Bank Regulation: Modified Prompt Corrective Action Framework Would Improve Effectiveness
Published: 2011-06-23T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: More than 300 insured depository institutions have failed since the current financial crisis began in 2007, at an estimated cost of almost $60 billion to the deposit insurance fund (DIF), which covers losses to insured depositors. Since 1991, Congress has required federal banking regulators to take prompt corrective action (PCA) to identify and promptly address capital deficiencies at institutions to minimize losses to the DIF. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires GAO to study federal regulators' use of PCA. This report examines (1) the outcomes of regulators' use of PCA on the DIF; (2) the extent to which regulatory actions, PCA thresholds, and other financial indicators help regulators address likely bank trouble or failure; and (3) options available to make PCA a more effective tool. GAO analyzed agency and financial data to describe PCA and DIF trends and assess the timeliness of regulator actions and financial indicators. GAO also reviewed relevant literature and surveyed expert stakeholders from research, industry, and regulatory sectors on options to improve PCA.
section_title: What GAO Found
paragraphs: Although the PCA framework has provided a mechanism to address financial deterioration in banks, GAO's analysis suggests it did not prevent widespread losses to the DIF--a key goal of PCA. Since 2008, the financial condition of banks has declined rapidly and use of PCA has grown tenfold. However, every bank that underwent PCA because of capital deficiencies and failed in this period produced a loss to the DIF. Moreover, these losses were comparable as a percentage of assets to the losses of failed banks that did not undergo PCA. While regulators and others acknowledged PCA's limitations, regulators said that the PCA framework provides benefits, such as facilitating orderly closures and encouraging banks to increase capital levels. PCA's triggers limit its ability to promptly address bank problems, and although regulators had discretion to address problems sooner, they did not consistently do so. Since the 1990s, GAO and others have noted that the effectiveness of PCA, as currently constructed, is limited because of its reliance on capital, which can lag behind other indicators of bank health. That is, problems with the bank's assets, earnings, or management typically manifest before these problems affect bank capital. Once a bank falls below PCA's capital standards, a bank may not be able to recover regardless of the regulatory action imposed. GAO tested other financial indicators, including measures of asset quality and liquidity, and found that they were important predictors of future bank failure. These indicators also better identified those institutions that failed and did not undergo the PCA process during the recent crisis. Although regulators identified problematic conditions among banks well before failure, the presence and timeliness of enforcement actions were inconsistent. For example, among the banks that failed, more than 80 percent were on a regulatory watch list for more than a year, on average, before bank failure. However, GAO's analysis of regulatory data and material loss reviews showed that actions to address early signs of deterioration were inconsistent and, in many cases, regulators either took no enforcement action or acted in the final days before an institution was subject to PCA or failed. Without an additional early warning trigger, the regulators risk acting too late, thereby limiting their ability to minimize losses to the DIF. Most stakeholders (23 of 29) GAO surveyed agreed that PCA should be modified and identified three top options to make it more effective. The first option--incorporating an institution's risk profile into PCA capital categories--would add a measure of risk to the capital category thresholds beyond the existing risk-weighted asset component. The second option was increasing the capital ratios that place banks in PCA capital categories. The third most popular option was including another trigger for PCA, such as asset quality or asset concentration. Each option has advantages and disadvantages. For example, while an additional trigger could account for other factors often found to precede capital deterioration, it might be difficult to implement. Although stakeholders supported these broad options, they cautioned that the manner in which any option was crafted would determine its success.
section_title: What GAO Recommends
paragraphs: GAO recommends that the bank regulators consider additional triggers that would require early and forceful regulatory action to address unsafe banking practices as well as the other options identified in the report to improve PCA. The regulators generally agreed with the recommendation.

section_title: Letter
paragraphs: After the savings and loan crisis, federal regulators were criticized for  failing to take timely and forceful action to address the causes of bank  failures and prevent losses to taxpayers and the deposit insurance fund  (currently and hereinafter referred to as the DIF). In response, Congress  passed the Federal Deposit Insurance Corporation Improvement Act  (FDICIA) of 1991, which made significant changes to the Federal Deposit  Insurance Act (FDIA). In particular, FDICIA created sections 38 and 39 of  FDIA to improve the ability of regulators to identify and promptly address  deficiencies at depository institutions—banks and thrifts—and better  safeguard and minimize losses to the DIF. Section 38 requires regulators to  classify banks into one of five capital categories and take increasingly  severe actions, known as prompt corrective action (PCA), as a bank’s  capital deteriorates. Section 38 primarily focuses on capital as an indicator  of bank health; therefore, supervisory actions under it are designed to  address a bank’s deteriorating capital level. 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 allows the  regulators to take action if a bank fails to meet one or more of these  standards.
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. And from June 2004 through January 2007, no banks failed.
Since 2007, failures have increased significantly. In 2010, 157 banks failed,  the most in a single year since the savings and loan crisis of the 1980s and  1990s. The 157 banks had combined assets of approximately $93 billion,  costing the DIF an estimated $24 billion. Overall, more than 300 banks  have failed since the current financial crisis began in 2007, at an estimated  cost of almost $60 billion to the DIF to cover losses to insured depositors.  During this time, the balance of the DIF has declined dramatically,  becoming negative in 2009. As of December 31, 2010, the DIF had a  negative balance of $7.4 billion. During this same period, beginning late in  2008, the federal government provided significant financial assistance to  many financial institutions through the Troubled Asset Relief Program and  other actions taken by the Federal Reserve System and FDIC to stabilize  the U.S. banking system. For example, regulators used certain emergency  authorities to enable assistance to some large banks because in their view  the failure of these institutions would have imposed large losses on  creditors and threatened to undermine confidence in the banking system.
The number and size of failures during the recent financial crisis have  raised questions about the ability of PCA to help turn around troubled  banks and minimize losses to the DIF. Section 202(g) of the Dodd-Frank  Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)  requires GAO to study the federal regulators’ use of PCA and report our  findings to the Financial Stability Oversight Council. The Dodd-Frank Act  also requires that the Financial Stability Oversight Council report to the  Committee on Banking, Housing, and Urban Affairs of the Senate and the  Committee on Financial Services of the House of Representatives on  actions taken in response to our report, including any recommendations  made to the federal banking regulators. Specifically, this report (1)  analyzes the outcomes of regulators’ use of PCA on the DIF; (2) evaluates  the extent to which regulatory actions, capital thresholds, and other  financial indicators helped regulators to address likely bank trouble or  failure; and (3) identifies options available to make PCA a more effective  tool to prevent or minimize losses to the DIF.
To describe trends in and outcomes from the implementation of PCA, we  analyzed banking data from regulators, including FDIC Quarterly Banking  Reports and the quarterly “problem” bank lists. We analyzed data on banks  that underwent the PCA process, failed from the first quarter of 2006  through the third quarter of 2010 (i.e., from January 1, 2006, through  September 30, 2010), or both, and identified their outcomes. To determine  the number of banks that produced losses to the DIF—including those  banks that underwent the PCA process before failure and those that did  not—we used the 2010 estimate of losses to the DIF from loss data  obtained from FDIC, which we determined to be sufficiently reliable for  our purpose of enumerating failed banks and the losses associated with  these failures based on our ongoing work related to the DIF. We also  interviewed representatives from FDIC, the Board of Governors of the  Federal Reserve System (Federal Reserve), the Office of the Comptroller  of the Currency (OCC), and the Office of Thrift Supervision (OTS).
To assess the utility of various financial indicators in predicting bank  distress, we developed a model of leading indicators of bank failure based  on financial ratios researchers identified in the 1990s that predicted bank  failures in previous stress periods. We used these financial ratios,  regulatory ratings, and an indicator we developed of sector loan  concentration to forecast bank failure within 1 to 2 years (for failed banks  and peers from 2006 through the third quarter of 2010). We used this  model to assess the predictive power of indicators other than bank capital.  To do this, we relied on data from FDIC and SNL Financial. We assessed  the reliability of data used in our analysis and found the data sufficiently  reliable for our purposes.
To examine the extent to which various regulatory activities and  enforcement actions, including PCA, detected and addressed troubled  banks, we examined the type and timing of regulatory actions across the  oversight cycle. This work encompassed analyzing the extent to which  existing regulatory steps provided warning of likely bank deterioration or  failure. Specifically, we reviewed off-site monitoring tools and examined if  these tools provided effective warnings of bank distress. For all bank  failures that occurred from the first quarter of 2006 through the third  quarter of 2010, we also reviewed formal and informal enforcement  actions in the 2-year period before a bank failed to identify the earliest  enforcement action taken in relation to other regulatory milestones  associated with financial deterioration. We also reviewed the timing and  nature of PCA enforcement actions in relation to bank failure. Upon  receiving enforcement data provided by FDIC, the Federal Reserve, OCC,  and OTS, we determined that the enforcement data provided could not be  relied upon without additional verification. In particular, the enforcement  data the Federal Reserve, OCC, and OTS provided could not be used alone  to make distinctions among different types of enforcement actions that  may or may not have been relevant to safety and soundness issues of  banks that were deteriorating financially. While enforcement data  provided by FDIC did make such distinctions, we did not rely exclusively  on the enforcement data provided by the regulators, but rather, used these  data to corroborate information on enforcement actions from material loss  reports prepared by the inspectors general (IG) of the banking regulators  and conducted case studies of 8 banks to highlight examples of oversight  steps taken by each of the regulators and various outcomes. We selected a  nongeneralizable sample of banks that is diverse with respect to  geography, asset size, franchise value, primary regulator, date of failure,  sequence of enforcement actions, outcome (failure or a return to financial  stability), and losses to the DIF. The inspectors general for the FDIC, the  Department of the Treasury, and the Board of Governors of the Federal  Reserve System are currently conducting a joint evaluation of the PCA  framework that will address the use of both sections 38 and 39 of FDICIA  during the last few years, among other issues.
To identify options to make PCA more effective, we surveyed informed  stakeholders from the regulatory agencies, research, and industry sectors.  We used a two-part Delphi survey to gather ideas from the stakeholders,  who were identified through professional credentials, authorship of  research, and membership in relevant research and industry groups. The  first survey, using open-ended questions, asked respondents to identify  options, including those outside the PCA framework, which could be more  effective in minimizing losses to the DIF. The second survey, through a set  of closed-ended questions created from a content analysis of the responses  from the first survey, asked the same stakeholders to rate and rank the  options in terms of feasibility and impact. To further illustrate the options  that may be considered to improve PCA effectiveness, we interviewed  supervisory and research staff at the four regulators about PCA and bank  failures during the financial crisis and any additional options that could  improve PCA effectiveness. Finally, we conducted a literature review on  PCA and early intervention and synthesized any additional options  presented in the literature that could make PCA more effective. Appendix  I contains a more detailed description of our scope and methodology.
We conducted this performance audit from July 2010 through June 2011 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: Four federal regulators oversee banks and savings associations (thrifts) in  the United States. The Federal Reserve is the primary regulator for state- chartered member banks (i.e., state-chartered banks that are members of  the Federal Reserve System) and bank holding companies, OCC is the  primary regulator of federally chartered banks, and OTS is the primary  regulator of federally and state-chartered thrifts and thrift holding  companies. FDIC is the primary regulator for state-chartered nonmember  banks (i.e., state-chartered banks that are not members of the Federal  Reserve System). In addition, FDIC insures the deposits of all federally  insured banks, generally up to $250,000 per depositor, and monitors their  risk to the DIF.
Regulators examine banks’ risk management systems to help ensure the  safe and sound operation of banks and protect the well-being of  depositors—those individuals and organizations that act as creditors by  “loaning” their funds in the form of deposits to banks for lending and other  activities. Regulators are responsible for supervising the activities of banks  and taking corrective action when their activities and overall performance  present supervisory concerns or could result in financial losses to the DIF  or violations of law. Losses to the DIF may occur when a bank does not  have sufficient assets to reimburse customers’ deposits and FDIC’s  administrative expenses in the event of closure or merger.
All the regulators assess the condition of banks through off-site  monitoring and on-site examinations. Examiners use Report of Condition  and Income (Call Report) and Thrift Financial Report data to remotely  assess the financial condition of banks and thrifts, respectively, and to  plan the scope of on-site examinations. Historically, banking regulators  have used tools to monitor the financial condition of banks between on- site bank examinations. The off-site monitoring or surveillance activities  rely largely on self-reported information from banks, filed through  quarterly Call Reports to the banking regulators. Off-site monitoring and  surveillance activities help alert regulators to potentially problematic  conditions arising in a financial institution. Using these tools, each of the  regulators identifies and flags banks with potential signs of financial  distress for further regulatory scrutiny and prepares lists or reports of  such institutions requiring further regulatory scrutiny (e.g., watch list,  review list, high risk profile list, etc.).
As part of on-site examinations, regulators closely assess banks’ exposure  to risk and assign ratings, under the Uniform Financial Institutions Rating  System, commonly known as CAMELS. The ratings reflect a bank’s  condition in six areas: capital, asset quality, management, earnings,  liquidity, and sensitivity to market risk. Each component is rated on a  scale of 1 to 5, with 1 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 problems. 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. Also as part of the examination and general supervision  process, regulators may direct a bank to address issues or deficiencies  within specified time frames. However, as figure 1 illustrates, a bank’s  condition can rapidly deteriorate and bypass the various regulatory steps  that usually occur as a bank’s condition deteriorates.
When regulators determine that a bank 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 and have some discretion in deciding which actions to take.  Regulators typically take progressively stricter actions against more  serious weaknesses. Informal actions generally are used to address less  severe deficiencies or when the regulator has confidence that the bank is  willing and able to implement changes. Examples of informal actions  include commitment letters detailing a bank’s commitment to undertake  specific remedial measures, resolutions adopted by the bank’s board of  directors at the request of its regulator, and memorandums of  understanding that note 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 Web sites or other channels) and  are not enforceable by sanctions. In comparison, regulators publicly  disclose and enforce formal actions. The regulators use formal actions to  address more severe deficiencies. Formal enforcement actions include  PCA directives, cease-and-desist orders, removal and prohibition orders,  civil money penalties, and termination of a bank’s deposit insurance.
A principal goal of PCA is to prevent losses to the DIF for the vast majority  of bank failures. Section 38 of FDIA requires regulators to categorize  banks into five categories on the basis of their capital levels (see table 1).  Regulators use four different capital measures to determine a bank’s  capital category: (1) a total risk-based capital ratio, (2) a Tier 1 risk-based  capital ratio, (3) a leverage ratio (or non-risk-based capital ratio). The  fourth PCA measure is a tangible equity to assets ratio for the Critically  Undercapitalized category. To be well capitalized, a bank must  significantly exceed the minimum standard for all three capital measures.  Depending on the level of deficiency, banks may be considered  undercapitalized or significantly undercapitalized if they fail to meet any  one of the ratios necessary to be considered at least adequately  capitalized. A bank that fails to meet the tangible equity to total assets  ratio is considered critically undercapitalized. For example, a bank that is  experiencing significant growth, with 9 percent total risk-based capital and  6 percent Tier 1 risk-based capital but only 3.5 percent leverage capital,  would be undercapitalized for PCA purposes.
Under section 38, regulators must take increasingly stringent supervisory  actions as a bank’s capital level deteriorates. For example, all  undercapitalized banks must implement capital restoration plans to  restore capital to at least the adequately capitalized level, and regulators  generally must close critically undercapitalized banks within a 90-day  period. Section 38 also authorizes several non-capital-based supervisory  actions designed to allow regulators some flexibility in achieving the  purpose of section 38. Specifically, under section 38(g) regulators can  reclassify or downgrade a bank’s capital category to apply more stringent  operating restrictions or requirements if they determine, after notice and  opportunity for a hearing, that a bank is in an unsafe and unsound  condition or engaging in an unsafe or unsound practice. Under section  38(f)(2)(F), regulators can require a bank to make improvements in  management—for example, by dismissing officers and directors who are  not able to materially strengthen a bank’s ability to become adequately  capitalized.
Section 39 directs regulatory attention to a bank’s operations and activities  in three areas aside from capital that also can affect safety and soundness:  (1) operations and management; (2) compensation; and (3) asset quality,  earnings, and stock valuation. Under section 39, if a regulator determines  that a bank has failed to meet a prescribed standard, the regulator may  require that the institution file a safety and soundness plan specifying how  it will correct the deficiency. If the bank fails to submit an acceptable plan  or fails to materially implement or adhere to an approved plan, the  regulator must require the institution, through the issuance of a public  order, to correct identified deficiencies and may place other restrictions or  requirements on the bank pending the correction of the deficiency. We  previously reported that regulators made limited use of their section 39  authority.
section_title: Changing Condition of the Banking Industry
paragraphs: During the last few years, the condition of the bank and thrift industry has  declined, particularly when compared with conditions in the relatively  positive period beginning in the early 1990s following the passage of  FDICIA. Indicators of bank health, such as the number of banks on FDIC’s  problem bank list, show the deteriorating condition of banks since 2007  (see fig. 2). For example, in the first quarter of 2007, 53 banks were on the  “problem” bank list, but by the third quarter of 2010, 860 banks were on  this list.
Moreover, the number of banks with CAMELS composite ratings of 1 and 2  has declined steadily since 2007 and 2008, respectively, and the numbers  of 3, 4, and 5 ratings have increased over this period (fig. 3).
Since the financial crisis began, the number of bank failures increased  yearly from 2007 to 2010, with more than 300 banks failing during this time  (see fig. 4). In 2010, 157 banks failed.
As a result of the rise in bank failures, the DIF balance has decreased  dramatically (see fig. 5). Since the first quarter of 2007, the DIF balance  has decreased by about $57 billion. The DIF balance was $50.7 billion at  the start of 2007, hit a low point of negative $20.8 billion in the fourth  quarter of 2009, and had a balance of negative $7.4 billion as of December  31, 2010.
section_title: PCA Did Not Prevent Widespread Losses to the DIF
subsections: section_title: Most Banks That Underwent the PCA Process Either Failed or Remained Troubled
paragraphs: As the recent financial turmoil unfolded, the number of banks that fell  below one of the three lowest PCA capital thresholds—undercapitalized,  significantly undercapitalized, or critically undercapitalized—increased  dramatically. All four regulators told us that PCA was not designed for the  type of precipitous economic decline that occurred in 2007 and 2008. As  figure 6 illustrates, the total number of banks in undercapitalized and  lower capital categories averaged fewer than 10 per quarter in 2006 and  2007, whereas the total averaged approximately 132 from 2008 through the  third quarter of 2010.
The number of banks that entered the PCA process for the first time each  quarter also increased dramatically. In 2006 and 2007, the number of banks  newly entering undercapitalized or lower capital categories averaged  fewer than 5 per quarter, compared with an average of 48 from 2008  through the third quarter of 2010 (see fig. 7).
The vast majority of banks that underwent the PCA process from 2006  through the third quarter of 2010 had not returned to a condition of  financial stability by the end of this period. As shown in figure 8, of the 569  banks that fell into the undercapitalized or lower capital categories of  PCA, 270 failed. Another 25 banks failed without first being identified as  falling into the undercapitalized or lower capital categories of PCA,  bringing total bank failures to 295 during this period. Banking regulators  told us that because of the sharp economic downturn in 2008, banks could  deteriorate more rapidly than PCA was designed to handle. For example,  nearly half failed after being undercapitalized for two or fewer quarters. In  addition, three regulators told us that early in the economic turmoil, banks  that encountered sudden liquidity problems often did not trigger the PCA  process before failure.
Although the remaining banks that underwent the PCA process did not  fail, most of them continue to struggle financially. Specifically, 299 of the  569 banks that underwent the PCA process did not fail during the period of  analysis. Of these 299 banks, 223 remained undercapitalized or on the  problem bank list through the third quarter of 2010 (see fig. 9). According  to regulators and industry representatives, the large number of troubled  banks may be due to sustained economic weakness during the period of  analysis, which likely has hindered the ability of these banks to raise  additional capital. Another 46 of the 299 undercapitalized banks were  dissolved with minimal or no losses to the DIF. And the remaining 30  banks remained open and were neither undercapitalized nor on the  problem bank list at the end of the period.
section_title: All Banks That Failed after Undergoing the PCA Process Caused Losses to the Deposit Insurance Fund
paragraphs: Although PCA was intended to prevent or minimize losses to the DIF when  banks failed, this goal was not achieved during the recent financial crisis.  All 270 banks that failed after undergoing the PCA process during the  period we reviewed caused losses to the fund, and these losses were  comparable as a percentage of assets with those of the generally larger  banks that did not undergo PCA. Thus, whether or not a bank underwent  the PCA process before failure, its losses to the fund totaled  approximately a third of its assets. Specifically, for banks that underwent  the PCA process before failure, the minimum loss to the DIF as a  percentage of assets was 1 percent, the median loss was 27.7 percent, and  the maximum loss was 87 percent (see fig. 10). For banks that did not  undergo the PCA process before failure, the minimum loss to the DIF as a  percentage of assets was 0 percent, the median loss was 29.1 percent, and  the maximum loss was 61 percent. However, after controlling for the  financial condition of banks before they failed, we found that PCA had a  small, positive impact on losses to the DIF as a percentage of assets. In  particular, banks that went through PCA had losses that were 1 to 3  percentage points lower than those that did not undergo PCA before  failure, but this difference was not statistically significant.
The 25 banks that failed without first being identified as undercapitalized  or in lower capital categories generated losses that were larger in absolute  terms, averaging $443 million compared with $246 million for the 270  banks that underwent PCA before failure. However, the 25 banks that did  not first undergo the PCA process tended to be larger—their median size,  as measured by assets held the quarter before failure, was $372 million,  versus $263 million for the 270 banks that underwent the PCA process. In  addition, our analysis suggests that the banks that did not undergo PCA  before failure may have had characteristics that made them less likely to  trigger the undercapitalized or lower capital thresholds of PCA because  these banks may have possessed more capital. However, they also may  have held fewer liquid securities or relied to a greater degree on unstable  sources of funding, such as high-yield deposits from large financial  investors.
section_title: Regulators Highlighted Benefits and Limitations of the PCA Framework
paragraphs: According to federal banking regulators, the PCA framework has provided  them with a useful tool to address deteriorating banks. Federal regulators  told us that the PCA process is most effective in combination with other  enforcement tools and it has multiple benefits in addressing financial  deterioration in bank. They most frequently cited the following benefits:    First, the PCA process may serve as a backstop or a safeguard to be  used if other enforcement actions were delayed (for example, because  a troubled bank contested a consent order).
Second, the PCA program empowers state banking regulators to close  critically undercapitalized banks—often in the face of significant  pressure to forbear—and provides a road map for doing so.  Furthermore, officials from FDIC told us that state regulatory agencies  had few occasions to close banks since the savings and loan crisis of  the 1980s and 1990s, making such a road map more important because  they could not draw on recent institutional memory of bank closures.
Third, the 90-day closure provision in PCA facilitates an orderly  resolution from the perspective of FDIC’s Division of Resolutions and  Receiverships (DRR), which manages the closures of failed federally  insured banks. FDIC DRR officials told us that the 90-day provision  provides advance notice of a potential failure, enabling both FDIC DRR  and potential buyers to conduct due diligence on the assets and  liabilities of the deteriorating bank. According to FDIC DRR officials,  the PCA advance notice results in higher bids for the failed bank. For  more information on the resolution methods used to close failed banks,  see appendix II.
Fourth, the PCA framework encourages banks to hold more capital  than otherwise would be the case. According to FDIC officials, banks  often hold capital in excess of the required PCA capital thresholds to  minimize the possibility of triggering mandatory supervisory action  under section 38 of FDIA.
The banking regulators cited other benefits of PCA, including the specific  authorities that section 38 affords. For example, OTS, OCC, and Federal  Reserve officials said the ability to dismiss officers and directors from  deteriorating banks was helpful, and FDIC officials said it was useful to be  able to restrict the use of brokered deposits by banks categorized as  adequately capitalized under the PCA framework. Regulators also noted  that PCA increases consistency across the various regulatory agencies,  which creates shared expectations about the process of monitoring,  managing, and closing deteriorating banks. However, they emphasized that  the effectiveness of PCA depended on making early and forceful use of  their other enforcement tools.
Although regulators cited benefits of the PCA framework, they and  industry groups also recognized several potential drawbacks of it. Some  representatives specifically noted that PCA may discourage potential  investors from investing in the troubled bank because of concerns that the  bank’s closure will wipe out their investment. In addition, some officials  and an industry group said that large banks with capital deficiencies are  more likely to receive financial assistance or time to recapitalize than are  smaller banks. Finally, one industry group said that PCA is procyclical— that is, it magnifies the impact of wider economic trends on banks by  compelling them to maintain, rather than draw down, their capital buffers.  According to this industry group, by preventing banks from using their  capital cushions, PCA hinders their ability to recover from financial  distress.
section_title: Other Indicators Provide Early Warning of Deterioration, and although Regulators Identified Conditions Early, Responses Were Inconsistent
paragraphs: Because they rely on capital, PCA’s triggers have weaknesses, and the PCA  framework does not take full advantage of early warning signs of bank  distress that other financial indicators we tested can provide. Capital can  lag behind other indicators of bank health, and once a bank’s capital has  deteriorated to the undercapitalized level, it may be too late for the bank  to recover. Leading indicators of bank failure beyond capital—including  measures of asset quality and liquidity—provided early warning of bank  distress during the period we reviewed. Collectively, we found these  indicators better identified those banks that did not undergo the PCA  process before failure. Regulators generally were successful in identifying  early warning signs of bank distress, but the presence and timeliness of  subsequent enforcement actions were often inconsistent. While their off- site monitoring tools and CAMELS ratings often indicated deteriorating  conditions more than a year before banks failed, regulators did not  consistently take enforcement actions before banks underwent the PCA  process.
subsections: section_title: PCA’s Triggers Have Weaknesses
paragraphs: PCA’s triggers have weaknesses in terms of initiating regulatory action  upon early warning signs of bank distress. In the 1990s, several  researchers at the bank regulatory agencies, as well as GAO, identified  significant concerns associated with using the PCA bank capital  thresholds to determine when to intervene in troubled banks. For  example, one study found that capital is likely to trigger intervention after  examiners already were aware of problems at a bank. Another study  found that most banks with a significant risk of failure in 1984-1989 (prior  to the existence of PCA) would not have been considered undercapitalized  under PCA. Similarly, we have found that while capital was a valid  measure of a bank’s financial health, waiting until the capital standards  have been violated may be too late for a bank to be able to address its  problems. Banks had other identifiable issues before they were reflected  in capital. As discussed earlier we found that most banks that underwent  the PCA process either failed or remained on the problem bank list.  Furthermore, nearly 1 in 10 banks failed without undergoing the PCA  process.
section_title: Other Leading Indicators or a Composite Indicator Provided Early Warning of Bank Distress and Impending Failure
paragraphs: Other leading indicators, or a composite indicator, provided additional  early warning of bank distress. Several studies published in the 1990s  demonstrated that in addition to capital, indicators based on earnings,  asset quality, liquidity, and reliance on unstable funding provide early  warning of bank distress. Capital on its own may provide some early  warning of bank failure but does not capture weaknesses that manifest— perhaps earlier—in other areas of the bank’s operations. We developed a  model based on this earlier research to determine if these leading  indicators would have been useful tools to predict bank failures during the  current crisis. As discussed below, our analysis confirmed that these  same indicators (see table 2), as well as an indicator we developed based  on sector loan concentration, would have provided early warning of  problems in the banking system during this crisis.
In general, those key indicators identified by researchers in the 1990s are  both statistically and practically significant predictors of bank failure  during this crisis period (see app. III for more information). Indicators of  earnings, liquidity, and asset quality, in addition to capital, contain  information about the condition of the bank that provides warning of bank  distress up to 1-2 years in advance. For example, large differences in the  level of nonperforming loans between healthy banks (our peer group) and  banks that ultimately failed were evident well before the bulk of bank  failures in 2009–2010 (see fig. 11). Starting in 2006, the difference between  the two groups of banks increased as nonperforming loans grew  dramatically over the next 3-4 years for banks that ultimately failed, but  only modestly for healthy banks. Quantitatively, a one standard deviation  increase in the level of nonperforming loans increased the chance of  failure from roughly 2.8 percent to 7.8 percent over the next year.
Similarly, large differences in the level of liquid assets (securities) between  healthy banks and banks that ultimately would fail are evident well before  the bulk of bank failures (see fig. 12). The degree of liquidity fell somewhat  over time, both at banks that ultimately would fail and healthy banks.  Quantitatively, a one standard deviation increase in the level of securities  decreased the chance of failure from roughly 2.8 percent to 2.3 percent  over the next year. The Basel Committee has proposed two liquidity  standards designed to promote resilience in the banking system.
As with indicators of earnings, liquidity, and asset quality, a measure of  sector loan concentration we developed contains information about the  condition of the bank that provides warning of bank distress up to 1–2  years in advance. Sector loan concentration is calculated as an index that  incorporates the shares of an institution’s loan portfolio allocated to  certain broad economic sectors (e.g., residential real estate, consumer  lending, etc.). Our concentration index also proved to be an important  predictor of bank failure—it is both statistically and practically significant  (see app. III for more information). Banks that ultimately failed had  considerably more concentrated loan portfolios than healthy banks well  before the bulk of bank failures. Specifically, a one standard deviation  increase in the degree of concentration increased the chance of failure  from roughly 2.8 percent to 3.7 percent over the next year. Our  concentration index partly reflects banks heavily invested in commercial  real estate (see fig. 13)—a troubled sector during the recent downturn.  Failed banks had roughly 20 percent more loans in commercial real estate  than their peers. However, even among banks with the same degree of  commercial real estate exposure, those with less diversified lending were  more likely to fail. The concentration index we developed would be a  more flexible forward-looking indicator than commercial real estate  concentration alone because the next episode of banking stress will not  necessarily be driven by commercial real estate.  3% 3% 2% The PCA framework does not take full advantage of early warning signs  that financial indicators we tested can provide. Because PCA relies only  on capital-based indicators, it may not capture institutional vulnerabilities  that can manifest in, for example, limited liquidity, low asset quality, or  high loan concentrations in particular sectors. Early warning signs in  earnings, liquidity, asset quality, or concentration could be identified by  assessing each indicator individually and setting indicator-specific  thresholds. Later in this report we discuss indicators that could be used  for triggers that respondents to our expert survey favored.
Composite indicators based on the model we developed or based on an  existing regulatory tool (such as CAMELS ratings) provide a convenient  way of combining information from a number of financial indicators, and  can better identify risks in banks that did not undergo the PCA process  before failure. Our analysis showed that a model incorporating these well- known leading indicators of bank distress better identified those banks  that did not undergo the PCA process before failure—that is, the model  placed them at a much higher risk of failure than healthy banks—than  capital-based triggers alone. The average failure rate estimated by our  model over the next year was about 20 percent for banks that ultimately  would fail without triggering PCA (similar to the rate for all failures), and  about 3 percent for healthy banks, as of the first quarter of 2008. Similarly,  CAMELS ratings were higher (inferior) than ratings of peers at banks that  did not undergo the PCA process before failure. The CAMELS ratings were  on average 2.13 for banks that failed without first undergoing the PCA  process (similar to the ratings for all failures), and about 1.75 for healthy  banks. While regulators use information from noncapital financial  indicators in their supervision and off-site monitoring of banks, as we  describe in the next section of this report, this does not always lead to  timely enforcement action at problem banks. Two researchers also  recently have suggested that PCA would benefit from the use of a  composite indicator, such as those embodied in existing FDIC and Federal  Reserve models, rather than only capital-based indicators.
Regulators face a challenging trade-off between false positives (in this  context, taking an action based on an incorrect prediction of bank  distress) and false negatives (in this context, failing to take an action  based on an incorrect prediction of bank health) in establishing a  threshold or thresholds for capital or other indicators that might trigger  intervention in potentially troubled banks. Striking the right balance  between these two errors depends on the relative costs of each error, and  other considerations. For example, the cost of acting on false positives  could be quite high if healthy banks undertook costly and unnecessary  measures to avoid regulatory triggers or similarly if regulators and banks  expended significant resources during unnecessary interventions.  Comparatively, the cost of failing to act on false negatives could be quite  high if bank failures imposed dramatic costs on the DIF and the economy.  In general, setting a high threshold for action only rarely would trigger  unnecessary intervention in healthy banks but also might yield failures to  intervene in some genuinely troubled banks. On the other hand, a low  threshold would be more likely to trigger intervention unnecessarily in  healthy banks but would correctly identify the bulk of troubled banks.
section_title: Regulators Used Tools other than PCA to Identify Early Signs of Bank Distress
paragraphs: All of the regulators used off-site monitoring or surveillance tools as well  as CAMELS ratings to identify early signs of potentially problematic  conditions among banks. In general, these regulatory tools, which  incorporate assessments of bank characteristics beyond capital, provided  early warnings of bank distress. For instance, FDIC and Federal Reserve  models are key tools used for off-site monitoring or surveillance activities  and contain many similar indicators of capital, liquidity, asset quality, and  earnings. As mentioned earlier, such models and other tools help  regulators flag deteriorating conditions in banks for further regulatory  scrutiny (e.g., placing banks on watch or review lists).
In our review of 252 banks that failed from the first quarter of 2008  through the third quarter of 2010, most (82.5 percent) had been identified  on review or watch lists within 2 years of their failure. For these banks  (regulated by FDIC, OCC, and the Federal Reserve), the median time  between being placed on a watch or review list and failure was 631 days.
CAMELS ratings also provided early warning signs of bank failure. As  described earlier, 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. Any factor bearing significantly on the condition and soundness  of the institution may be incorporated. 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. 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.
Specifically, among the 292 failed banks we reviewed (across all  regulators), 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. Our case studies of 8 banks also  provided examples of this phenomenon, as banks frequently received  multiple downgrades in the CAMELS composite ratings in a single quarter  (see table 3 below).
For the failed banks that received either a CAMELS component or  composite rating of 3, these ratings demonstrated the utility of CAMELS to  provide early warning of bank distress. For example, among the failed  banks that received a CAMELS component rating of 3, the median number  of days between this component rating and bank failure was 459 days.  Similarly, for failed banks that received a CAMELS composite rating of 3,  the median number of days between banks receiving this composite rating  and their subsequent failure was 508 days. In a separate analysis  comparing peer and failed banks, we found that CAMELS ratings were  useful leading indicators of bank failure. See appendix III for more  information.
section_title: While the Presence and Timeliness of Enforcement Actions Were Inconsistent, Regulators Have Incorporated Lessons Learned from the Financial Crisis
paragraphs: Although regulators generally were successful in identifying early warning  signs of bank distress, the presence and timeliness of subsequent  enforcement actions were often inconsistent. Most banks that failed had  received an enforcement action (informal or formal) before undergoing  the PCA process. The banking regulators told us that they typically issued  enforcement actions to troubled banks—such as an informal enforcement  action when a bank was downgraded to a CAMELS composite score of 3,  and a formal enforcement action when it was downgraded to a 4—before  these banks received a PCA directive. However, some banks did not  receive any enforcement action before undergoing the PCA process, and  many did not receive timely enforcement action prior to bank failure.
In our review of enforcement information available in material loss reviews  or other evaluations on 136 failed banks, we found that the timeliness of  enforcement actions was inconsistent. However, we also noted that the  timeliness of enforcement actions appeared to have improved during the  banking crisis. 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.
Our case studies also provided examples of inconsistent enforcement  actions. While some banks received an enforcement action before being  subject to PCA, being placed on the problem bank list, or receiving a  CAMELS 4 composite rating, others did not receive any enforcement  action before these milestones. Table 4 highlights examples from our case  studies of inconsistent regulatory attention tied to key regulatory activities  and milestones. Furthermore, our findings related to presence and  timeliness of enforcement actions were consistent with findings we  reported in 1991. Specifically, we found then that the banking regulators  did not always use the most forceful actions available to correct unsafe  and unsound banking practices.
Use of the current PCA mechanism as an enforcement tool was also  inconsistent. As stated earlier, 25 banks (8 percent of the failed banks we  reviewed) did not undergo the PCA process. For instance, in our case  studies, we noted two institutions that were never subject to PCA prior to  failure. For those that were, the initial PCA capital category triggering  enforcement actions frequently occurred at a more distressed capital  threshold—significantly or critically undercapitalized—than the  undercapitalized level. For instance, of the 270 failed banks we reviewed  that underwent the PCA process, 40 percent were subject to an initial PCA  enforcement action below the undercapitalized threshold, with 25.5  percent triggering PCA at the significantly undercapitalized level and 14.4  percent triggering PCA at the critically undercapitalized level. Figure 14  illustrates how PCA was used among 295 failed banks, including the initial  capital thresholds triggering PCA enforcement actions. Similarly, our case  studies provided examples of different initial capital thresholds that  triggered PCA, including those occurring at the significantly  undercapitalized and critically undercapitalized levels, as highlighted in  table 4.
Regulators have begun to incorporate a number of lessons learned from  the financial crisis into their regulatory processes, including IG report  findings. For instance, FDIC has developed and initiated training to be  delivered in phases to reinforce and enhance its supervisory program.
These efforts include identifying lessons learned from the results of the IG  material loss reviews, emphasizing the importance of implementing timely  and effective corrective programs, mandatory training for risk  management and compliance examination staff to emphasize a forward- looking approach to examination analysis and ratings assessment  activities, and providing enhanced guidance regarding supervision and  examination procedures for de novo institutions. At OCC, the Mid-Size  and Community Banks Division issued a Matters Requiring Attention  Reference Guide that provides examiners with OCC policy guidance on  how to report, follow up on, and keep records related to Matters Requiring  Attention. OTS has enhanced its Regulatory Action Data system to better  flag matters requiring increased regulatory attention. We also noted that  the Federal Reserve incorporated a new liquidity measure into its model  used to identify banks that warrant being placed on its watch list.
section_title: While Most Stakeholders Favored Modifying PCA, Their Preferred Options Involve Some Trade- offs
paragraphs: Most of the informed stakeholders we surveyed told us the PCA  framework should be retained but changed. We asked stakeholders from  research organizations, regulatory agencies, and the banking industry  whether PCA should be changed and, if so, to identify and rank broad  options to change the current framework to make it more effective in  minimizing losses to the DIF. In response, 23 of 29 stakeholders said that  PCA should be modified using one or more of the survey’s listed options.  More specifically, they preferentially ranked three options—incorporating  additional risk measures, raising capital thresholds, and adding an  additional trigger—to make the PCA framework more effective. See table  5 for the full list of options in the survey and appendix V for full survey  results. While each of these three options could improve the PCA  framework, each presents certain advantages and disadvantages to  consider. Furthermore, a few stakeholders emphasized that if PCA were  modified, the specific details to implement such a policy change would  determine whether the goal of minimizing losses to the DIF would be  realized.
subsections: section_title: Incorporate an Institution’s Risk Profile into the PCA Capital Category Thresholds
paragraphs: Stakeholders responding to our survey were most supportive of  incorporating a bank’s risk profile into the PCA capital category  thresholds. Specifically, 12 stakeholders selected this option among the  top three that should be considered, with 5 selecting it as their first option  and 6 selecting it as their second option (see table 5). In addition, 21 of 29  stakeholders responded that incorporating an additional measure of risk  into the PCA capital category thresholds would improve the effectiveness  of PCA. This option would add an additional risk element to the PCA  capital measures beyond the already existing risk-weighted asset  component. All four federal regulators told us that they can require banks  to hold additional capital through formal or informal enforcement actions,  but as noted earlier in the report, such actions are not always taken or the  actions are not timely. Stakeholders suggested a few ways this change  could be made. For example, in formulating the most appropriate capital  thresholds, banks could be required to maintain an appropriate level of  tangible equity or a capital buffer based on the level of risk-weighted  assets. Alternatively, specific risk areas such as liquidity or concentration  could be factored into the determination of capital adequacy. Regulators  already have the ability (on a case-by-case basis) to require banks to hold  more capital than the amount required by PCA thresholds if they deem it  necessary based on a bank’s risk exposure.
There are advantages and disadvantages to making this change to the PCA  framework.
Potential advantages. Adding an additional risk component to PCA  capital measures may make PCA more responsive to specific trends.  For example, in the current crisis many banks failed, in part, because  of risks associated with high asset concentrations. A stakeholder told  us that incorporating early indicators of heightened risk into PCA  capital thresholds could be an additional way to minimize losses to the  DIF. Also, this change would not affect all banks but only those banks  engaging in riskier activities. Moreover, incorporating a bank’s risk  profile into the PCA capital category thresholds would be an  opportunity to broaden the scope of the PCA framework, helping  mitigate the repeated concern among stakeholders that PCA, as  currently constructed, is too narrowly focused.
Potential disadvantages. This option could complicate the process  of determining capital adequacy for PCA purposes, according to one  stakeholder responding to our survey. For example, banks would vary  in the levels of capital they needed to meet PCA capital thresholds,  depending on their risk level. A stakeholder also cautioned that risk- based measures were complex and dependent on information from  banks. Finally, adding a risk component to PCA could be duplicative  because regulators already use risk-based capital ratios in PCA.
section_title: Raise All the PCA Capital Category Thresholds
paragraphs: Raising all the PCA capital category thresholds had the second-highest  weighted score on our survey, and stakeholders selected it most often as a  first choice. Specifically, 10 stakeholders selected this option among the  top three that should be considered, with 7 selecting it as their first option  (see table 5). In addition, 17 of 29 stakeholders told us increasing the  capital category thresholds would improve the effectiveness of PCA. This  option would increase the capital ratios required for a bank to be  classified as well capitalized, adequately capitalized, undercapitalized,  significantly undercapitalized, and critically undercapitalized. Federal  regulatory agencies have amended and updated the regulations and rules  on measuring a bank’s capital level in the past, often in conjunction with  recommendations from the Basel Committee on Banking Supervision.  However, the capital thresholds have not changed since the  implementation of the PCA provisions of FDICIA in 1992. The Basel  Committee recently released guidelines recommending increased capital  requirements to be phased in by January 1, 2015. Federal regulators  typically adopt, with some national discretion, Basel Committee  recommendations.
Raising only the critically undercapitalized threshold also was on our list  of options. Twenty of 29 stakeholders we surveyed told us that raising the  critically undercapitalized threshold would improve the effectiveness of  PCA, more than the number who told us raising all PCA capital category  thresholds would improve PCA effectiveness. However, when asked to  select top options to improve the PCA framework, fewer stakeholders  selected raising only the critically undercapitalized threshold. Currently, a  bank is categorized as critically undercapitalized if its tangible equity is 2  percent or less. Regulators generally must close critically undercapitalized  banks within a 90-day period.
Increasing PCA’s capital category thresholds would change a nearly two- decades-old policy and involve trade-offs among the following advantages  and disadvantages.
Potential advantages. Raising thresholds would create an incentive  for banks to increase capital levels. According to our previous work  and the work of others, by holding more capital, a bank would have a  greater capacity to absorb losses and remain solvent, particularly when  a financial crisis occurred. Similarly, with more capital, banks should  be able to survive higher levels of borrower defaults. Thus, if banks  were required to hold more capital, this might limit losses to the DIF in  the event of failure by shifting risks from the DIF and taxpayers to the  providers of capital, according to researchers. Moreover, increasing  capital levels might not be a major change, as banks sometimes hold  more capital than PCA requires.
Potential disadvantages. If banks were required to hold more  capital, they might change the way they conduct business. For  example, banks might limit the amount of credit made available to  businesses, households, and governments; charge higher interest rates  on loans; or offer lower interest rates on deposits, according to  researchers. In addition, some banks might compensate for having  less to lend by investing in riskier assets to seek higher returns. An  industry group told us that raising the capital category thresholds could  be particularly harmful for community banks, which often face  additional challenges raising capital. A stakeholder told us this option  also could create more instances in which regulators intervened in the  operation of healthy banks (false positives)—that is, more banks may  fall below a higher set PCA capital ratio standard even though they are  not in financial distress. Additionally, 22 of 28 survey respondents said  that PCA’s focus on capital was a shortcoming of the process, and this  option would not broaden the scope of PCA to other potential  indicators of bank failure.
section_title: Add an Additional PCA Trigger
paragraphs: As their third preference, our survey respondents selected adding another  PCA trigger. Specifically, 12 stakeholders selected this option among the  top three that should be considered, with 3 selecting it as their first option,  4 selecting it as their second option, and 5 selecting it as their third option  (see table 5). Overall, 18 of 29 respondents said this option would improve  the effectiveness of PCA. This option would require regulators to monitor  other aspects of a bank’s performance, such as asset concentration, asset  quality, or liquidity, and if problems were identified, to take increasingly  severe actions to address problems in that area. While regulators routinely  monitor other aspects of bank safety and soundness, making these  additional factors part of the PCA process would compel regulators to act  when these areas were found to be deteriorating. However, as discussed  previously in this report, we found that although regulators identified signs  of bank distress, the timeliness of subsequent enforcement actions was  inconsistent.
Stakeholders responding to our survey who recommended adding an  additional PCA trigger were most supportive of using asset quality and  asset concentration triggers. As discussed earlier in this report, our  analysis of leading indicators of bank health found asset quality and asset  concentration provided early warning of bank deterioration. When asked  about the impact of an asset quality trigger, 26 of 28 survey respondents  told us that it would improve the effectiveness of PCA. Twenty of 29  survey respondents said an asset concentration trigger would improve the  effectiveness of PCA. See appendix V for more information on how the  survey respondents rated potential additional triggers.
Regulators have attempted to adopt additional triggers in the past. For  example, regulators and a stakeholder with whom we spoke said that in  the 1990s regulators tried to modify risk-based capital measures to  account for asset concentration but were unable to develop a sufficiently  reliable concentration metric. Instead, regulators decided to take risky  asset concentrations into account during bank examinations. Additionally,  FDIA (section 39) requires banking regulators to prescribe safety and  soundness standards related to noncapital criteria, including operations  and management; compensation; and asset quality, earnings, and stock  valuations, allowing regulators to take action if a bank fails to meet one or  more of these standards. 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, changes to FDIA in the Riegle Community  Development and Regulatory Improvement Act of 1994 gave regulators  considerable flexibility over how and when to use their authority under  the section to address safety and soundness deficiencies at banks. After  this change, we reported that section 39, as amended, appeared to leave  regulatory discretion largely unchanged from what existed before the  passage of FDICIA. We also reported in 2007 that regulators made limited  use of this authority, preferring other formal and informal enforcement  actions.
Including another PCA trigger could also produce advantages and  disadvantages for regulators and banks.
Potential advantages. Adding another trigger could mitigate the  limitations of capital as an indicator. As we discussed in this and prior  reports, regulatory actions focused solely on capital may have limited  effects because of the extent of deterioration that already may have  occurred. Capital typically does not begin to decline until a bank has  experienced substantial deterioration in other areas, such as asset  quality and the quality of bank management. We previously  recommended a “tripwire” approach to banking regulation, urging  regulators to consider an array of factors such as assets, earnings, and  capital deterioration and requiring banks to take specific actions to  address problems in those areas. We concluded that complements to  capital standards such as industrywide measures for asset,  management, and earnings conditions and a prescribed set of  enforcement responses would improve the outcomes of the bank  regulatory process.
Potential disadvantages. Another trigger might duplicate other tools  regulators already use in their supervision of banks, thereby creating  inefficiencies in oversight. Also, the PCA trigger chosen might not be  applicable to all banks. For example, one stakeholder cautioned that  some triggers, such as asset concentration, sources of funding, and  liquidity, might not apply uniformly to all banks.
Finally, a few stakeholders responding to our survey and experts with  whom we spoke said that if PCA were modified, the specific details that  shape the broad policy ideas would ultimately determine if the goal of  minimizing losses to the DIF was realized. For example, some regulatory  officials told us that in order for an earlier trigger to be effective,  legislative changes would be needed to allow regulators to use the same  authorities under the current PCA framework, such as the authority to  dismiss bank officers and directors. Stakeholders also told us that the  details matter greatly and how regulators ultimately crafted and applied  the policies would determine if the policies were successful.
section_title: Conclusions
paragraphs: Before the current financial crisis, PCA was largely untested because the  financial condition of banks generally had been strong since PCA was  enacted. More than 300 bank failures later and despite some benefits in  closing banks, the current PCA framework repeatedly has demonstrated  its weaknesses for addressing deteriorating conditions in banks. In turn,  PCA has not achieved a principal goal of preventing widespread losses to  the DIF when banks fail.
Weaknesses in the current PCA framework stem primarily from tying  mandatory corrective actions to only capital-based indicators. We and  others have argued since 1991 that capital-based indicators have  weaknesses, particularly because they do not provide timely warnings of  bank distress. A number of alternative indicators exist or could be  developed, and their advantages derive primarily from the early warnings  of distress they could provide. In particular, a composite indicator can  integrate information from a number of noncapital indicators in a single  number. Regulators have stressed that the effectiveness of the PCA  framework depended on making early and forceful use of other  enforcement tools. However, while regulators have their own authorities  and PCA also authorizes other discretionary actions, the regulators have  not used these enforcement tools consistently. Tying mandatory corrective  actions to additional indicators could mitigate these current weaknesses  of PCA and increase the consistency with which distressed banks would  be treated. And, enhancing the PCA framework in such a way would allow  both regulators and banks more time to address deteriorating conditions.  More important, banks facing such corrective actions likely would not be  in as weakened a condition as typically is the case when current capital  thresholds are triggered. Thus, the banks might have more options  available to them to bolster their safety and soundness and avoid failure.  Moreover, without an additional PCA trigger, the regulators risk not acting  soon enough to address a bank’s deteriorating condition, thereby limiting  their ability to minimize losses to the DIF.
Expert stakeholders we surveyed also called for modifications to the PCA  framework and identified several options for doing so. The top three  options they identified include (1) adding a measure of risk to the capital  category thresholds; (2) increasing the capital ratios that place banks into  PCA capital categories and (3) adding an additional trigger.  As the expert  stakeholders noted and we also recognize, making any changes to the PCA  framework would entail some trade-offs. Specifically, regulators would  have to strike a balance between more corrective actions and unnecessary  intervention in healthy banks. The Financial Stability Oversight Council  could provide a forum for vetting changes to the PCA framework and  proposing these changes to Congress. Building consensus for potential  changes, including working through the details of the changes and the  associated trade-offs, will not be easy. But, in light of significant losses to  the DIF in recent years, including at banks that underwent the PCA  process, changes to the PCA framework are warranted.
section_title: Recommendation for Executive Action
paragraphs: To improve the effectiveness of the PCA framework, we recommend that  the heads of the Federal Reserve, FDIC, and OCC consider additional  triggers that would require early and forceful regulatory actions tied to  specific unsafe banking practices and also consider the other two  options—adding a measure of risk to the capital category thresholds and  increasing the capital ratios that place banks into PCA capital categories— identified in this report to improve PCA. In considering such  improvements, the regulators should work through the Financial Stability  Oversight Council to make recommendations to Congress on how PCA  should be modified.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to FDIC, the Federal Reserve, OCC, and  OTS for review and comment. All of the agencies provided technical  comments, which we considered and have incorporated as appropriate.   FDIC, the Federal Reserve, and OCC also provided written comments that  we have reprinted in appendices VI, VII, and VIII, respectively.
In written comments, FDIC, the Federal Reserve and OCC agreed with our  recommendation to consider options to make PCA more effective.  All  three regulators noted that future enhancements to regulatory capital  requirements could lead to raising the PCA capital category thresholds.   FDIC and the Federal Reserve specifically stated that enhancements to  capital requirements will likely be addressed when the regulators consider  Basel III standards and that the PCA capital category thresholds could be  impacted by rules implementing the Basel III standards.  FDIC’s written  comments also reflected a concern regarding using noncapital based  triggers for PCA and suggested such triggers “appear to have greater risk  of unintended consequences” and should not be implemented without  further study.  However, the basis for FDIC’s concern that triggers such as  measuring concentrations, liquidity, management, or overall risk profile  would pose greater risk of unintended consequences is unclear.  As  discussed in the report any changes to PCA require considering both the  advantages and disadvantages.  Our analysis demonstrated that adopting  additional triggers within PCA also offers the potential for valuable  benefits that must be considered. For example, our analysis demonstrated  that noncapital triggers are more effective in identifying those banks that  failed without undergoing the PCA process. The Federal Reserve also  commented that one of the other options covered in the survey—changing  accounting rules used to measure capital levels—but not discussed in  detail in the report also offered promise in enhancing the effectiveness of  PCA.  As noted in the report, this was the fourth ranked option along with  enhancing restrictions and requirements at the holding company level.
All three regulators noted in their written comments that they take  supervisory enforcement actions in addition to PCA, as discussed in the  draft report. Specifically, FDIC stated in its written comments that it had  taken many supervisory actions in response to problems identified at the  institutions it supervises and that it has strived to improve its supervisory  processes based on lessons learned from material loss reviews.  The  Federal Reserve wrote that it did not find its supervisory enforcement  actions to be inconsistent.  OCC commented that it already imposes higher  minimum capital standards for national banks whose risk profile warrants  it.  The enforcement action information presented in our report is  compiled in aggregate from all of the banking regulators where material  loss reviews or other evaluation reports were prepared subsequent to  bank failure.  However, we found examples from each of the regulators  where no enforcement action (formal or informal) occurred until less than  180 days prior to bank failure.  The material loss reviews for all of the  regulators also commonly cited that earlier and more forceful supervisory  action could have helped address deteriorating conditions earlier.  We also  noted in our report improvements over time in the overall timeliness of  enforcement actions and that all of the regulators had taken actions to  address previous weaknesses and lessons learned.
FDIC and the Federal Reserve also commented on the time period of our  analysis.  In written comments, FDIC noted that our results were “heavily  influenced by the timing of the evaluation period” while the Federal  Reserve similarly noted that because of the time period of analysis  troubled banks had difficulty recovering due “to limited access to capital  more than to the ineffectiveness of PCA.”  While we acknowledge that  recent years have put considerable stress on the banking system, we  believe that circumstances like this are critically important for assessing  the performance of PCA—periods of bank distress are when PCA will be  most seriously tested.  In addition, changes to PCA based on options  identified in our survey—such as higher capital thresholds—could assist  banks in recovering during periods in which they have difficulty accessing  capital from external sources.
We are sending copies of this report to FDIC, the Federal Reserve, OTS,  and OCC, the Financial Stability Oversight Council, and other interested  parties. The report also is available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staffs have any questions about this report, please contact A.  Nicole Clowers at (202) 512-8678 or clowersa@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff that made major contributions to  this report are listed in appendix IX.
section_title: Appendix I: Objectives, Scope, and Methodology
subsections: section_title: Data Sources and Period of Analysis
paragraphs: To describe outcomes from and issues related to bank failures and losses  to the deposit insurance fund (DIF), we analyzed quarterly data on the  capitalization levels of federally insured banks from the Federal Deposit  Insurance Corporation (FDIC). We obtained these data from FDIC  Quarterly Banking Reports, which publish industry statistics derived from  Reports on Condition and Income (Call Reports) and Thrift Financial  Reports. All banks and thrifts must file Call Reports and Thrift Financial  Reports, respectively, with FDIC every quarter. We have assessed the  reliability of FDIC’s Call and Thrift Financial Report databases as part of  previous studies and found the data to be reliable for the purposes of our  review.
Our period of analysis extended from January 2006, immediately after the  ending point of our previous study, GAO-07-242, through the third quarter  of September 2010. For this period, we calculated the total number of  banks in any of the lowest three categories for prompt corrective action  (PCA)—undercapitalized, significantly undercapitalized, or critically  undercapitalized—in each quarter. We also calculated how many banks  entered one of these capital categories for the first time in each quarter.
Our analysis excludes 13 institutions that received other assistance, such  as assistance pursuant to systemic risk determinations. Although FDIC  classified these banks as resolved, we excluded them because they  remained operational.
section_title: Analysis of Bank Outcomes and Losses to the DIF
paragraphs: We reviewed bank failure data provided by FDIC to determine the number  of banks that failed during our period of analysis, including their  associated losses. We also reviewed data from FDIC that identified those  banks that were subjected to PCA before failure and those that were not.  We determined that the information from these datasets, related to DIF  losses and capital levels from Call and Thrift Financial Reports, was  sufficiently reliable for the purposes of our review based on ongoing and  prior work using such data.
In addition, we used loss data from FDIC to identify the losses that each  failed bank caused to the DIF failure, which we determined to be  sufficiently reliable for our purpose of enumerating failed banks and the  losses associated with these failures. We also analyzed losses to the DIF  relative to the size of each failed bank. To do so, we identified the total  assets of each failed bank as reported on its Call Report or Thrift Financial  Report in the quarter before failure. We used this measure and the losses  that the bank caused the DIF (as estimated in 2010) to determine losses as  a percentage of assets.
To analyze the outcomes of banks in our analysis, we determined whether  by the third quarter of 2010 a bank (1) had failed; (2) remained  undercapitalized, was on the problem bank list, or both; (3) was dissolved;  or (4) was not undercapitalized or on the problem bank list. We  considered banks dissolved if they were not in the FDIC loss dataset or  classified as active by FDIC by the end of this period. Many dissolved  banks were merged into an acquiring bank without governmental  assistance, although some were merged with assistance or were dissolved  through a voluntary liquidation that did not result in a new institution.  Although components of these dissolved banks may have remained active,  they operated under the certification number of their acquiring bank. We  did not count banks as dissolved if they operated under their original  certification number and FDIC classified them as active, regardless of  whether a new entity had gained a large or controlling stake in their  operations.
We used a number of econometric models to estimate the impact of PCA  on losses to the DIF. We controlled for the financial condition of banks  before they fail by holding constant factors affecting the quality of the  balance sheet and the size of deposit liabilities. For more information, see  appendix III.
We also interviewed officials from FDIC, the Office of the Comptroller of  the Currency (OCC), the Office of Thrift Supervision (OTS), and the Board  of Governors of the Federal Reserve System (Federal Reserve) to obtain  their views on the effectiveness of PCA in minimizing losses to the DIF.
section_title: Analysis of Indicators, Enforcement Data, and Case Studies of Deteriorating Banks
paragraphs: To assess the utility of various financial indicators in predicting bank  distress, we developed a model of leading indicators of bank failure based  on financial ratios researchers had identified in the 1990s that predicted  bank failures in previous stress periods. Specifically, we used these  financial ratios, regulatory ratings, and an indicator we developed of  sector loan concentration to forecast bank failure within 1 to 2 years (for  failed banks and peers from 2006 through the third quarter of 2010). We  used this model to assess the predictive power of indicators other than  bank capital. Additional information concerning the methodology for this  analysis can be found in appendix III. To perform this work, we relied on  data from FDIC and SNL Financial. We assessed the reliability of data used  in our analysis and found the data sufficiently reliable for our purposes.
To assess the regulatory enforcement actions associated with banks that  had deteriorated, we examined the type and timing of regulatory actions  for failed banks with various outcomes, and analyzed the extent to which  regulatory indicators provided warning of likely bank deterioration or  failure. To conduct this work, we requested enforcement data from FDIC,  the Federal Reserve, OCC, and OTS. Upon receipt of this information, we  determined that the enforcement data provided could not be relied upon  for our specific analysis without additional verification. In particular, the  enforcement data the Federal Reserve, OCC, and OTS provided could not  be used alone to make distinctions among different types of enforcement  actions that may or may not have been relevant to safety and soundness  issues of banks that were deteriorating financially. While enforcement data  provided by FDIC did make such distinctions, we did not rely exclusively  on the enforcement data provided by the regulators. We determined that it  was necessary to systematically pull relevant enforcement data on failed  banks from material loss reviews and other evaluation reports prepared by  the inspectors general (IG) of the banking regulators and corroborated  this information with the enforcement data provided by regulators.  Specifically, we reviewed material loss reviews and other evaluation  reports available on 136 institutions that failed in 2008, 2009, and 2010.  From these reports, we systematically identified the first enforcement  action relevant to the regulator’s efforts to address deteriorating  conditions in a 2-year period before failure.
Further, we conducted case studies to explore supervisory, managerial,  financial, and other characteristics commonly present in troubled or failed  banks and illustrate the sequence of steps between the onset of trouble  and a bank’s closure. Specifically, we conducted case studies of eight  banks to highlight examples of oversight steps taken by each of the  regulators and various outcomes. For this work, we selected a  nongeneralizable sample of banks that is diverse with respect to  geography, asset size, franchise value, primary regulator, date of failure,  sequence of enforcement actions, outcome (failure or a return to financial  stability), and losses to the DIF. The case studies also allowed us to  observe the off-site monitoring tools employed by regulators and examine  whether these tools provided effective warnings of likely bank  deterioration or failure.
section_title: Identifying Options That Could Improve PCA
paragraphs: To identify options that could help improve the effectiveness of PCA in  minimizing losses to the DIF, we gathered ideas from a range of informed  stakeholders from the regulatory, research, and industry sectors through a  series of surveys. We discuss the process used to identify stakeholders  later in this appendix. We also conducted a literature review and  interviewed agency officials and industry groups, and we incorporated the  results into the survey process.
subsections: section_title: Delphi Survey Method
paragraphs: To gather options from informed stakeholders that could help improve the  effectiveness of PCA, we employed a modified version of the Delphi  method, which follows a structured process for collecting and distilling  knowledge from a group through a series of questionnaires. For our  purposes, we employed two iterative Web-based surveys.
Our first survey consisted of open-ended questions that asked respondents  to provide their views on the positive aspects and shortcomings of the  PCA framework, changes to the PCA framework that could make it more  effective in minimizing losses to the DIF, and trade-offs associated with  suggested changes to the framework. We conducted the first survey  between November and December 2010. We distributed a link for the  survey to 44 individuals by e-mail and also subsequently e-mailed and  telephoned nonrespondents to encourage a higher response rate. We  received completed surveys from 28 respondents (64 percent). Of the 28  completed responses, 17 were from regulators and supervisors, 9 were  from researchers and consultants, and 2 were from industry participants.  Of the 16 nonrespondents, 1 was an industry participant, 1 was a regulator  and supervisor, and 14 were researchers and consultants. On the basis of  the 28 completed surveys, we performed a content analysis of the open- ended responses for all questions on the survey. We categorized the  responses on the positive aspects and shortcomings into five categories  each. We jointly analyzed the responses to the two questions asking about  changes to or alternatives beyond the PCA framework and ultimately  categorized the responses into 12 broad options.
To help ensure that our list of options for the second survey was thorough,  we also reviewed literature on PCA and conducted interviews. We  performed a literature search of studies (dating from January 2000 through  October 2010) from major electronic databases, such as ProQuest and  EconLit. We included studies that focused on PCA or reducing losses to the  DIF in the U.S. financial system. We only included studies that came from  one of the following sources: peer-reviewed journals; federal regulatory  agencies, GAO, Congressional Research Service, IGs; conference  proceedings; advocacy and think tank organizations; or research institute,  government, or think tank working paper series. We then reviewed the  resultant studies to identify options that could improve the effectiveness of  the PCA framework. In addition, we synthesized options that federal  regulators, IGs, industry groups, and academics suggested during  interviews. Overall, the literature review and interviews did not identify any  broad options beyond those identified in the content analysis of the first  survey. However, we used specific examples for the options—specifically  the option to include another trigger for PCA—from the literature review  and interviews to supplement those gathered through the first Delphi  survey. We also used the literature review and interviews to learn about  trade-offs associated with options to change the PCA framework.
We conducted the second survey from February 2011 through March 2011.  In our second survey, we asked recipients their opinion on the positive  aspects and shortcomings of PCA identified in our analysis of the first  survey. We also asked recipients to rate the potential impact and feasibility  of the options to change the PCA framework and rank the three top  options. We sent this survey to the same 44 individuals, and we sent out  reminder Email messages and subsequently e-mailed and telephoned  nonrespondents to encourage a higher response rate. We received  completed surveys from 29 for a response rate of 66 percent. Of the 29  completed responses, 15 were from regulators and supervisors, 11 were  from researchers and consultants, and 3 were from industry participants.  Of the 15 nonrespondents, 3 were regulators and supervisors and 12 were  researchers and consultants. Because of the number of nonrespondents  who were from the research sector, the data collected from these surveys  may not fully represent the views of this group.
section_title: Selecting Survey Recipients
paragraphs: We used a three-step process to determine which individuals would be  invited to participate in our Delphi surveys. First, we identified the  relevant sectors or groups of banking supervision stakeholders. We  identified three sectors of stakeholders:  1.  regulators and supervisors,  2.  researchers and consultants, and  3. industry participants.
Next, we identified individuals within each of these sectors, through  formal organizations when possible, including federal regulatory agencies,  state regulatory associations, and industry groups. Our decisions to  identify individuals were informed by the following criteria:    authorship of research on PCA,  testimony at relevant congressional hearings,    membership in the Shadow Financial Regulatory Committee, and  recommendations we received during initial interviews with industry  groups and researchers.
When possible, we also consulted with organizations to confirm that we  had identified the appropriate staff or member to include in our list of  informed stakeholders.
To help ensure that our selection was thorough, we asked respondents in  our first survey to recommend additional groups or individuals who they  felt should be included. Additional groups or individuals identified through  this process were invited to complete both surveys based on the criteria  described above. See appendix IV for a list of survey respondents.
Although we believe that this sample was sufficient for the purposes of  identifying options that may improve PCA and for getting a sense of the  relative impact and feasibility of these options, the survey was not a  census of all informed stakeholders and was not given to a random,  generalizable sample of stakeholders. Therefore, the results represent only  the views of the individuals who responded and are not representative of  or generalizable to all informed stakeholders or all three sectors identified  above. In addition, the practical difficulties of conducting any survey may  introduce errors, commonly referred to as nonsampling errors. For  example, difficulties in interpreting a particular question, differences in  sources of information available to respondents, or differences when  analyzing data can introduce unwanted variability into the survey results.  We took steps in developing the surveys, collecting the data, and analyzing  them to minimize such nonsampling errors. For example, we conducted a  series of pretests with several survey recipients prior to distributing both  surveys. The goals of the pretests were to help ensure that (1) the  questions were clear and unambiguous and (2) terminology was used  correctly. We made changes to the content and format of both surveys as  necessary based on the pretests.
section_title: Appendix II: The Resolution Process Also Can Help Minimize Losses to the Deposit Insurance Fund
paragraphs: Beyond PCA, the selection of the bank closure method serves as an  additional process for minimizing losses to the DIF. According to section  13 of the Federal Deposit Insurance Act (FDIA), the resolution method  FDIC selects must be the alternative that is least costly to the insurance  fund, except in cases involving systemic risk where FDIC may take other  action for the purpose of winding up the insured depository institution for  which the FDIC has been appointed receiver as necessary to avoid or  mitigate such effects. To select the least costly method, FDIC compares  the estimated cost of liquidation—basically, the amount of insured  deposits FDIC must pay minus the net realizable value of a bank’s assets— with the amounts that potential acquirers bid for the bank’s assets and  deposits. The most common resolution method for failing banks is the  purchase and assumption transaction, in which a healthy bank purchases  certain assets and assumes certain liabilities of a failed bank. FDIC sells  banks through a purchase and assumption transaction unless another  approach is less costly to the DIF.
According to FDIC, their ability to influence the cost of bank failures to  the DIF is limited, but FDIC said certain resolution methods helped  minimize losses. FDIC’s Division of Resolutions and Receiverships (DRR)  told us that the cost of a bank failure to the DIF is embedded in the  financial position of the failed bank. According to FDIC DRR, factors  (beyond the resolution process) that affect the cost of a bank failure are  both internal and external to the failed bank. For instance, the stability of  the bank’s funding sources—that is, the degree to which the bank has a  stable base of customers rather than “brokered” or bulk deposits from out- of-state institutional investors—is a key internal factor. The quality of the  bank’s assets (for example, the proportion of its loans that carry a high  risk of default) is a second, key internal factor. External factors such as  wider economic conditions and the risk appetite of potential buyers also  affect the cost of a bank failure.
FDIC DRR officials told us that although the cost of a bank failure is  largely fixed by the time of failure, the manner of resolution can affect  losses to the DIF “in the margin.” In an effort to minimize these losses,  FDIC DRR customized purchase and assumption transactions, which it  used to sell 254 of the 270 banks that failed after undergoing the PCA  process, to the needs of the market. In a purchase and assumption  transaction, a healthy bank purchases certain assets and assumes certain  liabilities of a failed bank. The specific composition of the transaction  depends on the assets and liabilities held by the failed bank as well as  wider market conditions. FDIC may offer to sell acquirers (1) the whole  failed bank; (2) the whole failed bank with a shared-loss agreement, an  arrangement whereby FDIC, with the intent of limiting losses to the  deposit insurance fund, agrees to share with the acquirer the losses on  those assets; (3) less than whole bank with a shared-loss agreement; or (4)  a clean transfer (cash, securities, and insured deposits). FDIC DRR  resolved the remaining 16 of the 270 banks that failed after being subject  to PCA through direct payout, a scenario in which FDIC pays depositors  directly and places the assets of the failed bank in a receivership.
Beyond tailoring purchase and assumption transactions to the needs of the  market, FDIC DRR pursued strategies based on the rationale that the long- term intrinsic value of the assets of failed banks exceeded their depressed  market value. Examples are the FDIC structured transaction program, in  which FDIC acts as a receiver and partners with a private-sector  institution to dispose of assets from failed banks. According to FDIC DRR,  this program enables FDIC to take advantage of private-sector knowledge  while recouping future cash flows from the failed bank. FDIC also sought  to increase the value of distressed assets through a loan modification  program. In this program, FDIC works with failed banks to modify rather  than foreclose on residential mortgages. This reduces the number of  borrowers who face foreclosure and rehabilitates inactive mortgages into  performing loans.
FDIC DRR told us that it used shared-loss agreements to increase the  value of distressed assets and protect the DIF. When market values were  falling, in 2008, FDIC DRR’s valuations of failed banks were too high to  attract bidders. As its backlog of banks grew, FDIC DRR adopted a loss- share approach in which it sold a pool of problem assets to an acquirer  under an agreement that FDIC would share a portion of the losses. This  structure allowed FDIC to reduce the immediate cash outlays for the  transaction. Figure 15 illustrates the increase in shared-loss agreements  from 2007 through the third quarter of 2010. According to FDIC, these  shared-loss agreements enabled FDIC to transfer failed banks to a private- sector acquirer, an outcome that cost the fund less than liquidation of the  failed bank.
FDIC DRR told us that as the economy improved in 2010, it received bids  for failed banks that included no loss-share agreement. For shared-loss  agreements that FDIC did offer in this time period, it shifted more risk to  bidders. Because the losses to the DIF from these shared-loss agreements  will be realized over longer time horizons (for example, 8-10 years), it is  too early to thoroughly evaluate the relative merits of the shared-loss  agreements against other resolution methods.
section_title: Appendix III: Econometric Analysis of Leading Indicators of Bank Failure and Determinants of Losses to the Deposit Insurance Fund
paragraphs: This appendix describes the methodological approach we took to identify  potential leading indicators of bank failure, generate a peer group for the  population of failed banks, and evaluate the statistical and practical  significance of potential leading indicators during the current period of bank  distress. The appendix also describes the methodology and results for  assessing potential determinants of losses to the DIF and impact of PCA.
subsections: section_title: Methodological Approach
paragraphs: In order to construct a logistic (logit) regression model of bank failure  prediction, we identified leading indicators from a previous period of bank  failures based principally on two studies. We selected the following five  financial ratios: equity capital/assets, earnings/assets, nonperforming loans  (sum of past due loans, nonaccrual loans, and real estate owned)/assets,  securities/liabilities, and “jumbo” ($100,000 plus) certificates of  deposit/liabilities. The rationale for each of these indicators is described in  table 6 below.
We found that the equity capital measure from the literature evolved in a  way that was quite similar to certain regulatory capital measures (see fig.  16) for banks that ultimately failed. The correlation between the aggregate  equity capital measure and the leverage ratio was 0.99; the correlation with  the tier 1 capital to risk-weighted assets ratio was 0.97.
Given the attention to commercial real estate concentrations during this  crisis, we developed a more generic measure of loan concentration as a  potential leading indicator. The Bank for International Settlements and  Deutsche Bundesbank have described how a Herfindahl-Hirschman Index  (HHI) could be used to measure loan concentration. We adopted a version  based on sectors defined below. This is an imperfect measure of  concentration because it does not account for the correlations between  the various sectors and with the overall economy. However, an HHI is a  useful and straightforward indicator of credit concentration. All else being  equal, it should be associated with greater risk and there may therefore be  associated with a greater likelihood of failure. We define two possible  HHIs based on two different sector definitions (identical except for one  distinction—in HHI 1 multifamily residential real estate is included with  one-four family residential real estate, and in HHI 2 it is included with  commercial real estate):    HHI 1: Sector shares are defined as acquisition, development, and  construction loans (ADC) plus nonfarm nonresidential real estate  (commercial real estate, or CRE, narrowly defined), residential real  estate (including one-four family and multifamily  real  estate), consumer loans, loans to farms plus agricultural production  loans, commercial and industrial (C&I) loans, and other (a residual).
HHI 2: Sector shares are defined as ADC loans plus nonfarm  nonresidential real estate (CRE narrowly defined) plus multifamily  residential real estate loans (these three sectors are similar to the  broad definition of CRE used in the joint CRE concentration guidance  that the federal banking regulators issued), one-four family residential  real estate loans, consumer loans, loans to farms plus agricultural  production loans, C&I loans, and other (a residual).
We identified failed banks and dates of failure based on FDIC data. To  properly assess the predictive power of potential leading indicators during  the present bank crisis, we developed a control group of healthy banks.  We used the Uniform Bank Performance Report to identify banks in the  same general peer group and then selected two in the same state for each  failed bank. For each failed thrift, we selected two thrifts from the same  state as peers.
subsections: section_title: Econometric Results
paragraphs: We estimated a variety of four- and eight-quarter ahead forecasting models  via logit using Huber-White robust standard errors. Technically, our  estimates were based on five- and nine-quarter ahead forecasts because  the Call Report data are released well after the dated quarter. For example,  we used fourth-quarter 2006 data, available sometime during the first  quarter of 2007, to determine if a bank failed in the second, third, or fourth  quarter of 2007 or the first quarter of 2008.
We adopt in-sample measures of model and variable performance but no  traditional test of out of sample forecasting ability (e.g., estimating the  model through 2009 and measuring forecast accuracy in 2010).  However,  the logistic regressions can be thought of (with the exception of the  concentration index) as an out-of-sample test of the models and variables  as they were estimated in the aforementioned assessments of earlier  waves of bank failures published 1995 and 1998.
We first estimated a model with the five leading indicators identified  previously, at four- and eight-quarter forecasting horizons. As evident in  tables 7 and 8 below, these five indicators remain highly significant  predictors of bank failure.
Next we estimated two models at a four-quarter horizon with our two  measures of sector loan concentration in addition to the five indicators. As  evident in tables 9 and 10 below, both concentration indices are significant  predictors of bank failure, though the p-value of the coefficient estimate  for HHI 2 is much smaller.
We estimated marginal effects of one-standard deviation changes based on  the coefficients in table 10. The magnitude or practical significance of  these indicators is also notable, with a one-standard deviation increase in  the indicator changing the probability of failure over the next year (from  about 2.8 percent at the means of the independent variables) in the next  four quarters as follows:    capital: down 2.7 percentage points,    earnings: down 0.7 percentage points,    nonperforming loans: up 5.0 percentage points,    securities: down 0.5 percentage points,    unstable funding: up 0.3 percentage points,    concentration index: up 0.9 percentage points.
It is possible that the concentration index is predictive of failure because  many failed banks had loan concentrations in sectors that experienced  downturns, not because the institutions were less diversified overall.  Concentration in the CRE sector in particular could explain the predictive  power of the concentration index because of the recent downturn in CRE.  As evident in tables 11 and 12 below, while CRE is predictive of bank  failure, HHI 2 remains predictive after controlling for CRE concentration,  though the coefficient is smaller and less significant than the model in  table 10.
Next we estimated a model with HHI 2 at the eight-quarter horizon. As  evident in table 13, the concentration index remained a statistically  significant predictor at the longer horizon.
Next we estimated a model with only CAMELS ratings at four- and eight- quarter horizons, along with a model combining CAMELS ratings with the  model in table 10 (five indicators plus HHI 2) also at four- and eight-quarter  horizons. As evident in tables 14-17, CAMELS ratings on their own are  predictive of bank failure within four and eight quarters. As a composite  index meant to capture the underlying CAMELS component factors (capital,  asset quality, management, earnings, liquidity, and sensitivity to market risk)  CAMELS are similar to a predictive regression model based on financial  indicators that represent some of those categories—in the sense that they  both take into account more than just capital. However, CAMELS ratings  have less explanatory power by themselves, as measured by McFadden’s r- squared, 0.26 versus 0.47 for the logit with the financial ratios and  concentration index. Furthermore, CAMELS ratings and the financial ratios  we have chosen each contain unique information that can be helpful in  anticipating bank distress. CAMELS ratings remain a highly statistically  significant predictor of bank failure when added to a regression with capital,  earnings, nonperforming loans, securities, unstable funding, and the  concentration index, though unsurprisingly the coefficient is somewhat less  significant than on its own. Thus CAMELS ratings contain information that  is not fully accounted for by the financial indicators we have identified and  included in the regression, and vice versa.
Finally, we estimated marginal effect of a one-rating increase  (deterioration) in the CAMELS rating based on the coefficients in table 15.  The magnitude or practical significance of the CAMELS rating is also  notable, with a one-rating increase changing the probability of failure over  the next year from about 2.8 percent to 4.2 percent.
section_title: Analysis of DIF Losses
paragraphs: We estimated a variety of econometric models to assess the impact of PCA  on the DIF. Our model includes all bank failures from first quarter 2007 to  third quarter 2010. In order to derive a better estimate of PCA’s impact  than comparing mean or median losses, we controlled for other factors  that might affect losses to the DIF and therefore account for some  systematic differences between banks that underwent the PCA process  before failure and those that did not. We attempted to control for factors  related to the quality of the bank’s balance sheet (and therefore expected  value to potential buyers) and the size of FDIC’s deposit liabilities.
We report on the results of several models we estimated via ordinary least- squares (OLS) below. All models reported below were estimated with  White standard errors. Prompt corrective action is a dummy variable equal  to “1” if the failed institution underwent the PCA process, “0” otherwise.
While PCA was not statistically significant in any of the specifications we  ran, it was consistently negative in the 1-3 percentage point range.  Because institutions that underwent PCA had on average almost $1 billion  in assets, a small effect that did not meet conventional standards for  statistical significance might in some circumstances be of practical or  economic significance.
Mean losses for PCA versus non-PCA banks are 28 percent of assets versus  25.6 percent of assets (the difference was not statistically significant)  before controlling for other factors. After controlling for other factors,  banks that underwent the PCA process had 1-3 percentage point lower  losses as a percentage of assets, though the difference remained  statistically insignificant. In total, controlling for balance sheet quality  resulted in a roughly 3-5 point change in DIF losses and suggests a more  positive role for PCA in reducing losses to the DIF. In addition, the balance  sheet factors are all highly statistically significant.
As shown in table 19, in the model with deposits measured as the total  deposits of the bank (which may exceed the liabilities of the FDIC), the  coefficient on PCA was roughly negative 3—banks that underwent PCA  had DIF losses that were roughly 3 percentage points less as a percentage  of assets—but not statistically significant.
As shown in table 20, in the model with deposits measured as the small  deposits of the bank (which may understate the liabilities of the FDIC), the  coefficient on PCA was roughly negative 1—banks that underwent PCA  had DIF losses that were roughly 1 percentage point less as a percentage  of assets—but not statistically significant.
As shown in table 21, in the model with deposits measured as the small  deposits of the bank and nonperforming assets substituted for  nonperforming loans, in table 20, the coefficient on PCA was also roughly  negative 1—banks that underwent PCA had DIF losses that were roughly 1  percentage point less as a percentage of assets—but not statistically  significant.
section_title: Appendix IV: PCA Survey Respondents
paragraphs: We asked 44 informed stakeholders from the regulatory, research, and  industry sectors to complete our first and second surveys about prompt  corrective action. For more information on our survey and selection  methodologies, see appendix I. The following table lists the individuals  from whom we received completed responses to the first, second, or both  surveys.
section_title: Appendix V: Responses to Questions from GAO’s Second Delphi Survey on the Prompt Corrective Action Framework
paragraphs: We distributed a survey to 44 individuals from the regulatory, research,  and industry sectors to determine their views on the PCA framework and  options for modifying the PCA framework to minimize losses to the DIF.  We received completed responses from 29 of 44 individuals, for a response  rate of 66 percent. Tables 23-28 and figures 17-18 below show responses to  questions from the survey. For more information about our methodology  for designing and distributing the survey, see appendix I.
section_title: Appendix VI: Comments from the Federal Deposit Insurance Corporation
section_title: Appendix VII: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix VIII: Comments from the Office of the Comptroller of the Currency
section_title: Appendix IX: GAO Contacts and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts above, Kay Kuhlman (Assistant Director),  JoAnna Berry, Gary Chupka, Bill Cordrey, Andrea Dawson, Michael  Hoffman, Barry Kirby, Joanie Lofgren, Grant Mallie, Marc Molino, Tim  Mooney, Steven Putansu, Ellen Ramachandran, Linda Rego, Barbara  Roesmann, and Andrew Stavinsky made key contributions to this report.