In the 1980s and early 1990s, the solvency of the federal depository insurance funds was threatened when hundreds of thrifts and banks failed. Taxpayers were forced to bailout the insurance fund for thrifts, and the insurance fund for banks had a negative balance for the first time in its history. This situation prompted concern and considerable debate about the need to reform federal deposit insurance and regulatory oversight. In response, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) to, among other things, improve the supervision and examination of depository institutions and to protect the federal deposit insurance funds from further losses. Among its various provisions, FDICIA added two new sections to the Federal Deposit Insurance Act of 1950—sections 38 and 39—referred to as the Prompt Regulatory Action provisions. The Prompt Regulatory Action provisions required federal regulators to institute a two-part system of regulatory actions that would be triggered when an institution fails to meet minimum capital levels or safety-and-soundness standards. Enactment of this two-part system was intended to increase the likelihood that regulators would respond promptly and forcefully to prevent or minimize losses to the deposit insurance funds from failures. The Federal Deposit Insurance Corporation (FDIC), Federal Reserve System (FRS), and two agencies within the Department of the Treasury—the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS)—share responsibility for regulating and supervising federally insured banks and thrifts in the United States. FDIC regulates state-chartered banks that are not members of FRS; FRS regulates state-chartered, member banks; OCC regulates nationally chartered banks; and OTS regulates all federally insured thrifts, regardless of charter type. The regulators carry out their oversight responsibilities primarily through monitoring data filed by institutions, conducting periodic on-site examinations, and taking actions to enforce federal safety-and-soundness laws and regulations. From 1980 to 1990, record losses absorbed by the federal deposit insurance funds highlighted the need for a new approach in federal regulatory oversight. Sharply mounting thrift losses over the decade bankrupted the Federal Savings and Loan Insurance Corporation (FSLIC), which was the agency responsible for insuring thrifts until 1989, despite a doubling of premiums and a special $10.8 billion recapitalization program. During this period, a record 1,020 thrifts failed at a cost of about $100 billion to the deposit insurance funds for thrifts. Banks also failed at record rates. From 1980 to 1990, a total of 1,256 federally insured banks were closed or received FDIC financial assistance. Estimated losses to the bank insurance fund for resolving these banks was about $25 billion. These losses resulted in the bank insurance fund’s incurring annual net losses in 1988, 1989, and 1990 that jeopardized the fund’s solvency for the first time since FDIC’s inception. Industry analysts have recognized many factors as contributing to the high level of thrift failures from 1980 to 1990. For example, thrifts faced increased competition from nondepository institutions, such as money-market funds and mortgage banks, as well as periods of inflation, recession, and fluctuating interest rates during that period. High interest rates and increased competition for deposits during the decade also created a mismatch between interest revenues from the fixed rate mortgages that constituted the bulk of the thrift industry’s assets and the cost of borrowing funds in the marketplace. Increased powers granted to thrifts in a period during which supervision did not keep pace has also been cited by some analysts, including us, as contributing to the problems of the industry. Regulators and industry analysts have associated a number of factors with the problems of banks during the 1980s. First, banks suffered losses resulting from credit risk—risk of default on loans—in an environment of prolonged economic expansion and increasingly volatile interest rates. The decade began with crises in agricultural loans and loans to developing nations. Next, unrepaid energy loans took a toll and led to the downfall of several major banks, including Continental Illinois in Chicago and First RepublicBank in Texas. As the decade came to a close, highly leveraged transactions and the collapse of commercial real estate markets, in which banks had been heavy lenders, depleted the capital structures of some major East Coast and West Coast banks and led to their failures. 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 that they took against depository institutions with unsafe and unsound practices. In addition, regulators had a common philosophy of trying to work informally and cooperatively with troubled institutions. In a 1991 report, we found that this approach, in combination with regulators’ wide discretion in the oversight of financial institutions, 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. Regulators themselves recognized that their supervisory practices in the 1980s failed to adequately control risky practices that led to the numerous thrift and bank failures. Congress passed two major laws to address the thrift and bank crisis of the 1980s. The first, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), was enacted primarily in response to the immediate problems surrounding FSLIC’s bankruptcy and troubles in the thrift industry. FIRREA created a new regulator for the thrift industry, OTS, and a new insurance fund, the Savings Association Insurance Fund (SAIF), to replace the bankrupt FSLIC. In addition, FIRREA increased the enforcement authority of both bank and thrift regulators. For example, FIRREA expanded the circumstances under which regulators could assess civil money penalties and increased the maximum penalty to $1 million per day. FIRREA also authorized FDIC to terminate a bank’s or thrift’s deposit insurance on the basis of unsafe and unsound conditions. The second major piece of legislation, FDICIA, contains several provisions that were intended to collectively improve the supervision of federally insured depository institutions. Specifically, FDICIA requires a number of corporate governance and accounting reforms to (1) strengthen the corporate governance of depository institutions, (2) improve the financial reporting of depository institutions, and (3) help in the early identification of emerging safety-and-soundness problems in depository institutions. In addition, FDICIA contains provisions that were intended to improve how regulators supervise depository institutions. Among the corporate governance and accounting reforms, FDICIA establishes generally accepted accounting principles as the standard for all reports and statements filed with the regulators. FDICIA also requires the management and auditors of depository institutions to annually report on their financial condition and management. The report is to include management’s assessment of (1) the effectiveness of the institution’s internal controls and (2) the institution’s compliance with designated laws and regulations. In addition, FDICIA requires the institution’s external auditors to report separately on management’s assertions. Furthermore, FDICIA requires the institutions to have an independent audit committee composed of outside independent directors. Among the supervision provisions, FDICIA requires regulators to perform annual on-site examinations of insured banks and thrifts (an 18-month cycle was allowed for qualified smaller institutions with assets of less than $100 million). FDICIA’s sections 131 and 132 added two new sections to the Federal Deposit Insurance Act (sections 38 and 39) that require the implementation of a “trip wire” approach to increase the likelihood that regulators will address the problems of troubled institutions at an early stage to prevent or minimize loss to the insurance funds. Section 38 creates a capital-based framework for bank and thrift oversight that is based on the placement of financial institutions into one of five capital categories. Capital was made the centerpiece of the framework because it represents funds invested by an institution’s owners, such as common and preferred stock, that can be used to absorb unexpected losses before the institution becomes insolvent. Thus, capital was seen as serving a vital role as a buffer between bank losses and the deposit insurance system. Although section 38 does not in any way limit regulators’ ability to take additional supervisory action, it requires federal regulators to take specific actions against banks and thrifts that have capital levels below minimum standards. The specified regulatory actions are made increasingly severe as an institution’s capital drops to lower levels. Section 38 requires regulators to establish criteria for classifying depository institutions into the following five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The section does not place restrictions on institutions that meet or exceed the minimum capital standards—that is, those that are well- or adequately capitalized—other than prohibiting the institutions from paying dividends or management fees that would drop them into the undercapitalized category. A depository institution that fails to meet minimum capital levels faces several mandatory restrictions or actions under section 38. The mandatory actions are intended to ensure a swift regulatory response that would prevent further erosion of an institution’s capital. Specifically, section 38 requires an undercapitalized institution to submit a capital restoration plan detailing, among other things, how the institution is going to become adequately capitalized; restrict its asset growth during any quarter so that its average total assets for the quarter do not exceed the preceding quarter’s average total assets, unless certain conditions are met; and receive prior regulatory approval for acquisitions, branching, and new lines of business. Section 38 allows regulators to take additional actions against an undercapitalized institution, if deemed necessary. It also requires regulators to closely monitor the institution’s condition and its compliance with section 38’s requirements.