Ms. Chairwoman and Members of the Committee: We are pleased to be here today to discuss bank and thrift supervision and examination. Supervisory and examination procedures today show evidence of lessons learned from the bank and thrift crises of the 1980s and early 1990s. These procedures are the primary basis used by the federal regulatory agencies to assess the risks that banks and thrifts assume and to take actions that are needed to maintain a safe and sound banking system and protect the deposit insurance funds. A combination of regulatory and legislative changes, along with market forces, has expanded the number and scope of activities undertaken by insured depository institutions, particularly the largest ones, and thus the risks that they assume. These expanded activities include offering and/or dealing in a range of nontraditional bank products, such as mutual funds, securities, derivatives, and other off-balance sheet products. The resulting complex institutions represent a major supervisory and regulatory challenge. In keeping with the changes in the banking environment, federal bank and thrift regulators have recently announced that bank examinations will explicitly include an assessment of how effectively banks manage risk and a rating on their sensitivity to risks posed by a variety of market factors. Although we have not yet fully assessed the implementation of most of the recent changes to supervisory and examination policy, they appear to address some of our concerns about examinations in the aftermath of bank failures in the 1980s and early 1990s. Perhaps the most important—yet unanswered—question to ask in assessing changes in bank and thrift supervision is to what extent improvements in the detection of problems can help ensure that regulators take timely and forceful corrective action to prevent or minimize losses to the deposit insurance funds. describe the history of the bank and thrift crises of the late 1980s and early 1990s and the legislative response to these crises, highlight supervisory and examination weaknesses we have noted in the past and improvement efforts that have been made or are under way, and identify continuing issues. From 1980 to 1994, record losses were absorbed by the federal deposit insurance funds. In this period, nearly 1,300 thrifts failed, and 1,617 federally insured banks were closed or received FDIC financial assistance. Losses to deposit insurance funds have been estimated at about $125 billion. Banks and thrifts failed during the 1980s for several reasons. A mismatch between the income from fixed rate mortgages and the costs of borrowing funds at market rates in competition with nondepository institutions were among the reasons for large losses that led to the failure of thrifts. Banks suffered losses from defaults on loans concentrated in several industries that suffered economic downturns over the decade, including agriculture, real estate, and developing nation loans. One factor we and others cited as contributing to the problems of both thrifts and banks during this period was excessive forbearance by federal regulators. Regulators had wide discretion in choosing the severity and timing of enforcement actions to correct unsafe and unsound practices. They also had a common philosophy of trying to work informally and cooperatively with troubled institutions. In a 1991 report, we concluded that these conditions had resulted in enforcement actions that were neither timely nor forceful enough to (1) correct unsafe and unsound banking practices or (2) prevent or minimize losses to the insurance funds. The regulators themselves have recognized that their supervisory practices failed to adequately control risky practices that led to numerous thrift and bank failures. We made specific recommendations for changes to the supervisory process that would help ensure that institutions failing to operate in a safe and sound manner would be subject to timely and forceful supervisory response, including, if necessary, prompt closure. of the Federal Savings and Loan Insurance Corporation (FSLIC) and troubles in the thrift industry. In addition to creating the Savings Association Insurance Fund to replace FSLIC, FIRREA created a new thrift industry regulator with increased enforcement authority—the Office of Thrift Supervision. It also authorized FDIC to terminate a bank’s or thrift’s deposit insurance for unsafe and unsound conditions. The second law, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), was enacted, in part, because of concerns that the exercise of regulatory discretion during the 1980s did not adequately protect the safety and soundness of the banking system or minimize insurance fund losses. FDICIA contains several safety and soundness provisions based on a simple principle: if a depository institution fails to operate in a safe and sound manner, it should be subject to timely and forceful supervisory response, including, if necessary, prompt closure. Also, FDICIA requires a number of corporate governance and accounting reforms to (1) strengthen corporate governance, (2) improve financial reporting, and (3) aid early identification of safety and soundness problems. Among the corporate governance and accounting reforms, FDICIA establishes generally accepted accounting principles as the standard for all reports to regulators; requires that management and auditors annually report on the financial condition and management of the largest depository institutions, including effectiveness of and compliance with internal controls; and requires that institutions have independent audit committees composed of outside directors. In addition, FDICIA contains provisions for improving regulatory supervision. FDICIA mandates annual on-site examinations of insured banks and thrifts. Also, consistent with specific recommendations we made, it requires implementation of a “trip wire” approach to limit regulatory discretion in key areas, including capital, by mandating specific regulatory responses to safety and soundness problems. These changes, incorporated in sections 38 and 39 of the Federal Deposit Insurance Act, were intended to increase the likelihood of prompt regulatory action to prevent or minimize loss to the insurance funds. regulatory action as an institution’s capital drops to lower levels. Although this requirement should strengthen oversight in several ways, it is inherently limited as a tool for early intervention to correct problems and thus safeguard the insurance funds. This is because impaired capital levels often do not appear until after a bank has experienced problems in other areas, such as asset quality and management. Section 39 allows regulatory action before capital is impaired. However, section 39, as implemented, appears to do little to reduce regulatory discretion. The implementing guidelines and regulations did not (1) establish clear and specific definitions of unsound conditions and practices or (2) link such conditions or practices to specific mandatory regulatory actions. As we noted in our 1996 report, the subjective nature of the implementation continued the wide discretion that regulators had in the 1980s over the timing and forcefulness of enforcement actions. did not systematically test critical internal controls such as compliance with loan underwriting policies. We recommended that a comprehensive review of internal controls be a part of bank and thrift examinations and that the condition of a bank’s or thrift’s system of internal controls receive explicit consideration in a determination of an institution’s examination rating. Insufficient review of loan quality and loan loss reserves: Effective loan quality assessment is important, because loans generally make up the majority of bank and thrift assets and involve the greatest risk. Determining the adequacy of loan loss reserves is critical because without such a determination, in combination with a proper assessment of loan quality, examiners have no reliable basis to understand an institution’s true financial condition. We recommended that examination policies require a representative sampling of loans and better documentation of loan quality and the development of a methodology to determine the adequacy of loan loss reserves. Weaknesses in detecting and ensuring corrective actions related to insider lending: Loans to insiders—such as bank directors, officers, or principals—should pose no greater risk than transactions with other bank customers. Abusive insider activities can be among the most insidious of reasons for the deterioration of the health of a bank. In 1994, we reported that examiners faced numerous impediments to determining the full extent of insider problems at banks and that such problems were not always corrected as a result of examinations. We recommended that bank regulators review insider activities in their next examination of each bank, partly by comparing data provided during the examination with information from other sources. We also recommended that federal bank regulators ensure that all directors understand their responsibility for seeing that effective corrective action is taken. Insufficient assessment of actual and potential risks of bank holding company activities to insured bank subsidiaries: In our reports, we have found that transactions between a bank holding company and its insured bank subsidiary were not always thoroughly reviewed. Such transactions include loans from the bank to other, nonbank subsidiaries; fees charged by the bank holding company to the bank subsidiary; and asset transfers from nonbank subsidiaries to the bank subsidiary. We recommended that the supervisors develop and require mandatory procedures for assessing the actual and potential risks to insured bank subsidiaries of bank holding company activities. as essential, because examiners have broad discretion and must exercise considerable judgment in planning and conducting examinations and in drawing conclusions about bank safety and soundness. Our findings led us to recommend that regulators establish policies to ensure sufficient documentation of the analysis that underlies the examination report, and thorough supervisory review of all examination and inspection procedures Finally, we have noted in past reports that improved coordination among federal and state banking supervisors could result in more efficient and effective use of examination resources. Coordination is also critical for the supervision of large banking institutions in that it could foster consistency in examinations and reduce regulatory burden. Regulators have made a number of changes in an effort to improve their examinations since the bank and thrift crises of the late 1980s, and I would like to highlight some that seem most significant. In general, these changes appear appropriate and consistent with recommendations we have made. However, we have not fully assessed the effectiveness of their implementation. When evaluating these changes, it is also important to note that they have occurred during favorable economic conditions that have contributed to strong bank and thrift profits. The most important test for the changes will be whether the information they provide in examination reports would lessen the severity of problems for banks and thrifts during any future economic downturn.