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. 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. 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.