessons learned into a two-part framework for monitoring regulators' efforts to identify and respond to emerging risks to the banking system. First, the framework incorporates quantitative information in the form of financial indicators that can help users of the framework track and analyze emerging risks and qualitative sources of information on emerging risks—such as regulatory reports and industry and academic studies. Second, the framework monitors regulatory responses to emerging risks, such as agency guidance, with the goal of flagging issues for further review when questions arise about the effectiveness of these responses. Users—oversight bodies such as inspectors general—can analyze regulatory actions taken to address emerging risks and gain insights into regulators' ability to take forceful actions to address problematic behavior at banks. Such ongoing monitoring can provide a starting point for identifying opportunities for more targeted and frequent assessments of these efforts. GAO plans to implement this framework in its future work.

section_title: Letter
paragraphs: Weakness in federal oversight was one of many factors that contributed  to the size of federal losses and the number of bank failures in banking- related crises over the past 35 years. Between 1980 and 1990, a record  1,020 thrifts failed at an estimated cost of about $100 billion to the  Federal Savings and Loan Insurance Corporation (FSLIC) that insured  thrift deposits, leading to its demise. During this same period,  commercial banks also failed at record rates—a total of 1,315 federally  insured banks were closed or received financial assistance from the  Federal Deposit Insurance Corporation (FDIC). Estimated losses to the  bank insurance fund for resolving these banks was about $26 billion,  jeopardizing the fund’s solvency for the first time since FDIC’s inception.  Federal regulators were criticized for not taking prompt and forceful action  to minimize or prevent losses to the insurance funds due to the failures.
In response, two laws were enacted. First, the Financial Institutions  Reform, Recovery, and Enforcement Act of 1989 (FIRREA) authorized  the use of taxpayer funds to resolve failed thrifts, replaced the existing  thrift regulator, and moved thrift deposit insurance to FDIC. Federal Deposit Insurance Corporation Improvement Act of 1991  (FDICIA) made fundamental changes to federal oversight of depository  institutions that included prescribing a series of specific prompt corrective  actions (PCA) to be taken as capital ratios of banks and thrifts declined to  certain levels, mandating annual examinations and audits, and mandating  a risk-based deposit insurance assessment system.
Pub. L. No. 101-73, 103 Stat. 183 (codified in scattered sections of 12, 18, and 31  U.S.C.).
More recently, the financial crisis of 2007- 2009 resulted in the failure, or  the threat of failure, of hundreds of financial institutions, including the  failure of more than 400 commercial banks and thrifts that will likely  require an estimated $43 billion in losses to the FDIC’s Deposit Insurance  Fund (DIF). The results also included unprecedented taxpayer-funded  assistance to financial companies to stabilize the financial system. The  financial crisis revealed weaknesses in the existing regulatory framework  for overseeing financial institutions, including banks. In an April 2012  speech, the then Chairman of the Board of Governors of the Federal  Reserve System (Federal Reserve) said regulators and supervisors did  not always use their authorities forcefully or effectively. For example,  bank regulators did not do enough to force large financial institutions to  strengthen their internal risk-management systems or to curtail risky  practices. Furthermore, he said that the crisis revealed gaps in the  statutory framework of financial regulations. Critically, he noted, shadow  banking activities largely were not subject to consistent and effective  regulatory oversight.address risks across the financial system.
The crisis also highlighted the need to monitor and  To address these shortcomings, the Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act) was enacted in 2010.other things, the Dodd-Frank Act mandates that the Federal Reserve  impose enhanced prudential standards, including higher capital and  liquidity requirements, for banks and nonbank financial institutions  designated as systemically important, and dismantled the existing federal   Among  thrift regulatory structure and transferred responsibility for thrift  supervision to federal banking regulators. It also established the  Financial Stability Oversight Council (FSOC) to provide, for the first time,  an entity charged with monitoring and identifying risks to financial stability  throughout the financial system. Federal banking regulators—the  Federal Reserve, FDIC, and the Office of the Comptroller of the Currency  (OCC)—also responded with their own initiatives to strengthen oversight  over their banks in the aftermath of the crisis.
This report examines what lessons can be drawn from regulatory activity  in the lead-up to past crises and how they can be used to inform ongoing  and future regulatory efforts and the oversight of them. This report also  describes some recent activities that regulators have taken in response to  the recent financial crisis. Although future banking or financial crises are  unlikely to unfold in the same manner as past crises, understanding  regulatory activity leading up to past crises can provide a useful context  for monitoring regulatory responses to emerging risks. In particular, this  report (1) examines regulatory lessons learned from the 1980s thrift and  commercial bank crises and the 2007-2009 financial crisis, focusing on  the efforts of federal banking regulators to identify and address emerging  risks to the solvency of insured banks before the onset of these crises;  and (2) offers a strategy that we and other oversight bodies, such as  inspectors general (IGs) and the international auditing community  (hereafter, oversight bodies) can use to provide continuous future  oversight of regulatory responses to emerging risks. We prepared this  report under the authority of the Comptroller General to conduct work on  GAO’s initiative to assist Congress with its oversight responsibilities.
To identify regulatory lessons learned from the crises, we reviewed and  analyzed studies by GAO, IGs of the federal banking regulators, the  federal banking regulators, and academics. We also interviewed the  federal banking regulators—FDIC, OCC and the Federal Reserve. We  analyzed this information to identify common and unique challenges  regulators faced across the crises in identifying emerging risks and  responding to them effectively.
To incorporate the regulatory lessons learned into a strategy that  oversight bodies and others can use to monitor regulatory responses to  emerging risks, we established a framework for monitoring (1) known  emerging risks to the safety and soundness of the banking system, and  (2) regulatory responses to these risks, including detecting trends in  regulatory responses that might signal a weakening of regulatory  oversight. To develop the first part of our framework—monitoring known  emerging risks to the safety and soundness of the banking system—we  first reviewed frameworks or programs for monitoring domestic and global  financial systems that included banking systems. We identified relevant  frameworks and programs developed by federal banking regulators, other  federal agencies, foreign banking regulators, and international  organizations through our interviews with the regulators and other audit  work as well as prior audit work. We analyzed these frameworks and  programs to identify key areas from where risks to the banking system  could arise and identified three: (1) bank financial condition and  performance, (2) asset markets in which banks have direct or indirect  exposure, (3) and overall economic conditions. We also identified  financial indicators that will assist users of the framework in monitoring  potential risks to the banking industry emerging from the key areas. Some  of our indicators are derived from the Uniform Financial Institutions Rating  System, commonly known as CAMELS—the ratings system that banking  regulators use to, among other things, monitor aggregate trends in overall  soundness of financial institutions and assess their exposure to risks.  Other financial indicators are derived from the monitoring frameworks.  In addition to financial indicators, our framework also relies on publicly  available qualitative information on emerging risks to the banking sector  from banking regulators, and other entities that might have a unique or  varying perspective on emerging risks, such as investors, rating agencies,  trade associations, and academics.
To develop the second part of our framework, we reviewed prior GAO  work and the domestic monitoring frameworks and conducted interviews  with the banking regulators to identify the range of supervisory actions  that banking regulators have available to them to respond to emerging  issues in banks and the banking system. From our prior work, we also  identified those actions that can be observed and analyzed over time to  monitor for changes in regulatory behavior and that could signal potential  weaknesses in regulatory oversight—such as examinations and  enforcement actions. To supplement this effort, we interviewed a  judgmental sample of financial market specialists with a range of  professional experience in government, academia, and business as well  as in-depth knowledge of the 1980s thrift and commercial bank crises or  the 2007-2009 financial crisis. From the federal banking regulators’  annual reports, we used data on the number and type of enforcement  actions taken against supervised financial institutions to illustrate trends in  enforcement activity. We also used regulatory financial data compiled by  SNL Financial to illustrate trends in bank growth and profitability over  time. We have assessed the reliability of federal banking regulators’  enforcement action data as part of previous studies. We assessed the  reliability of the SNL Financial data by reviewing existing information  about the data and the system that produced them. We determined that  the enforcement action and financial information we used was sufficiently  reliable for the purposes of this report. See appendix I for more  information on our scope and methodology.
We conducted this performance audit from February 2013 to June 2015  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Bank Supervision
paragraphs: Federal banking regulators supervise the activities of banks and require  the banks to take corrective action when the banks’ activities and overall  performance present supervisory concerns or could result in financial  losses to the DIF or violations of law or regulation. See table 1 for an  overview of their functions.
Federal banking regulators supervise the condition of most banks through  off-site monitoring and on-site examinations. Regulators use off-site  systems to monitor the financial condition of an individual bank; groups of  banks with common products, portfolio or risk characteristics; and the  banking system as a whole between on-site examinations. The off-site  monitoring or surveillance activities rely on self-reported information from  banks, filed through quarterly Reports of Condition and Income (Call  Reports) to the banking regulators, supplemented with other market  derived data, and in some cases, more detailed transaction level  reporting on certain products or entities. The monitoring and surveillance  activities help alert regulators to potentially problematic conditions arising  in an individual bank, groups of banks with common products, portfolio or  risks characteristics, and the banking system as a whole. Using these  tools, each of the regulators identifies and flags banks with potential signs  of financial distress and prepares lists or reports of such institutions (e.g.,  watch list, review list, high-risk profile list) requiring further follow up.  These tools also help alert regulators to the need for other actions, such  as a horizontal review of a group of banks, or broader policy guidance.
To oversee large, complex banks, including bank holding companies,  federal banking regulators conduct on-site supervision by stationing  examiners at specific institutions. This practice allows examiners to  continuously analyze information provided by the financial institution,  such as board meeting minutes, institution risk reports or management  information system reports, and for holding company supervisors’  supervisory reports to be provided to other regulators, among other  things. This type of supervision allows for timely adjustments to the  supervisory strategy of the examiners as conditions change within the  institution. Bank examiners do not conduct an annual point-in-time  examination of the institution. Rather, they conduct ongoing examination  activities that target specific functional areas or business lines at the  institutions based on their examination strategy, the institution’s risk  profile, and the extent of supervisory concern during the supervisory  cycle. Such activities are discussed with bank management throughout  the year and incorporated into the final full-scope examination report  issued at the end of the supervisory cycle.
With respect to other individual banks, examiners use Call Report data to  remotely assess the financial condition of banks and thrifts and plan the  scope of on-site examinations. As part of on-site examinations,  regulators also closely assess banks’ exposure to risk and assign ratings,  under the CAMELS rating system. The ratings reflect a bank’s condition  in six areas: capital, asset quality, management, earnings, liquidity, and  sensitivity to market risk. Evaluations of CAMELS components consider  the institution’s size and sophistication, the nature and complexity of its  activities, and its risk profile. Each component is rated on a scale of 1 to  5, with 1 being the best and 5 the worst. The component ratings are then  used to develop a composite rating, also ranging from 1 to 5. Banks with  composite ratings of 1 or 2 are considered to be in satisfactory condition,  while banks with composite ratings of 3, 4, or 5 exhibit varying levels of  safety and soundness concerns. Banks with composite ratings of 4 or 5  are included on FDIC’s problem bank list, which designates banks with  weaknesses that threaten their continued financial viability. The  regulators supplement the CAMELS rating system with other risk  assessment methodologies and frameworks. For example, OCC uses a  Risk Assessment System that characterizes the level of risk, quality of  risk management, or aggregate and direction of risk across eight risk  categories. Also as part of the examination and general supervision  process, regulators may direct a bank to address issues or deficiencies  within specified time frames.
When regulators determine that a bank’s or thrift’s condition is less than  satisfactory, they may take a variety of supervisory actions, including  informal and formal enforcement actions, to address identified  deficiencies. Regulators have some discretion in deciding which actions  to take, but 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 the bank can and  will make changes. Informal actions include supervisory letters  detailing specific remedial measures for the bank to implement, safety  and soundness plans, resolutions adopted by the bank’s board of  directors at the request of its regulator, individual minimum capital  ratio letters, and memorandums of understanding or agreements  between the regulator and the bank’s board of directors. Informal  actions are not public agreements (regulators do not make them  public through their websites or other channels) and are not  enforceable by sanctions.
The regulators use formal actions to address more severe  deficiencies. Formal enforcement actions include PCA directives,  safety and soundness orders, cease and desist orders, removal and  prohibition orders, civil money penalties, formal agreements, and  termination of a bank’s deposit insurance. Regulators publicly disclose  formal enforcement actions.
section_title: 1980s Thrift and Commercial Banking Crises
subsections: section_title: Thrift Crisis
paragraphs: A number of factors contributed to the severe crisis experienced by the  thrift industry in the 1980s. Thrifts were regulated by the Federal Home  Loan Bank Board (FHLBB) and insured by FSLIC within a legislative  framework separate from the one that surrounded commercial banks. At  the time, thrifts were largely restricted to making long-term, fixed-rate  home mortgage loans. Because they issued short-term deposits to fund  their long-term mortgage assets, thrifts were exposed to interest rate risk.  When inflation resulted in rising interest rates in the mid-1970s and early  1980s, thrifts were unable to respond, losing many depositors to  competitors such as money market funds because regulations prevented  them from raising the interest they could pay on deposits. Inflation  diminished the value of the long-term, fixed-rate mortgages they held, and  virtually wiped out all the industry’s net worth, driving many institutions  into insolvency.
Because the assets of FSLIC were inadequate to close all insolvent  thrifts, FHLBB forestalled actual insolvency in the early 1980s by reducing  capital standards and allowing the use of alternative accounting  procedures to increase reported capital levels. At the same time,  Congress deregulated thrifts with measures that included phasing out  deposit interest-rate ceilings, broadening the lending and investment  powers of thrifts, and more than doubling the limit of federal deposit  insurance per thrift account holder. A 1997 FDIC study reviewing the  1980s crises in the thrift and banking industries found that as a result of  these regulatory and legislative actions, the thrift industry grew rapidly,  funded by an influx of deposits—often higher-risk brokered deposits.Loan portfolios at thrifts shifted from home mortgage financing into  commercial real estate (CRE) loans—particularly into higher-risk  acquisition, development, and construction (ADC) loans in areas of the  country experiencing a real estate boom. The profitability of many of  these activities depended heavily on continued inflation in real estate  values. Tax legislation passed in 1981 further stimulated demand for CRE  loans by increasing the rate of return. Our June 1989 report on failed  thrifts found that in many cases, diversification was accompanied by  inadequate internal controls and noncompliance with laws and  regulations; thus, the risk of these activities was further increased.  Consequently, many institutions experienced substantial losses on loans  and investments, a condition that was made worse by an economic  downturn in the later 1980s and by the repeal of the CRE tax incentives in  1986.
section_title: Commercial Bank Crisis
paragraphs: The competitive environment for the banking industry became  increasingly demanding in the 1980s. As with thrifts, the development of  money market funds and the deregulation of deposit interest rates, which  removed the cap on the maximum amount of interest banks and thrifts  were allowed to pay on deposits, spurred a competition to attract  depositors with higher interest rates. This competition resulted in further  squeezing what the banks could earn net of what they had to pay to  acquire the deposits. Further, competition increased in the banking  industry not only from within, but also from thrifts, foreign banks, and  credit markets such as the commercial paper and bond markets.
The 1997 FDIC study noted that a series of regional and sectoral  recessions had a severe impact on local banks and led to many bank  failures, especially in areas that had been preceded by rapid regional  expansions; that is, boom-and-bust patterns of economic activity. The  magnitude of the banks’ losses was compounded because many banks  active in these areas assumed excessive risks, with the result that they  failed in disproportionate numbers. For example, many banks greatly  increased their exposure to CRE as demand surged during the 1980s,  particularly as deregulation, tax incentives, and other factors created an  environment in which CRE lending became lucrative. To boost profits,  some large banks assumed additional risk by, for example, increasing  their off-balance-sheet activities.
The 1997 FDIC study identified four major regional and sectoral economic  recessions that were associated with widespread bank failures during the  1980-1994 period. The first recession was related to a downturn in  farmland prices in the early and middle 1980s and led to a number of  failures of banks with heavy concentrations of agricultural loans,  particularly in the Midwest. The second recession occurred in Texas and  other oil producing southwestern states after oil prices began dropping in  1981. While initial bank failures in this region were primarily due to  problems with energy-related loans, substantial losses on CRE and  residential real estate loans were responsible for the rising number of  bank failures in this region in the second half of the decade. The third and  fourth recessions occurred in the northeastern United States and in  California at the end of the 1980s, largely due to a sharp decline in real  estate prices that resulted from an oversupply of CRE and residential real  estate in these areas and led to defaulted real estate loans and bank  failures.
section_title: 2007-2009 Financial Crisis
paragraphs: In January 2010 testimony, the former FDIC Chairman commented that a  number of the products and practices that led to the 2007-2009 financial  crisis had their roots in mortgage market innovations that began in the  1980s.residential mortgage investments that precipitated the thrift crisis of the  1980s, banks and thrifts began selling a major share of their mortgage  loans for securitization. The housing government-sponsored enterprises  (GSEs) create a market for investors to purchase securities backed by  loans originated by banks and thrifts. Through the 1990s, the GSEs  increased in size as they purchased and retained the mortgage-backed  securities (MBS) they issued.
She noted that following the large interest rate-losses from  As interest rates declined in the early 2000s, mortgage originations  surged, driven primarily by the refinancing of existing mortgages as  borrowers sought to lower the interest rates on their home loans and as  home price appreciation in the United States began accelerating rapidly in  2000. This wave of refinancing activity was originally dominated by prime,  fixed-rate loans. However, declining affordability in high-priced housing  markets as well as increased competition by mortgage originators for loan  volume contributed to a shift towards nontraditional mortgage products,  which allowed borrowers to defer repayment of principal or part of the  interest for the first few years of the mortgage. Growth in the subprime  market also increased. Many borrowers eventually faced large payment   Many providers of these  increases and had difficulty making payments. products—mortgage brokers, mortgage bankers, and mortgage affiliates  of bank, thrift, and other financial holding companies—operated outside  the traditional thrift and bank regulatory system.
We reported on the risks of nontraditional mortgage products to borrowers and lenders,  the extent to which mortgage disclosures discussed the risks to borrowers, and federal  and selected state regulatory responses to nontraditional mortgage product risks in 2006.  See GAO, Alternative Mortgage Products: Impact on Defaults Remain Unclear, but  Disclosure of Risks to Borrowers Could be Improved, GAO-06-1021 (Washington D.C.:  Sept.19, 2006). or quality standards. Private-label MBS backed by lower-quality  mortgage pools left investors exposed to greater risk of default. The  market share of private-label MBS, which typically pool jumbo and  nonprime mortgages, grew rapidly from 2004 to 2006. During this time,  the market share of the GSEs, which pool eligible prime mortgages,  decreased. Other investment structures such as collateralized debt  obligations (CDO) were also instrumental to creating demand for these  riskier, lower quality loans.  In a basic CDO, a group of loans or debt  securities are pooled and securities are then issued in different tranches  that vary in risk and return depending on how the underlying cash flows  produced by the pooled assets are allocated. If some of the underlying  assets defaulted, the more junior tranches—and thus riskier ones—would  absorb these losses first before the more senior, less-risky tranches.  Purchasers of these CDO securities included insurance companies,  mutual funds, commercial and investment banks, and pension funds.  Many of these CDOs largely consisted of mortgage-backed securities,  including subprime mortgage-backed securities. The growth of the  mortgage-linked derivatives market further allowed investors to take on  exposure to the subprime and Alt-A markets without actually owning the  mortgages or the MBS or CDO on the entities that owned the mortgages.  Through the use of such credit derivatives, investor exposure to losses in  these markets was multiplied and became many times larger than the  exposures generated by the mortgages alone.
The dramatic decline in the U.S. housing market that began in 2006  precipitated a decline in 2007 in the price of mortgage-related assets,  particularly mortgage assets based on nonprime loans. Some financial  institutions were so exposed that they were threatened with failure, and  some failed because they were unable to raise capital or sell assets to  generate liquidity as the value of their portfolios declined. Other  institutions, ranging from the GSEs to large securities firms, were left  holding “toxic” mortgages or mortgage-related assets that became  increasingly difficult to value, were illiquid, and potentially had little worth.  Moreover, investors not only stopped buying private-label MBS but also  became reluctant to buy securities backed by other types of assets.  Because of uncertainty about the liquidity and solvency of financial  entities, particularly among large, financially interconnected firms, the  prices banks charged each other for borrowing funds rose dramatically,  and interbank lending conditions deteriorated sharply. The resulting  liquidity and credit shortage made the financing on which businesses and  individuals depend increasingly difficult to obtain. By the late summer of  2008, the ramifications of the financial crisis ranged from the continued  failure of financial institutions to increased losses of individual wealth,  reduced corporate investments, and further tightening of credit that would  exacerbate the emerging global economic slowdown.
Bank failures associated with the financial crisis were concentrated in  areas where the housing markets experienced strong growth. In response  to the demand for housing stock in the years prior to the crisis, residential  development activity increased. Many banks exhibited rapid growth in  their ADC portfolios, resulting in significant concentrations in ADC and  CRE loans. Strong competition for higher yielding assets contributed to a  decline in underwriting standards. Our prior work found that losses on  higher-risk residential mortgages drove the failure of large banks (those   Failures of the small  with more than $10 billion in assets) in these areas.and medium banks (those with less than $1 billion in assets, and between  $1 billion and $10 billion in assets, respectively) in these areas were  largely driven by losses on CRE and ADC loans.
section_title: Past Crises Highlight Continued Need for Early and Strong Regulatory Response to Identified Problems
paragraphs: Early intervention is a key lesson learned for successfully resolving the  problems of troubled institutions. In the 1980s thrift and banking crises  and the 2007-2009 financial crisis, regulators could have provided earlier  and more forceful supervisory attention to troubled institutions. In  addition, the crises revealed limitations in regulatory tools for identifying  and addressing emerging risks. The 2007-2009 financial crisis also  highlighted the need for federal banking regulators to consider the impact  of emerging risks in the broader financial system on individual banks.
subsections: section_title: Regulators Did Not Always Provide Sufficiently Timely and Robust Supervisory Attention to Troubled Institutions
paragraphs: Although the relative causes, scope, and duration of the 1980s thrift and  commercial bank crises and the 2007-2009 financial crisis were distinct,  our past reviews of the banks that failed during these crises found similar  contributing factors, particularly weak management practices that  involved banks engaged in higher-risk activities. Although regulators often  identified these risky practices early on in each crisis, the regulatory  process was not always effective in correcting the underlying problems  before the banks became undercapitalized and failed.
For example, in our June 1989 report, examiners for 26 failed thrifts cited  management weaknesses as a leading factor in the failures. In virtually all  of these cases, the thrifts shifted their focus from traditional home  mortgage lending to higher-risk activities. Moreover, management at  these thrifts often pursued business decisions and strategies that  increased their risks, such as a heavy reliance on brokered deposits to  fund rapid growth, poor underwriting and credit administration practices,  and concentrations in ADC lending. These management problems  consequently made them more vulnerable to poor regional economic  conditions. We found that thrift management was often unresponsive to  supervisory concerns the examiners raised in these cases and that thrift  management did not always act on problems examiners identified or  implement promised corrective actions. In our April1989 testimony, we  analyzed the supervisory history of an additional 47 thrifts that were near  failing. For more than half, no formal enforcement actions were taken  and many had no history of formal actions. Where enforcement actions  were taken, they were often not effective in correcting problems. Further,  the length of time that elapsed between identification of a need for formal  action and implementation of the action was often unduly lengthy.
Similarly, in our April 1991 report, examiners of 72 troubled banks  identified similar management weaknesses as the most common reason  for assets and earnings problems, including heavy concentrations in  specific types of assets, industries, or local economies, and excessive  growth combined with poor lending practices or controls. frequently cited asset problems involved problem real estate loans and  the most frequently cited reasons for the asset problems involved lax  underwriting practices. Losses on these problem assets resulted in  earnings problems and eventually capital problems for the banks. In  about half of the 72 failed banks, we concluded the banking regulators  should have been more aggressive and used stronger measures than  they did (e.g., some formal enforcement action instead of only an informal  enforcement action).underlying causes for problems were known but remained uncorrected or  the bank had a history of noncompliance with enforcement actions or of  violating banking regulations. We also found that better outcomes were  associated with the most forceful actions taken, and worse outcomes  were associated with not taking the most forceful action available.
In 1991, we reported on a random sample of 72 banks that as of January 1, 1988,  regulators identified as having difficulty meeting minimal capital standards. GAO, Bank  Supervision: Prompt and Forceful Regulatory Actions Needed, GAO/GGD-91-69  (Washington D.C.: Apr. 15, 1991). choosing among enforcement actions of varying severity, they preferred  to work with bank management to resolve problems during the 1980s  thrift and commercial bank crises over taking enforcement actions. For  example, we identified 37 cases from our sample of 72 banks where  regulators decided not to use available enforcement actions. In 26 cases,  the unsafe and unsound practices that caused the capital depletion  remained uncorrected.
FDIC’s 1997 study noted the ability of regulators to curb excessive risk  taking on the part of healthy banks was limited by the problem of  identifying risky activities before they produced serious losses. The study  found that bank regulators were reasonably successful in curbing risk- taking on the part of officially designated problem banks. However, in  dealing with ostensibly healthy banks, regulators had difficulty restricting  risky behavior while the banks were still solvent and the risky behavior  was widely practiced and profitable. The study found it was challenging  for regulators to distinguish such behavior from acceptable risk/return  trade-offs, innovation, and other appropriate activity, or to modify the  behavior of banks while they were still apparently healthy.
We concluded in our 1991 report outlining our strategy for reforming the  deposit insurance system in the wake of the thrift and commercial banks  crises that meaningful reform would not succeed without an enforcement  process that was less discretionary than the approach used at the time.
GAO, Deposit Insurance: A Strategy for Reform, GAO/GGD-91-26 (Washington, D.C.:  Apr. 15, 1991). we proposed that the first tripwire address unsafe activities that indicate  management inadequacies that could lead to further financial problems;  that is, unsafe practices in seemingly healthy institutions. We proposed  that a second tripwire address poor asset quality and earnings, as our  prior work showed that serious asset deterioration and earnings problems  are leading indicators of bank financial problems. Our third and fourth  tripwires addressed capital deterioration.
Subsequently, Congress established the PCA framework in 1991.The  framework is set forth in sections 38 and 39 of the Federal Deposit  Insurance Act, as amended by FDICIA. Section 38 requires regulators  to classify banks into one of five capital categories and take increasingly  severe actions as a bank’s capital deteriorates. Section 39 requires 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. Section  39 was intended to allow regulators to take action against seemingly  healthy banks that were engaging in risky practices before losses  occurred. Initially, the standards for asset quality and earnings were to be  quantitative and intended to increase the likelihood that regulators would  address safety and soundness problems before capital deteriorated.  However, later legislative changes gave regulators considerable flexibility  to implement these standards, and regulators determined instead to issue  guidance in 1995 setting out broad standards addressing these areas.  Section 39 allows the regulators to take action for non-problem  institutions in which inadequate practices and policies could result in a  material loss to the institution or in cases where management has not  responded effectively to prior criticisms.
Despite this new regulatory framework, regulators continued to face  challenges in restricting risky bank behavior in the years leading up to the  2007-2009 financial crisis. As we will discuss later, PCA was not effective  in resolving underlying problems at failed banks and preventing  widespread losses to the deposit insurance fund during the financial  crisis. Our more recent work and that of the federal banking regulator IGs  found that many of the banks that failed during the financial crisis were  susceptible to the same risks that gave rise to the bank failures of the  1980s and 1990s. For example, in our January 2013 report, we found  management weaknesses also contributed to many failures, including  poor underwriting and credit administration practices, rapid growth funded  by brokered deposits, and high concentrations—in particular, high CRE  and ADC concentrations for small and medium-sized banks and high  concentrations of higher risk residential mortgage products at large  banks. With the downturn in the housing market and the onset of the  financial crisis, asset problems manifested. The rising level of  nonperforming loans, particularly ADC loans, was a key factor driving a  decline in capital for many failed banks. As another example, an April  2013 report by the Treasury IG noted that many of the OCC-supervised  banks that failed from 2008 to 2012 evidenced weaknesses with bank  boards of directors or management and high concentrations in CRE  loans. The Federal Reserve IG also found similar factors in its review of  failed banks supervised by the Federal Reserve, in particular, that many  bank failures involved the board and management making strategic  decisions to pursue aggressive growth that increased the bank’s risk  profile and ultimately contributed to the failure. And, in its 2010 report,  the FDIC IG found that risky bank behaviors associated with bank failures  included pursuit of aggressive growth in CRE and ADC loans, excessive  levels of asset concentration with little risk mitigation, and inadequate  loan underwriting.
We and the federal banking regulator IGs also found that regulators had  identified underlying risks of banks that failed during the 2007-2009  financial crisis well before their failure, but did not always take timely  supervisory action. For example, of the 136 failed banks we reviewed for our 2011 PCA report, we found that most had received an informal or  formal enforcement action before undergoing the PCA process, although  the timeliness of enforcement actions was inconsistent. Specifically,  among 60 banks that failed between January 2008 and June 2009,  approximately 28 percent did not have an initial informal or formal non- PCA enforcement action until 90 days or less before bank failure. Further,  50 percent of these failed banks did not have an enforcement action until  180 days or less prior to failure. After June 2009, these percentages  improved, with approximately 8 percent not having an enforcement action  until 90 days or less before failure, and approximately 22 percent not  having an action until 180 days or less before failure.
Similarly, a September 2011 report by the Federal Reserve IG analyzing  the failure of 20 state member banks noted that examiners identified key  safety and soundness risks but did not take sufficient supervisory action  in a timely manner to compel the boards and management to mitigate  those risks. In many instances, the IG found the examiners eventually  concluded that a supervisory action was necessary, but that conclusion  came too late to reverse the bank’s deteriorating condition. Further, a  December 2010 report by the FDIC IG found that in many cases,  examiners identified significant risks but did not take timely and effective  action to address those risks until the bank had started to experience  significant financial deterioration in the loan or investment portfolios.
Staff from one regulator told us that when they have a bank failure, they  always look back at that failure and assess what they could have done  differently in terms of supervision. They found that generally, examiners  had identified the underlying issues that eventually led to the failures but  did not press management hard enough to deal with those issues. These  staff explained that it can be difficult for examiners to make the case to  bank management that they need to ratchet down a profitable line of  business because at the time the examiners see risk building up, the  bank’s performance may not yet have been impacted. These staff also  said that if the agency decides to take an enforcement action when the  bank is still in good financial shape, and the bank refuses to sign it, a  lengthy and resource-intensive legal process could ensue. Staff from  another regulator acknowledged that examiners had often uncovered  problems at the banks long before they failed, yet bank management did  not take action to address their recommendations. These staff noted that  part of the role of the examiner is to be skeptical, and it is difficult to be  skeptical when loans are paying as agreed. These staff recognized that in  the past they have not always been effective in getting bank management  to take action to address potential problems before their effect hits the  balance sheet.
Banking regulators also received considerable feedback in response to  proposed actions to address emerging risks that resulted in delays. The  regulators issued draft guidance in January 2006 on CRE concentrations  and risk management, based partly on the trends they observed in CRE  concentrations and risks, but the guidance was not finalized until  December 2006. Staff from one regulator told us the guidance was  issued too late to allow for corrective actions to be taken across the  banking system before the crisis ensued. The draft guidance elicited  about 4,400 comments letters from bankers, industry trade groups, state  financial regulatory agencies, appraisers and real estate industry  representatives. The vast majority of the commenters expressed strong  resistance to the proposed guidance, and the staff told us that working  through the comment process resulted in delays to final issuance. In its  September 2011 report summarizing state member bank failures, the  Federal Reserve IG reported that examiners they spoke with perceived  the guidance to be “too little, too late” and that examiners mentioned that  many institutions did not quickly adopt the risk management practices  outlined in the guidance prior to the onset of the financial crisis.
section_title: Past Crises Revealed Limitations in Existing Tools for Monitoring and Addressing Emerging Risks
subsections: section_title: PCA Reliance on Capital Triggers Limited Its Effectiveness
paragraphs: As discussed earlier, in the aftermath of the thrift and commercial bank  crises regulators were criticized for failing to take timely and forceful  action to address the causes of thrift and bank failures and prevent losses  to taxpayers and the deposit insurance fund. The PCA framework was  intended to improve regulators’ ability to identify and promptly address  deficiencies at banks by, in part, limiting their discretion and mandating  them to take corrective actions under certain circumstances. Staff from  one regulator told us that PCA likely prompts bank management to  address problems earlier than is the case without PCA and that failure  costs are likely lower with PCA than without it. However, the PCA  framework did not prevent widespread losses to the deposit insurance  fund—a key goal of PCA. In June 2011, we reported on the effectiveness  of the PCA framework for addressing financial deterioration of banks  during the financial crisis and concluded that PCA’s reliance on capital  triggers limited its ability to promptly address bank problems.
Before 2007, PCA was largely untested by a financial crisis that resulted in a large  number of bank failures. After the passage of FDICIA, sustained growth in the U.S.  economy meant that the financial condition of banks was generally strong. For instance,  as a result of positive economic conditions, the number of bank failures declined from 180  in 1992 to 4 in 2004. Furthermore, from June 2004 through January 2007, no banks failed. regulator IGs found that regulators, with the exception of OCC, made  limited use of their section 39 authorities, consistent with our prior  findings.
As part of our June 2011 work, we tested financial indicators other than  capital and found that there were important predictors of future bank  failure that could be used in developing non-capital triggers for PCA. For  example, indicators of earnings, liquidity, asset quality, and sector loan  concentration contain information about the condition of the bank that can   To  provide warning of bank distress up to 1 to 2 years in advance. improve the effectiveness of the PCA framework, we recommended,  among other things, that the banking regulators consider additional, non- capital triggers that would require early and forceful regulatory actions   In written comments, FDIC,  tied to specific unsafe banking practices.the Federal Reserve, and OCC agreed with our recommendation to  consider options to make PCA more effective. As of June 2015, federal  banking regulators were still considering the pros and cons of modifying  the PCA framework, such as the use of additional noncapital-based  triggers. For instance, FDIC staff noted that non-capital triggers could  strengthen the supervisory process and help banks avoid mistakes  leading to crisis, address GAO and FDIC IG recommendations, and  involve low implementation costs since the infrastructure is already in  place. However, FDIC staff said that the additional hard-wired PCA  triggers, which would likely require interagency rulemaking, could  encourage banks to operate just below a given threshold to avoid  scrutiny, and banks tripping PCA non-capital triggers could be perceived  in the capital markets as being on a path toward regulatory intervention.  In addition, FDIC staff noted that while additional tripwires would result in  greater stringency of supervision, there could also be unintended  consequences resulting in constraints on well-managed banks performing  their financial intermediation function.
section_title: CAMELS Ratings Did Not Systematically Reflect Long- Term Risk Factors
paragraphs: CAMELS ratings have not always reflected long-term risk factors,  particularly with respect to poor management practices. The CAMELS  rating system contains explicit language in each of the components  emphasizing the importance of management’s ability to identify, measure,  monitor, and control risks. For example, a poor management component  rating (M) may indicate that the bank suffers from weak internal controls  or management information systems or other deficiencies that could   Thus,  threaten the safe, sound, and efficient operation of the bank.deterioration of the management component may yield future information  about risk.
However, in prior crises, regulators did not always assign management  component ratings that were reflective of weaknesses in management,  and staff from one regulator said that there was a tendency to use the  rating more as a point in-time snapshot of a bank’s condition, rather than  a reflection of long-term risk factors that may cause losses several years  later. In its 1997 study, FDIC analyzed the management component  ratings for the 1,564 banks that failed between 1980 and 1994 (excluding  banks that received FDIC assistance) during the commercial bank  crisis. The results showed that 2 years before failure, in only 6 percent  of the cases was the management rating one full number worse than the  average of the other four components. The FDIC IG noted in a 2010  report that examiners did not always place sufficient emphasis on risk  mitigation when assigning ratings to banks that later failed. The IG  noted that bank management’s lack of responsiveness to examiners’  concerns was not always reflected in assigned CAMELS ratings until  significant financial deterioration occurred. In its 2011 report, the Federal  Reserve IG said its work highlighted the need for supervisors to ensure  that CAMELS composite and component ratings are consistent with  narrative examination comments to clearly convey the need for urgent  action when appropriate.
Staff from one regulator told us that although the management  component of the CAMELS is stand-alone, in some instances, examiners  found it difficult to rate management low (i.e., 4 or 5) if capital and  earnings were strong, even if they had noted concerns with management  practices. As a result, in some cases, composite CAMELS ratings  remained relatively high (i.e., 1 or 2) until capital and earnings began to  decline. Because capital and earnings tend to be lagging indicators, such  ratings decreases were not reflected in some cases until before the bank  failed. In our 2011 PCA report, we found that most banks that failed  degraded from a CAMELS composite rating of 2 to a 4 in one quarter,  though they generally had at least one component rating of a 3 prior to  failure.
section_title: Bank Supervision Did Not Consider the Impact of Risks from the Broader Financial System on Banks
paragraphs: The financial crisis also highlighted the need for regulators to consider the  impact of risks in the broader financial system on individual banks. Before  the 2007-2009 financial crisis, banking supervision was microprudential;  that is, generally focused on the activities of individual institutions or  groups of insitutions. Staff from two federal banking regulators  underscored that financial stability requires looking beyond the safety and  soundness of individual banks to across the financial system with a  macroprudential approach that focuses on assessing systemic risks.  Staff from one regulator said that the problem with focusing solely on the  activities of individual banks could be seen in the “originate to distribute”  model that banks used to originate mortgages in the years leading to the  financial crisis. That is, banks were originating mortgages with the intent  to sell them in the secondary market as mortgage-backed securities, and  not keep them in portfolio as held-for-investment. These staff also said  that although the underwriting risk of these mortgages was significant,  they believed that there was little risk to the bank’s capital because the  bank was making fees but was not retaining the credit risk of the  mortgages.
These staff said they incorrectly assumed that investors were paying  attention to the underwriting risk embedded in the securitized mortgages,  because investors were buying the securities and not putting pressure on  the banks to increase their underwriting standards for the underlying  mortgages. When the real estate bubble burst and homeowners began to  default on their mortgages, these investors suffered heavy losses. As a  result, staff said they learned that financial stability oversight requires a  different perspective and a different, more global approach that considers,  among other things, the interconnectedness of financial institutions and  their activities. In retrospect, staff noted that stronger bank capital  standards—notably those relating to the quality of capital and the amount  of capital required for banks’ trading book assets—and more attention to  the liquidity risks faced by the largest, most interconnected firms would  have made the financial system as a whole more resilient.
Although the activities of large, interconnected financial institutions often  crossed traditional sector boundaries, banking regulators did not always  have sufficient tools and capabilities to adequately oversee the risks that  these financial institutions pose to themselves and other institutions. In  June 2008 testimony, a former Federal Reserve Vice Chairman noted  that under the current U.S. regulatory structure, challenges can arise in  assessing risk profiles of large, complex financial institutions operating  across financial sectors, particularly given the growth in the use of  sophisticated financial products that can generate risks across various  legal entities. He also said that the financial crisis highlighted the  importance of enterprise wide risk management, particularly that  supervisors need to understand risks across a consolidated entity and  assess the risk management tools being applied across the financial  institutions. For example, the former Federal Reserve Chairman said  that stress tests of the 19 largest bank holding companies, conducted by  federal banking regulators in 2009 as part of the Supervisory Capital  Assessment Program, demonstrated that many of these institutions’  information systems could not provide timely, accurate information about  bank exposures to counterparties or complete information about the  aggregate risks posed by different positions and portfolios.
Staff from another regulator said that fragmented databases and  otherwise insufficient processes at large banks to identify similar risks  within and across various lines of businesses and legal entities both on  and off the balance sheet resulted in the failure to identify and therefore  measure, monitor, and control exposure to concentrations. Further,  accounting rules in effect at the time permitted special-purpose entities— legal entities often used by banks to facilitate the securitization of real- estate loans—to remain off the banks’ balance sheets, thus obfuscating  regulators’ ability to fully understand the extent of the banks’ business  activities and risk exposures. Our own work had raised concerns over the  adequacy of supervision of large financial conglomerates. For example,  one of the large entities that OTS oversaw was the insurance  conglomerate American International Group, Inc. (AIG), which was  subject to a government takeover necessitated by financial difficulties the  firm experienced as the result of OTC derivatives activities related to  mortgages. In a March 2007 report, we expressed concerns over the  appropriateness of having OTS oversee diverse global financial  institutions given the size of the agency relative to the institutions for  which it was responsible.
Staff from one regulator said that another lesson learned was that an  enormous amount of systemic risk had been concentrated in the shadow  banking system before the onset of the 2007-2009 financial crisis in  several nonbank financial firms, such as large investment firms. However,  the regulators did not perceive the buildup of risk and leverage across the  financial system because of a gap in the regulation of the shadow  banking system. Staff said that the increase in system-wide leverage  during the years leading up to the financial crisis distinguished the impact  that real estate problems of the 1980s had on thrifts and commercial  banks from the impact that real estate problems of the 2000s had on the  banking sector and larger financial system. That is, losses from real  estate-related loans, while primary factors in the failures of banks and  thrifts during the 1980s, did not have a systemic impact on the larger  financial system because these institutions had originated the loans and  retained the associated credit risk.
In contrast, they said that losses from real estate-related loans during the  2007-2009 financial crisis had a systemic impact because the risks  associated with these loans were spread and amplified throughout the  financial system. Contributing to the buildup of risk and leverage across  the financial system was the fact that shadow banking activities were, for  the most part, not subject to consistent and effective regulatory oversight.  The former Federal Reserve Chairman noted that much shadow banking,  including various special-purpose entities and many nonbank mortgage- origination companies, lacked meaningful prudential regulation. In our  January 2009 report, we noted that the role of nonbank lenders in the  recent financial collapse provided an example of a gap in our financial  regulatory system resulting from the activities of institutions that were  generally subject to little or no direct oversight by federal regulators. The  significant participation by these nonbank lenders in the subprime  mortgage market—which targeted products with riskier features to  borrowers with limited or poor credit history—contributed to a dramatic  loosening of underwriting standards leading up to the crisis. Staff from  one regulator noted that, at the large investment firms, broker-dealers  arranged for investors to fund these long-term mortgage assets with  short-term financial instruments, typically with original maturities of less  than nine months, which allowed leverage in the whole financial system to  build to unprecedented levels and distribute risk throughout the system.
However, some of the top investment banks were subject to voluntary  and limited oversight at the holding company level—the level of the  institution that generally managed its overall risks. holding companies faced serious losses and funding problems during the  crisis, and their instability severely damaged the financial system. The  financial crisis demonstrated that the failure of large interconnected  financial institutions, such as the failure of Lehman Brothers Holdings,  Inc. in the fall of 2008, could trigger systemic events through a rise in the  price of risk (that is, the risk-adjusted return on investments) and  deleveraging in the broader financial system.
The Securities and Exchange Commission terminated its program for overseeing these  large broker-dealer holding companies in September 2008 but continues to oversee these  firms’ registered broker-dealer subsidiaries.
section_title: Regulators Have Taken Steps Intended to Improve Their Ability to Identify and Respond to Emerging Risks
paragraphs: Federal banking regulators have taken steps to incorporate the lessons  learned from the 2007-2009 financial crisis and improve their ability to  identify and respond to emerging risks. First, regulators told us that they  recognize bank supervision needs to be less historically focused and  more forward-looking. As such, they have been working to include more  forward-looking elements into examinations, such as bank-performed  stress test processes and results, and to reflect such forward-looking  information in the CAMELS ratings and other risk assessment tools.  Second, to improve their ability to respond earlier and more forcefully to  banks’ risky behavior, the three regulators have initiated more granular  tracking of supervisory issues that surface during examinations, referred  to as matters requiring attention (MRA). Third, through their participation  in FSOC and their own surveillance activities, they also have been  monitoring the financial system more broadly for risks that could affect  their regulated institutions. We and others have begun to review some of  these regulatory initiatives, but further work is needed to fully evaluate  their effectiveness in improving regulators’ ability to identify and respond  to emerging risks in a timely manner.
subsections: section_title: Stress Testing
paragraphs: Federal Reserve, FDIC, and OCC staff have been using banks’ stress  tests as a way to incorporate forward-looking elements into the  examiners’ considerations of risk in individual institutions. Stress testing is  a forward-looking, quantitative evaluation of the potential effects of stress  scenarios that could impact a banking institution’s financial condition and  capital adequacy. These risk assessments are based on assumptions  about potential adverse external events, such as changes in real estate or  capital markets prices, or unanticipated deterioration in a borrower’s  repayment capacity. In supervisory guidance for stress testing practices  of large banks issued in May 2012, the regulators noted that the financial  crisis underscored the need for banks to incorporate stress testing into  their risk-management practices and demonstrated that banking  organizations unprepared for particularly adverse events and  circumstances can suffer acute threats to their financial condition and  viability.
Section 165(i) of the Dodd-Frank Act requires two types of stress tests on  large banks. Section 165(i)(1) requires the Federal Reserve to conduct  annual stress tests of bank holding companies with $50 billion or more in  total consolidated assets and nonbank financial companies supervised by  the Federal Reserve, while Section 165(i)(2) requires companies with  more than $10 billion in total consolidated assets to conduct annual stress  tests themselves, in addition to requiring companies with $50 billion or  more in total consolidated assets and nonbank financial companies  supervised by the Federal Reserve to conduct their own stress tests  semi-annually. In October 2012, the Federal Reserve issued final rules for  the tests of holding companies with $50 billion or more in total  consolidated assets and also required the companies to conduct and  disclose annual company-run stress tests. Also in October 2012, FDIC,  OCC, and the Federal Reserve issued final rules requiring annual  company-run stress tests for bank holding companies with total  consolidated assets between $10 billion and $50 billion and for national  banks and state member banks, state nonmember banks, state and  federal thrifts and thrift holding companies with $10 billion or more in total  consolidated assets. The results of the stress tests provide the  regulators with more forward-looking information that they plan to use in  bank supervision and to assist them in assessing the company’s risk  profile and capital adequacy. In March 2014, FDIC, OCC, and the  Federal Reserve issued final guidance describing supervisory  expectations for stress tests conducted by financial companies with total  consolidated assets between $10 billion and $50 billion.
Banks with less than $10 billion in assets are not required or expected to  conduct the types of stress testing specifically articulated in the initiatives  which are directed at larger organizations. However, the three regulators  continue to emphasize that all banks, regardless of size, should have the  capacity to analyze the potential impact of adverse outcomes on their  financial condition.  Banks in this range also remain subject to the stress  testing guidance contained in prior interagency issuances. OCC issued  guidance specifically designed for community banks on how they can  effectively use simple stress testing concepts and methods to help  identify and quantify risk in loan portfolios and help establish effective  strategic and capital planning processes. For example, OCC staff said  that their examiners and economists developed stress testing tools for  analyzing commercial real estate, agriculture, and other loan portfolios  that are also available to community banks. And, FDIC published an  article illustrating approaches to assist community banks with credit stress  testing in an edition of Supervisory Insights.
The former Federal Reserve Chairman said that one of the most  important aspects of regular stress testing is that it forces banks and their  supervisors to develop the capacity to quickly and accurately assess the  enterprise-wide exposures of their institutions to diverse risks, and to use  that information routinely to help ensure that they maintain adequate  capital and liquidity. risk-management capacity is itself critical for protecting individual banks  and the banking system. Federal Reserve staff also noted that the stress  test is the best way to communicate to bank management that risks have  built up and need attention, because it is data driven. Without such data,  they said it is difficult to make a convincing case to management because  bank managers do not want to hear that they should act more cautiously  when their banks are profitable.
Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System,  Stress Testing Banks: What Have We Learned? Conference on “Maintaining Financial  Stability: Holding a Tiger by the Tail”, Presented by the Federal Reserve Bank of Atlanta  (Stone Mountain: Apr. 8, 2013).
As a complement to stress testing, federal banking regulators have also  emphasized the importance of forward-looking capital planning to  evaluate and assess a bank’s capital needs relative to its current and  planned business strategies. For example, OCC issued guidance that  discusses the OCC’s processes for evaluating a bank’s capital planning  and the various actions OCC may take to ensure a bank’s process and  capital levels remain adequate for its complexity and overall risks. As  another example, the Federal Reserve issued guidance describing its  expectations for internal capital planning at the large, complex bank  holding companies subject to its capital plan rule.
section_title: CAMELS Ratings and Other Risk Assessment Tools
paragraphs: As part of their efforts to engage in more forward-looking supervision,  federal banking regulators have been directing examiners to use the  management component of the CAMELS ratings to reflect underlying  risks, and have also been focusing on other ways to build more forward- looking risk-based elements into the CAMELS ratings.
FDIC officials said they have been trying to look at underlying risks in  a forward-looking fashion rather than relying on absolute earnings,  problem assets, and delinquencies. In June 2009, FDIC’s Division of  Supervision and Consumer Protection announced the “Forward- Looking Supervision” approach, which was delivered as a training  program and reinforced in subsequent guidance. The training  emphasized a forward-looking approach to examination analysis and  ratings based on the lessons learned that were identified in the  material loss reviews for those FDIC-regulated banks that failed  during the financial crisis. In an audit that reviewed the training, the  FDIC IG noted that it directed examiners to consider bank  management practices as well as current and prospective financial  performance and conditions or trends when assigning CAMELS  ratings. FDIC dedicated an issue of Supervisory Insights to  discussing interest rates risk and issued examiner guidance about  addressing risk management deficiencies surrounding interest rate  risk early.
In September 2011, OCC issued a supervisory memorandum to  examiners, drawing upon lessons learned from the financial crisis.  The guidance was intended to enhance examiners’ use and  communication of the Risk Assessment System (RAS). Examiners  use RAS to identify, communicate, and affect appropriate responses  to the buildup of risks or deficiencies in risk-management systems at  OCC-supervised institutions. The memorandum stated that examiners  should use RAS in conjunction with CAMELS ratings to identify  current and prospective risks and that the RAS assessments should  help inform CAMELS ratings. The memorandum noted that the  CAMELS management component rating too often reflected banks’  cooperation and commitment to correct deficiencies without  demonstrated performance. It stated that the management component  rating should focus on actions and results, rather than commitments.  Finally, the memorandum stressed that assigning an adverse rating to  the management component based on poor or missing practices,  before problems were evident in a bank’s financial condition, was one  of the tenets of sound and forward-looking supervision and an  important lesson learned from the recent financial crisis. More  recently, in response to recommendations included in a 2013  international peer review report, OCC staff said they had formed a  working group to determine what additional changes may be needed  to enhance the application of CAMELS and its integration with OCC’s  RAS to ensure that examiners use the RAS and CAMELS to identify,  assess, and document current and emerging risks.
Federal Reserve staff said that they are in the process of updating  prior guidance to examiners for evaluating the adequacy of banks’ risk  management processes. In 1995, the Federal Reserve issued  guidance directing examiners to assign separate supervisory ratings  for banks’ risk management practices, including internal controls, and  to give this rating significant weight when determining the rating of  management under CAMELS.  Federal Reserve staff said that they  tracked CAMELS downgrades both before and during the crisis and  believe the guidance was instrumental in helping examiners identify  and rate poor management practices. They said they are reviewing  the guidance to incorporate lessons learned from the crisis and  update where appropriate.
section_title: Matters Requiring Attention
paragraphs: MRA describes bank practices that deviate from sound governance,  internal control, and risk management principles, and have the potential  to adversely affect the bank’s condition, including its financial  performance or risk profile, if not addressed. MRAs also describe bank  practices that result in substantive noncompliance with laws and  regulations, enforcement actions, supervisory guidance, or conditions  imposed in writing. To improve the utility of MRA as a tool for getting  banks to address supervisory concerns in a timely manner, the Federal  Reserve, OCC, and FDIC have issued updated guidance on policy and  procedures related to the use of MRA.
In June 2013, the Federal Reserve updated and clarified existing  examiner guidance on communicating supervisory findings to banks.
Board of Governors of the Federal Reserve System, Rating the Adequacy of Risk  Management Processes and Internal Controls at State Member banks and Bank Holding  Companies, SR95-51 (Nov. 14, 1995).
In particular, the guidance addresses requirements for MRA and  matters requiring immediate attention (MRIA)—those matters that  pose potentially significant safety and soundness concerns, represent  significant noncompliance with applicable laws or regulations, or  repeat criticisms that have escalated in importance due to a bank’s  insufficient attention or inaction included in examination or inspection  reports or other supervisory communication. The guidance stipulates  that MRA and MRIA concerning safety and soundness or consumer  compliance must specify a time frame within which the banking  organization must complete the corrective action. Examiners are  expected to follow up and assess bank progress and verify  satisfactory completion. If the follow-up indicates the organization’s  corrective action has not been satisfactory, the guidance notes that  additional formal or informal investigation or enforcement action might  be necessary. Federal Reserve staff said they intended to rigorously  track MRA and MRIA and their status across banks.
OCC’s September 2011 examiner guidance stressed that early  intervention, such as MRA or formal or informal enforcement action, is  essential to resolving problems successfully. In determining the  appropriate level and type of intervention, the guidance stated that  examiners must consider the ongoing ability to correct problems and  demonstrated performance of management and boards, and  cautioned examiners not to mistake management or board’s  cooperation and willingness with their ability to remediate problems,  reduce risk, and improve the bank’s condition. In October 2014, OCC  updated its policy and procedures on MRA in response to  recommendations in the 2013 international peer review report that  OCC enhance MRA communication, tracking, and resolution  processes. The new MRA guidance emphasizes effective  communication and prompt identification and correction of deficient  practices (including those that are unsafe and unsound) before they  affect the bank’s condition. The guidance requires that examiners  track the supervisory concerns identified in the MRA. For example, for  concerns that are open, examiners must categorize them as either  new, repeat (if the same or substantially similar concern has  recurred), self-identified (by the bank), past due (when the corrective  action is not implemented in the expected time frame), escalated  (when subsequent to the MRA OCC addressed the uncorrected action  in an enforcement action), or pending validation (when the bank  implemented the corrective action, but insufficient time has passed for  it to demonstrate sustained performance). Examiners may categorize  an MRA as closed if the bank implements and OCC verifies and  validates the corrective action, or if the banks’ practices are no longer  a concern because of a change in the bank’s circumstances. These  new agency-wide tracking requirements of individual concerns within  an MRA are intended to help improve macro-prudential metrics, which  OCC staff stated will be useful for further sharpening supervisory tools  and practices.
In January 2010, FDIC issued examination guidance that outlined  procedures for including matters requiring board attention—the FDIC  equivalent of MRA—in examination reports and the tracking of such  matters for follow-up purposes. In the guidance, FDIC recognized  the significance of ensuring timely communication of identified  deficiencies that require attention by the bank’s board and  management and timely and effective follow-up by examiners to  determine the institution’s progress in addressing those concerns.  FDIC began conducting additional training for examiners on the  effective use of the guidance in 2010, and followed with further  training in 2014 and 2015. FDIC tracks matters requiring board  attention and related issues and identifies those actions that are  outstanding and requires examiner followup with bank management.
section_title: Systemic Risk Monitoring
paragraphs: Federal banking regulators told us that through FSOC they share and  receive information on potential systemic risks, some of which may affect  banks. FSOC’s three primary purposes under the Dodd-Frank Act are to identify risks to the financial stability of the United States that could  arise from the material financial distress or failure, or ongoing  activities, of large, interconnected bank holding companies and  nonbank financial companies, as well as risks that could arise outside  the financial services marketplace; promote market discipline by eliminating expectations on the part of  shareholders, creditors, and counterparties of these large companies  that the U.S. government will shield them from losses in the event of  failure; and respond to emerging threats to the stability of the U.S. financial  system.
To achieve these purposes, the Dodd-Frank Act gave FSOC a number of  important authorities that allow it to, among other things, collect  information across the financial system so that regulators will be better  prepared to address emerging threats and designate as systemically  important certain nonbank financial companies and subject them to  enhanced supervision by the Federal Reserve.
The Dodd-Frank Act also established the Office of Financial Research  (OFR) to serve FSOC and its member agencies by improving the quality,  transparency, and accessibility of financial data and information,  conducting and sponsoring research related to financial stability, and   In September 2012, we  promoting best practices in risk management.reported on challenges FSOC and OFR faced in fulfilling their missions,  FSOC’s and OFR’s efforts to establish management structures and  mechanisms to carry out their missions, and FSOC’s and OFR’s activities  for supporting collaboration among members and external stakeholders.  We made a number of recommendations to improve FSOC’s and OFR’s  effectiveness. FSOC and OFR have made some progress in  implementing these recommendations but additional attention on them is  needed.
Banking regulators also have taken steps to establish or enhance their  internal capabilities for monitoring the financial system for emerging risks  to banks.
In 2010, the Federal Reserve established the Office of Financial  Stability Policy and Research, to coordinate and support the Federal  Reserve’s work on financial stability. Working with other divisions, the  office identifies and analyzes potential threats to financial stability;  monitors financial markets, institutions, and structures; and assesses  and recommends policy alternatives to address these threats. Federal  Reserve staff explained that this office is focused on thinking about  risk to the financial system as a whole, including the shadow banking  system, and identifying which features of the financial system are  weak. When issues surface that are centered on the banking system,  they said this office coordinates with the Division of Banking  Supervision and Regulation to address them. If the issues are not  centered on the U.S. banking system, they work with FSOC or other  appropriate groups.
OCC conducts agency-wide risk assessments through its National  Risk Committee, which was formed in late 1990s to, among other  things, monitor the condition of the federal banking system and  emerging threats to the system’s safety and soundness. Members  include senior agency officials who supervise banks of all sizes, and  officials from the law, policy, and economics departments. The  Committee meets biweekly to assess emerging risks and to evaluate  and make recommendations on appropriate supervisory responses to  address those risks The National Risk Committee also issues  quarterly guidance to examiners that provides perspective on industry  trends and highlights issues requiring supervisory attention. In  response to the financial crisis, OCC staff said the National Risk  Committee began publishing a public Semiannual Risk Perspectives  Report to provide bankers and other market participants with OCC’s  views on emerging risks facing the industry and OCC’s supervisory  priorities. Also in response to the financial crisis, the National Risk  Committee has developed various analytical tools as part of its  monitoring efforts, including early warning metrics designed to identify  early trends in financial markets, credit underwriting, credit  performance, and bank performance. In response to the 2013  international peer review report recommendations, OCC staff said  OCC established a pilot team in January 2015 to further develop and  enhance OCC’s supervisory risk analysis functions.
In response to the 2007-2009 financial crisis, FDIC broadened its  institutional approach to the identification and management of risk. In  2011, the Board of Directors created the new position of Chief Risk  Officer, and approved the creation of a new Enterprise Risk  Committee. That committee includes division and office directors and  meets at least monthly to review external and internal risks to FDIC. In  2014, the Enterprise Risk Committee established the External Risk  Forum and the Management Risk Roundtable to focus specially on  external risks. The Management Risk Roundtable serves as an  interdivisional forum for coordinating risk analysis, while the External  Risk Forum meets at least eight times per year to discuss external risk  topics proposed by the Management Risk Roundtable. To further  support the External Risk Forum, FDIC staff said FDIC continues to  convene Regional Risk Committees semi-annually in each of the six  FDIC supervisory regions. FDIC established these committees in  2003 to review and evaluate regional and economic banking trends  and risks.
The Federal Reserve, OCC, and FDIC also have established or  enhanced programs to supervise the largest, most complex, and  systemically important institutions, both in response to Dodd-Frank Act  requirements and internal initiatives.
Under the Dodd-Frank Act, the Federal Reserve has the responsibility  for the supervision of systemically important financial institutions  (SIFIs), including large bank holding companies, the U.S. operations  of certain foreign banking organizations, and nonbank financial  companies that are designated by FSOC for supervision by the  Federal Reserve. The act also requires the Federal Reserve to  impose a variety of regulatory reforms on SIFIs, including enhanced  risk-based capital, leverage, and liquidity requirements. The Federal  Reserve issued its final rule establishing enhanced prudential  standards for bank holding companies in March 2014. To fulfill this  mandate and to reorient its supervisory program in response to the  supervisory lessons learned from the financial crisis, the Federal  Reserve created the Large Institution Supervision Coordinating  Committee, which is tasked with overseeing the supervision of the  largest, most systemically important financial institutions in the United  States. Federal Reserve staff said the committee was developed to  provide strategic and policy direction for supervisory activities across  the Federal Reserve System, improve the consistency and quality of  supervision, incorporate systemic risk considerations, and monitor the  execution of the resulting supervisory program. Federal Reserve staff  noted that the committee takes a macroprudential perspective by  considering information gleaned from its Quantitative Surveillance  group, which is charged to identify systemic and firm-specific risks  through macroeconomic scenarios and loss forecasts, financial  market vulnerabilities, and measures of interconnectedness among  firms.
OCC supervises its largest and most complex banks through its Large  Bank Supervision Program. The 2013 international peer review report  recommended that OCC enhance risk identification by expanding the  role of lead experts in its examinations. OCC announced in May 2014  that it would take steps to address the report’s findings and  recommendations, for example, by expanding the responsibilities of  its Large Bank Supervision lead expert program to improve analysis,  systemic risk identification, quality control and assurance, and  resource prioritization. The lead experts provide additional guidance  during horizontal reviews into the strategy planning process for each  large bank portfolio.Supervision program has also established and implemented its Large  Bank Risk Committee, whose purpose includes discussing material  portfolio risks, including emerging risks, and determining appropriate  supervisory responses.
According to OCC staff, OCC’s Large Bank
FDIC was given significant new responsibilities under the Dodd-Frank  Act to resolve failing systemically important financial companies.  Specifically, FDIC obtained Orderly Liquidation Authority to resolve  the largest and most complex bank holding companies and non-bank  financial institutions, and the authority to review the resolution plans  submitted by covered financial companies. In late 2010, FDIC  established the Office of Complex Financial Institutions to carry out  three core functions: (1) monitor risk within and across these large,  complex firms from the standpoint of resolution; (2) conduct resolution  planning and the development of strategies to respond to potential  crises; and (3) coordinate with regulators overseas on the significant  challenges associated with cross-border resolution. In 2011, the office  established its complex financial institution monitoring program that is  intended to engage in continuous review, analysis, examination, and  assessment of key risks and control issues at institutions with assets  over $100 billion. FDIC staff said that the office’s risk monitoring  responsibilities were transferred to the FDIC’s Division of Risk  Management and Supervision–Complex Financial Institutions group in  early 2013. This group handles all institutions that are designated as  systemically important, not by a specific asset size.
As reported in our July 2012 report, the Federal Reserve and FDIC  have taken certain regulatory actions mandated by the Dodd-Frank  Act authorities toward facilitating orderly resolution, including efforts  that could contribute to cross-border coordination. Specifically,  certain large financial companies must provide the Federal Reserve  and FDIC with periodic reports of their plans for rapid and orderly  resolution in the event of material financial distress or failure under the  Bankruptcy Code. For example, bank holding companies with $50  billion or more in total consolidated assets and nonbank financial  companies designated for Federal Reserve supervision are to submit  resolution plans on an annual basis. The resolution plans or living  wills are to demonstrate how a company could be resolved in a rapid  manner under the Bankruptcy Code. In 2014, FDIC and the Federal  Reserve sent letters to a number of large financial companies  identifying specific shortcomings with the resolution plans that those  firms will need to address in their 2015 submissions, due on or before  July 1, 2015, for the first group of filers.
section_title: Framework for Monitoring Regulatory Efforts Could Identify Issues Requiring Additional Attention
paragraphs: Ongoing monitoring of banking regulators’ efforts to identify and respond  to emerging threats to the banking system can provide a starting point for  identifying opportunities for more targeted and frequent assessments of  these efforts. We have previously stated that identifying risks to U.S.  financial stability and responding to emerging threats to stability are  inherently challenging. It is important for oversight bodies such as IGs  and the international auditing community to understand how the banking  system could be vulnerable to such potential threats, so as to be better  prepared to consider whether regulators are alert to and responsive to the  buildup of risks in various markets and the threat of such risks to the  broader banking system. As regulators implement a forward-looking  approach to identify and respond to emerging risks to the banking  system, a near real time assessment of regulators’ efforts could provide  opportunities to identify weaknesses and provide timely suggestions to  enhance their effectiveness. As such, we have developed a framework for  oversight bodies and others to use to monitor regulatory efforts. Our  framework has two objectives: (1) to monitor known emerging risks to the  safety and soundness of the banking system; and (2) to monitor  regulatory responses to these risks, including detecting trends in  regulatory responses that might signal a weakening of regulatory  oversight. We have developed a monitoring program around each of  these objectives, described below.
subsections: section_title: Monitoring Emerging Risks
paragraphs: The first part of the framework focuses on monitoring emerging risks to  the banking system. Emerging risks are vulnerabilities in the banking  system which, given a shock or series of shocks outside the system, can  cause the failure of a systemically important bank or multiple banks.  Examples of vulnerabilities include a credit or asset price bubble, lax loan  underwriting standards, insufficient bank capital or liquidity buffers to  absorb losses or withdrawals, and risk exposure through a maturity  mismatch between assets and liabilities. A triggering event or shock  could be political or economic—such as turmoil in a region, the collapse  of a market—or even result from a natural disaster. The first part of the  framework centers around three key areas in the financial system in  which risks to banks can emerge: (1) bank financial condition and  performance, (2) asset markets in which banks have direct or indirect  exposure, (3) and overall economic conditions.
The framework identifies both qualitative and quantitative sources of  information to help users identify and monitor known emerging risks to the  banking system. Qualitative sources of publicly available information on  emerging risks include regulatory, market, and academic reports and  studies. For example, OCC semiannually publishes a report identifying  emerging risks to its regulated institutions, and the Federal Reserve and  OCC publish periodic surveys on underwriting practices at their regulated  institutions, which can provide insights into potential emerging risks from  the three key areas. Qualitative monitoring can also help identify financial  innovations and new banking products and services that could pose risks  to the banking system. FSOC and OFR annual reports, which identify  potential systemic risks that can include risks to the banking system, are  another source of information. In addition, market analyses, including  those by trade publications, policy or research organizations, and the  financial press often highlight industry trends, some involving risky bank  behavior. Academics also may produce work discussing emerging trends  in the banking industry including their potential impacts on bank capital,  liquidity, or borrowers.
To complement this review, the framework also identifies a set of financial  indicators commonly used by regulators and market professionals that  facilitate the monitoring of trends in banks’ financial condition, asset  markets, and general economic conditions. Regularly reviewing financial  data will allow oversight bodies to independently stay current with these  trends, track known risks to the banking system as the risks evolve, and  better understand the context for regulatory responses to these risks, as  we discuss below. Such a review also promotes continuity to monitoring  efforts, as qualitative information sources on emerging risks tend to  provide new or updated information on a periodic basis.
subsections: section_title: Bank Financial Condition
paragraphs: The framework includes financial indicators that reflect bank condition  and performance that can provide insight into emerging risks at banks  (and bank holding companies, in the case of the largest SIFIs), such as  credit risk, liquidity risk, and market risk. For example, users can  monitor capital levels and leverage, asset quality, ear  nings trends, funding liquidity, and sector loan concentrations. As a result,  they may be able to identify risk buildups or deteriorating credit trends.  For example, rapid increases in the price of particular kinds of assets and  concentrations relative to historical norms or increases in specific types of  funding sources could indicate high levels of credit or maturity  mismatches. These are all early warning indicators of bank vulnerabilities  or buildup of risk that could lead to failure if not addressed effectively and  in a timely manner. In the lead up to the most recent crisis, for example,  house prices rose rapidly, and when the real estate bubble burst, banks  with a significant concentration in commercial and residential real estate  suffered heavy losses that wiped out their capital and ultimately led to  their failures.
section_title: Asset Markets
paragraphs: The framework also includes indicators that detect changes in asset  markets, such as sharp increases in asset prices or deviations from  historical trends. In general, rapid growth in asset prices that leads to  overvalued assets can create vulnerability in the financial system,  including the banking sector, because the collapse of high prices can be  destabilizing—especially if the assets are widely held and the values are  supported by excessive leverage, maturity mismatch, or mispricing of risk.  For example, the former Federal Reserve Chairman noted in a May 2013  speech that the collapse of housing prices and related mortgage losses  during the recent crisis were concentrated in critical parts of the financial  system, and amplified through various financial instruments, resulting in panic that led to asset fire sales and the collapse of the credit markets.Conversely, he said, the bursting of the tech bubble—the rapid decline of  overvalued technology stocks in the equity markets in 2000 through  2001—did not result in systemic risk because the stock investments were  not funded with excessive leverage and maturity mismatch.
Commodities markets are very broad and they include soft commodities like agricultural  products such as wheat, coffee, and sugar, or hard commodities such as oil, gold, and  rubber. Risks to the banking sector may emerge from exposure to these markets. For  example, some banks might have lending exposures on their balance sheets that could be  impacted by falling oil prices. Should these loans become nonperforming or default, the  banks would have to incur some losses unless they successfully hedged the risk. ability to obtain new credit from banks as any additional debt could put a  strain on their repayment capacity. Similarly, volatility tends to be  negatively correlated with market performance. That is, volatility tends to  decline as the stock market rises and increase as the stock market falls.  When volatility increases, risk increases and expected returns decrease  and this in turn could negatively impact access and the availability of  credits to businesses and households.
section_title: Broader Economy
paragraphs: Finally, our framework includes indicators that monitor the overall health  of the broader economy. Interconnectedness and risk exposures among  the financial sector and broader economy can magnify systemic risks. For  example, the former Federal Reserve Chairman said that highly  leveraged households and businesses are less able to withstand adverse  changes in income and wealth, such as when financially stressed firms  are forced to lay off workers who, lacking financial reserves, sharply cut  their own spending. Such stress in the nonfinancial sector can  adversely affect banks, as borrowers begin to default on mortgages and  other types of consumer and business credit. As happened in the 2007- 2009 financial crisis, this can create a cycle where housing market  instability becomes self-reinforcing as banks reduce lending and shed  assets to conserve capital, thereby further weakening the financial  positions of households and firms. Thus, in monitoring for information on  emerging risks to banks’ safety and soundness, it is important to pay  attention to trends in the broader economy that could amplify these risks  (such as trends in household income and debt, unemployment and gross  domestic product) and their potential impact.
section_title: Monitoring Regulatory Responses
paragraphs: The second half of the framework focuses on monitoring corresponding  regulatory responses to emerging risks with the goal of flagging issues for  further review where the response may not be clear or questions have  arisen as to whether these measures have mitigated the risk. The review  of regulatory responses builds on the financial monitoring efforts  previously discussed, coupling efforts to better understand current  financial conditions and emerging risks with an enhanced understanding  of the regulatory efforts under way to address such conditions and  risks. Thus, the monitoring of regulatory responses includes the analysis  of regulatory actions taken to address emerging risks.
Regulators can respond to emerging risks in the banking sector with a  variety of supervisory tools. These include microprudential tools, which  traditionally have focused on the safety and soundness of individual  financial institutions, and macroprudential tools, which can be used to  address vulnerabilities across the banking system and broader financial  system. Microprudential tools include examinations and capital regulation  for individual institutions; macroprudential policy tools include  underwriting standards and countercyclical capital buffers. Supervisory  tools intended to address emerging risks can also be structural or cyclical.  Structural tools are intended to build resiliency of regulated institutions to  vulnerabilities, while cyclical tools are intended to limit vulnerabilities by  restraining financial institutions from excesses. Capital regulation is an  example of a structural tool because requiring banks to hold more and  higher quality capital improves the ability of regulated financial institutions  to withstand losses and maintain lending after a bubble has burst.  Countercyclical capital buffers, on the other hand, are an example of a  cyclical tool because they are intended to counter excessive credit growth  that can fuel asset bubbles. Supervisory stress tests are tools that include  both structural and cyclical aspects.
In monitoring regulatory responses to emerging risks, it is important to  identify the full range of tools regulators might employ to address such  risks, the goals of these tools, and their potential tradeoffs. For example,  a 2013 Federal Reserve Bank of New York staff report noted that  microprudential tools have largely been developed and evaluated on the  basis of the safety and soundness of individual institutions, not with  respect to the effects on financial stability of practices that are common to  many institutions, and it will be important to continue to evaluate their  effectiveness in this context. Further, while microprudential and macroprudential policy tools can be complementary, these two  approaches might also conflict with each other. Moreover, as a former  Federal Reserve Board member noted, regulatory tools that aim to  increase the resilience of regulated institutions and limit potential asset  bubbles by restraining the growth of lending by such institutions can be  circumvented when financial activities migrate into less regulated parts of  the financial system such as the shadow banking sector. As such, she  said that credit extension and associated vulnerabilities can increase  outside the heavily regulated banking system. To mitigate the risks that  may emerge as a result, effective and timely coordination among the  banking and other relevant financial regulators is essential. These  analyses could provide information on regulators’ willingness and ability  to take prompt and forceful actions to mitigate problematic behavior at  banks. They could also signal potential procyclical effects of regulation;  that is, when regulation may not adequately discourage overly risky  behavior during economic upswings or may inhibit bank lending during  downturns, as banks may need to meet requirements during times when  it is more difficult to do so.
A leveraged loan is a loan where the obligor’s post financing leverage as measured by  debt-to-assets, debt-to-equity, cash flow-to-total debt, or other such standards unique to  particular industries significantly exceeds industry norms for leverage.  Leveraged  borrowers typically have a diminished ability to adjust to unexpected events and changes  in business conditions because of their higher ratio of total liabilities to capital. These  loans are usually structured, arranged, and administered by one or several commercial or  investment banks known as arrangers. They are then sold, (or syndicated) to other banks  or institutional investors. lending volumes, leveraged lending loan losses, and reports on  underwriting standards. Where questions exist on regulators’ efforts to  mitigate emerging risks, including the propensity for such a risk to migrate  to a less regulated sector of the market, framework users can prioritize  those issues for further internal discussion and reach out to the regulators  to obtain clarification if necessary.
In applying the framework, there may be instances where users identify  issues that regulators may not consider to be emerging risks, but others  do, such as market participants or market researchers. Users of the  framework may also identify potential issues through their independent  review of source material. Such discrepancies may raise questions about  regulatory processes for monitoring and identifying emerging risks and  warrant additional follow up with regulators. Some issues may not  represent an emerging risk to the banking system, but may raise  questions about regulatory oversight over banks or banking activities. As  users apply the framework, it is essential they develop processes to  systematically evaluate the information gathered and identify and  prioritize those issues which merit continued monitoring and an  assessment of regulatory responses. In many cases, as illustrated earlier,  users of the framework can identify potential issues and assess  regulatory responses to them, determining to conduct additional follow up  with regulators only where this initial review reveals significant concerns  that a particular risk might not be effectively mitigated.
subsections: section_title: Trends in Examination Data
paragraphs: Trends in examination data, such as CAMELS ratings, can provide  information on regulators’ identification of and response to concerns of  banking safety and soundness. Our framework uses CAMELS ratings to  monitor regulatory activity in two ways: (1) trend analysis of composite  and component CAMELS ratings for insights into emerging risks  regulators have identified and (2) an econometric model that identifies  shifts in regulators’ assignment of CAMELS ratings relevant to bank  financial data.
Regulators formulate the CAMELS composite ratings using the individual  component ratings, but the rating is not a mathematical average of the  components. Individual component ratings may be lower or higher  compared with the overall composite rating assigned. As discussed  earlier, banking regulators generally consider banks with a composite  rating of 1 or 2 to be healthy, while banks receiving an unsatisfactory  examination warrant a composite rating of 3 or above. Monitoring trends  in CAMELS ratings could provide insights into risks that are emerging in  the banking system and prompt further review into the actions regulators  are taking to respond to those risks. To illustrate, in our June 2011 report  on PCA, we found that increases in CAMELS composite or component  ratings can serve as warning signals of distress in banks. While most  banks that failed degraded from a CAMELS composite rating of 2 to a 4 in  one quarter, they generally had at least one component rating of a 3 prior  to failure. Specifically, among the 292 failed banks we reviewed (across  all regulators) as part of our study, most (76 percent) received at least  one individual component CAMELS rating of a 3 before failure. At the  same time, most (65 percent) also moved past the composite CAMELS 3  rating in a single quarter (e.g., moving from a 2 to 4) before failure, as the  CAMELS composite ratings generally deteriorated precipitously.
As we discussed earlier, CAMELS ratings have not always reflected long- term risk factors, particularly with respect to poor management practices.  While trend analysis of CAMELS data is useful for spotting affirmative  regulatory actions—decisions to downgrade (or upgrade) ratings in  response to examination findings—such analysis is limited in that it does  not provide information when regulators are not changing CAMELS  ratings in response to observed bank conditions. Ideally, in applying our  framework, users could identify any issues or challenges regulators are  facing in mitigating emerging risks at banks before problems manifest  themselves on the balance sheets.
To better observe changes in regulatory behavior as banking and  economic conditions change, we are exploring the potential of using  econometric models to monitor for shifts in regulatory behavior, which  may help identify periods where regulators are having difficulty reigning in  risky behavior or are changing the levels of regulatory discretion they  apply to their supervision activities. Such models could also assist in  placing into context issues that arise during reviews of banking regulators  and prompt further follow up with regulators to understand more fully the  reasons behind the changes.
section_title: Monitoring Trends in Enforcement Activity
paragraphs: Trends in enforcement activity also can provide information on regulatory  responses to emerging risks. For example, 2005-2007 was a period of  strong earnings growth and profitability in the banking industry (see fig.  1).
During this time, three banks failed (all in 2007) and 76 intuitions or fewer  were on the problem bank list. This period of growth and profitability was  largely fueled by aggressive growth in higher risk mortgage-related loans  and funded by more volatile sources such as brokered funds and  wholesale short-term borrowing. However, enforcement activity was   From 2005 to 2007, the three regulators  relatively low (see fig. 2).issued a total of 740 informal enforcement actions and 392 formal  actions, an average of 247 informal actions and 131 formal actions per  year during that time frame.
Once the crisis began, and banks began suffering losses, the level of  informal and formal enforcement actions surged as did the number of  problem banks and failed banks. For example, from 2008 to 2010, the  three regulators issued a total of 2,513 informal actions and 1,871 formal  enforcement actions. This averaged about 838 informal actions and 624  formal actions per year. Since 2010, as the crisis and its effects began to  abate, both informal and formal actions steadily declined.
Monitoring trends in enforcement activity can provide oversight bodies  insight into identified risks and regulatory responses to those risks. When  evaluating trends in enforcement actions, it is important to understand the  underlying deficiencies in bank practice and performance, as enforcement  actions are taken for many reasons. Understanding trends in enforcement  activity in relation to identified risks could allow auditors to observe the  rigorousness of regulatory responses to such risks. In doing so, it is  important to also consider available information on other regulatory  responses to identified risks. For example, reviewing trends in MRA,  particularly those outstanding or repeat, could provide additional insights  about regulators’ efforts to take effective action to promptly address  problems at banks.
As with trend analysis of CAMELS ratings, trend analysis of MRA and  other informal and formal enforcement actions might be useful for spotting  changes in affirmative regulatory decisions to act on examination  findings—that is, an increase in the number of MRA related to credit  administration would indicate that examiners were concerned about risk  management practices at banks and were flagging these issues for banks  to address. While regulators have committed to using MRA more  aggressively, determining whether they have done so requires an in  depth review of examination findings and regulators’ actions to address  them in accordance with their policies and procedures. Such a review  could be conducted on a regular basis, or used as a more tailored  mechanism in response to findings from other monitoring activities.
section_title: Monitoring the Issuance of Agency Guidance and Regulation
paragraphs: Our framework also recognizes that regulators can respond to emerging  problems through regulation or guidance for the industry. Tracking the  issuance of agency guidance and regulations in response to emerging  issues will allow users of the framework to better understand how  regulators deal with a particular risk and also allow them to flag potential  issues in the efficiency and effectiveness of interagency coordination in  response to risks that affect the banking system. For guidance and  regulation to be effective, they must be issued in a timely manner. As  noted earlier, although banking regulators were concerned about the  rapid buildup of risky CRE concentrations across the banking system,  staff from one regulator said they acted too late in drafting and issuing  interagency guidance for the industry. Losses on these higher risk loans  were a primary factor in bank failures resulting from the financial crisis.  The 2013 OCC peer review noted that delays in the issuance of guidance  or regulation to address emerging risks can be demoralizing for  examiners who may perceive that agency management has not acted on  their risk identification and warnings.guidance or regulation, users of the framework would monitor quantitative  and qualitative sources for trend information on the identified problem  area for evidence that risk was increasing, flagging potentially harmful  delays in regulatory action for further follow up.
To monitor the timeliness of  For guidance and regulation to be effective, they also must serve to  mitigate the emerging risk. For that reason, we plan to review quantitative  and qualitative sources for information on the effectiveness of guidance or  regulation in addressing the problem identified. For example, in April  2013, Federal Reserve and OCC staff issued a study analyzing the  impact of the 2006 CRE guidance. was underway, banks responded to market conditions and the guidance  by shrinking their holdings of CRE loans, particularly for higher-risk ADC.  Should CRE lending show strong growth in the future, it will be important  to continue to monitor the effectiveness of the guidance for curbing  excessive risks in CRE lending while institutions are still profitable.
The study found that once the crisis  Banking regulators’ primary objective is the promotion of safety and  soundness of banks and the banking system. Effective regulation and  supervision can, in turn, provide an important safeguard against future  financial crises and provide an important source of confidence to the  market about the general health and resiliency of the banking sector.  Lessons learned from past banking-related crises identified the need for  federal banking regulators to respond proactively to problems developing  in the banking system. Building on these lessons, we plan to implement  our framework to monitor regulatory responses to emerging risks to the  banking system. We intend to refine our framework over time by  incorporating new sources of qualitative and quantitative information on  emerging risks and by developing additional models as new analytical  tools to aid in the monitoring and evaluating of regulatory responses to  these risks become available.
Friend, Keith; and Glenos, Harry (OCC), and Nichols, Joseph B. (Federal Reserve), An  Analysis of the Impact of the Commercial Real Estate Guidance (Washington, D.C.: April  2013).
section_title: Agency Comments
paragraphs: We are not making recommendations in this report. We provided a copy  of this draft report to the Federal Reserve, FDIC, OCC for review and  comment. The agencies did not offer formal comments but each agency  provided technical comments, which we have incorporated, as  appropriate.
We are sending copies of this report to the appropriate congressional  committees and members and other interested parties. This report will  also be available at no charge on our website at http://www.gao.gov.  Should you or your staff have questions concerning this report, please  contact me at (202) 512-8678 or evansl@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 II.
section_title: Appendix I: Objective, Scope, and Methodology
paragraphs: The thrift and commercial bank crises that emerged in the 1980s and the  2007-2009 financial crisis raised questions on our part about federal  banking regulators’ efforts to learn from past weaknesses in regulatory  oversight over insured banks and apply the appropriate lessons learned.  Such regulatory lessons learned also may offer potential insights for  Congress, the auditing community, and other “watchdog” entities in more  proactively assessing federal banking regulators’ efforts to identify and  respond to potential emerging risks to insured banks. This report (1)  examines regulatory lessons learned from the 1980s thrift and  commercial bank crises and the 2007-2009 financial crisis, focusing on  the efforts of federal banking regulators to identify and address emerging  risks to the solvency of insured banks before the onset of these crises;  and (2) offers a strategy that we and other oversight bodies, such as  inspectors general (IGs) and the international auditing community  (hereafter, oversight bodies) can use to provide continuous future  oversight of regulatory responses to emerging risks.
To identify regulatory lessons learned from the crises we reviewed and  analyzed studies by GAO, federal banking regulator IGs, the federal  banking regulators, and academics. To identify relevant academic  studies, we performed the literature search using the following databases:  ProQuest (which included SSRN, EconLit, and ABI/INFORM Global),  JSTOR, and NBER, using the following keywords or combinations of  them: financial crisis, savings and loan, thrift, lessons learned, regulatory  action, banking, and great recession. We performed these searches for  the period between January 1980 (the commencement of the 1980s thrift  and banking crises) and August 2013 and identified 24 studies. We  reviewed each study to identify those lessons learned that pertained  specifically to regulatory efforts to identify and address emerging risks to  the banking system in the years leading up to the crises. We did not  identify many studies on relevant lessons learned from this search. As  such, we determined to rely largely on our own prior work in the area. We  also interviewed the federal banking regulators—the Federal Deposit  Insurance Corporation (FDIC), the Office of the Comptroller of the  Currency (OCC), and the Board of Governors of the Federal Reserve  System (Federal Reserve)—and two of their IGs for their perspective on  regulatory lessons learned and regulatory actions taken to address these  lessons learned. We analyzed the information we gathered to identify  common and unique challenges regulators faced across the crises in  identifying emerging risks and responding to them effectively.
To incorporate the regulatory lessons learned into a strategy that  oversight bodies and others can use to monitor regulatory responses to  emerging risks, we established a framework for monitoring (1) known  emerging risks to the safety and soundness of the banking system, and  (2) regulatory responses to these risks, including detecting trends in  regulatory responses that might signal a weakening of regulatory  oversight. To develop the first part of our framework—monitoring known  emerging risks to the safety and soundness of the banking system—we  first reviewed frameworks or programs for monitoring domestic and global  financial systems that included banking systems. We sought to identify  relevant frameworks developed by federal banking regulators and federal  agencies through our interviews with the regulators and prior audit work.  We identified relevant frameworks developed by the Federal Reserve,  OCC, and the Office of Financial Research (OFR), as well as a banking  profile published quarterly by FDIC. We also sought to identify relevant  frameworks developed by foreign banking regulators and international  organizations that focus on global finance or banking issues. Through our  review, we identified relevant frameworks and monitoring programs  developed by the following entities: the European Central Bank, the  Financial Stability Board, the International Monetary Fund, and the Bank  for International Settlements. We analyzed these domestic and global  frameworks and programs to identify key areas where risks to the banking  system could arise and identified three: bank condition and financial  performance, asset markets in which banks may have direct or indirect  exposure, and overall economic conditions.
First, potential sources of risk can emerge from within the banking sector,  such as banks’ business models, size, scope of operations, and  organizational complexity, among other things. Other risks that can arise  from bank condition are driven by risk management practices, loan  portfolio composition, and underwriting standards. Second, risk  emanating from banks could spread and spillover to other industry  sectors. Risks to the banking system can originate from other areas of the  financial system, particularly asset markets in which banks participate  either directly or indirectly. Developments in these asset markets such as  rapid asset price growth or decline can have a direct impact on bank  portfolios and their capacity to access funding in a cost-effective way. The  third area we identified through our analysis as a potential area where risk  to banks could stem from was the broader economy, in that economic  conditions generally impact asset markets and the profitability of banks  and bank customers and counterparties. A growing economy with low  unemployment tends to have a more favorable impact on banks and  markets than a recessionary economy with high unemployed workers.
As part of our framework, we also identified financial indicators that will  assist users of the framework in monitoring potential risks to the banking  industry emerging from the focus areas. For example, a number of our  indicators for bank condition and safety and soundness are derived from  the Uniform Financial Institutions Rating System, commonly known as  CAMELS. Regulators use this ratings system to, among other things,  assess the soundness of banks on a uniform basis, identify those  institutions requiring special supervisory attention, monitor aggregate  trends in overall soundness of financial institutions, and assess their  exposure to risks. The ratings reflect a bank’s condition in six categories  or CAMELS’ components: capital adequacy, asset quality, management,  earnings, liquidity and sensitivity to market risk. For each CAMELS  component other than management, there are a number of financial ratios  that can be calculated based on Reports of Condition and Income (Call  Report) data that assist in the evaluation of how well or poorly a bank is  performing in that category. We selected those ratios that could be  determined quantitatively based on Call Report data. For example, the  management component of the CAMELS does not lend itself to the same  computation as that used for ratios based on capital or earnings. It  requires more qualitative assessment by examiners and therefore it is  more discretionary and more subjective than the other CAMELS  components. Also, all the ratios that pertain to a component need not be  included to show a trend. For example, in asset quality, we may choose  to illustrate loans that are 90 days or more past due rather than showing  also those that are 30 days past due and 60 days past due because the  implications of loans 90 days or more past due are more severe. From  the monitoring frameworks we reviewed, we identified indicators that track  asset price growth in key markets—including the residential and  commercial real estate markets, equity market, Treasury market,  corporate bond market, and the commodities market. In addition, we  include indicators that track leverage and volatility that could impact the  banking system. We also identified indicators that track the overall health  of the broader economy from the monitoring frameworks we reviewed,  such as household income and debt, unemployment, and gross domestic  product. In addition to financial indicators, our framework also  incorporates publicly available qualitative information on emerging risks to  the banking sector from banking regulators, and other entities that might  have a unique or varying perspective on emerging risks, such as  investors, rating agencies, trade associations, and academics. Our  framework does not prescribe specific entities or sources to review,  rather, we recommend incorporating a wide range of available analyses  and perspectives.
In developing the second part of our framework, we identified the range of  supervisory tools that banking regulators have available to them to  respond to emerging issues in banks and the banking system, including  both microprudential and macroprudential tools. From our prior work, we  identified microprudential tools, which traditionally have focused on the  safety and soundness of individual financial institutions. From the  monitoring frameworks we reviewed, we identified examples of  macroprudential policy tools, which can be used to address risk emerging  across the banking system and broader financial system. We also  identified those supervisory tools that can be observed and analyzed over  time to monitor for changes in regulatory behavior and that could signal  potential weaknesses in regulatory oversight—such as examinations and  enforcement actions. We did this by reviewing our prior work in assessing  regulatory responses to risks as they emerged in the lead up to the 1980s  bank and thrift crises and the 2007-2009 financial crisis. To supplement  this effort, we interviewed a judgmental sample of financial market  specialists for their views on those regulatory activities that could be  effectively monitored to detect meaningful changes in regulatory behavior.  Because the information and type of analysis we were interested in  required the knowledge of both regulatory activities and financial trends,  we interviewed a purposive or non-generalizable sample of seven  financial market specialists on their views of regulatory activities that  could be effectively monitored to detect meaningful changes in regulatory  behavior. To ensure the financial market specialists represented a broad  range of views and professional experience, we recruited participants  from government, academia, and business who had in-depth knowledge  of the 1980s thrift and commercial bank crises or the 2007-2009 financial  crisis as evidenced by holding key leadership positions in government or  industry or having published relevant academic research on the  regulation of financial services. We identified these financial market  specialists through prior GAO studies, academic publications, and from  recommendations by other financial market specialists.
To illustrate trends in enforcement activity across various economic  cycles, we obtained data on the number and type of enforcement actions  taken against financial institutions supervised by OCC, FDIC, and the  Federal Reserve, published in their annual reports dated 2005 through  2014. We have assessed the reliability of federal banking regulators’  enforcement action data as part of previous studies and found the data to  be reliable for the purposes of our review, which is to illustrate trends in  informal and formal enforcement actions. We also obtained Call Report  data from SNL Financial database on the yields on earnings assets of  financial institutions from 2005 to 2014 for four bank size groups. These  bank size groups include (1) banks with over $50 billion in assets, (2)  banks with assets between $10 billion and $50 billion, (3) banks with  more than $1 billion but less than $10 billion in assets, and (4) banks with  $1 billion or less in assets. We assessed the reliability of the SNL  Financial data by reviewing existing information about the data and the  system that produced them. In addition, we have assessed the reliability  of SNL Financial data as part of previous studies. As such, we found the  data to be reliable for the purposes of our review, which was to illustrate  trends bank profitability over time.
We conducted this performance audit from February 2013 to June 2015  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, A. Nicole Clowers (Managing  Director), Karen Tremba (Assistant Director), Stefanie Jonkman  (Assistant Director/Analyst-in-Charge), Abigail Brown, William Cordrey,  Janet Eackloff, M’Baye Diagne, Bethany Benitez, Pamela Davidson,  Rachel DeMarcus, Maksim Glikman, Michael Hansen, Risto Laboski,  Marc Molino, Robert Pollard, and Barbara Roesmann made key  contributions to this report.