Deposit Insurance: Assessment of Regulators' Use of Prompt	 
Corrective Action Provisions and FDIC's New Deposit Insurance	 
System (15-FEB-07, GAO-07-242). 				 
                                                                 
The Federal Deposit Insurance Reform Conforming Amendments Act of
2005 required GAO to report on the federal banking regulators'	 
administration of the prompt corrective action (PCA) program	 
under section 38 of the Federal Deposit Insurance Act (FDIA).	 
Congress created section 38 as well as section 39, which required
regulators to prescribe safety and soundness standards related to
noncapital criteria, to address weaknesses in regulatory	 
oversight during the bank and thrift crisis of the 1980s that	 
contributed to deposit insurance losses. The 2005 act also	 
required GAO to report on changes to the Federal Deposit	 
Insurance Corporation's (FDIC) deposit insurance system. This	 
report (1) examines how regulators have used PCA to resolve	 
capital adequacy issues at depository institutions, (2) assesses 
the extent to which regulators have used noncapital supervisory  
actions under sections 38 and 39, and (3) describes how recent	 
changes to FDIC's deposit insurance system affect the		 
determination of institutions' insurance premiums. GAO reviewed  
regulators' PCA procedures and actions taken on a sample of	 
undercapitalized institutions. GAO also reviewed the final rule  
on changes to the insurance system and comments from industry and
academic experts.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-242 					        
    ACCNO:   A65968						        
  TITLE:     Deposit Insurance: Assessment of Regulators' Use of      
Prompt Corrective Action Provisions and FDIC's New Deposit	 
Insurance System						 
     DATE:   02/15/2007 
  SUBJECT:   Agency evaluation					 
	     Bank deposits					 
	     Bank failures					 
	     Banking law					 
	     Banking regulation 				 
	     Capital						 
	     Federal regulations				 
	     Financial institutions				 
	     Financial management				 
	     Insurance						 
	     Risk assessment					 
	     Risk management					 
	     Safety regulation					 
	     Standards						 
	     Corrective action					 
	     NCUA Prompt Corrective Action Program		 

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GAO-07-242

   

     * [1]Results in Brief
     * [2]Background

          * [3]Federal Regulation of Banks and Thrifts
          * [4]Capital and Noncapital Actions of FDIA
          * [5]Deposit Insurance System

     * [6]Since the Enactment of FDICIA, the Financial Condition of De
     * [7]Regulators Used PCA Appropriately in Cases We Reviewed and O

          * [8]Regulators Used PCA Appropriately to Resolve Capital Problem

               * [9]PCA Requires Regulators to Take Specific Actions When
                 Capita
               * [10]Regulators Used PCA Appropriately at the Banks and
                 Thrifts W

          * [11]Regulators Used Other Enforcement Actions to Address Deficie
          * [12]Most Material Loss Reviews Also Found Appropriate Use of PCA

     * [13]Regulators Have Made Limited and Targeted Use of the Noncapi

          * [14]Regulators Prefer to Use Other Informal and Formal Enforceme
          * [15]Regulators Use Section 39 to Address Targeted Safety and Sou

     * [16]FDIC Has More Tightly Linked Deposit Insurance Premiums to I

          * [17]Changes to FDIC's Deposit Insurance System More Closely Tie

               * [18]Old System Relied on Two Factors to Determine Risk and
                 Premi
               * [19]The New System Links Risk and Premiums More Closely

          * [20]While Focusing More on Risk, the New System Stops Short of C
          * [21]Industry Officials and Academics Generally Support the New S

     * [22]Agency Comments
     * [23]Appendix I: Objectives, Scope, and Methodology
     * [24]Appendix II: Comments from the Board of Governors of the Fed
     * [25]Appendix III: GAO Contact and Staff Acknowledgments

          * [26]GAO Contact
          * [27]Acknowledgments

               * [28]Order by Mail or Phone

Report to Congressional Committees

United States Government Accountability Office

GAO

February 2007

DEPOSIT INSURANCE

Assessment of Regulators' Use of Prompt Corrective Action Provisions and
FDIC's New Deposit Insurance System

GAO-07-242

Contents

Letter 1

Results in Brief 5
Background 9
Since the Enactment of FDICIA, the Financial Condition of Depository
Institutions Has Been Strong and Regulators' On-site Monitoring Has Been
More Frequent 16
Regulators Used PCA Appropriately in Cases We Reviewed and Other
Enforcement Actions Generally Preceded Declines in These Institutions' PCA
Capital Categories 22
Regulators Have Made Limited and Targeted Use of the Noncapital
Supervisory Actions Available under Sections 38 and 39 38
FDIC Has More Tightly Linked Deposit Insurance Premiums to Institutional
Risk, but Some Expressed Concerns about Certain Aspects of the New System
44
Agency Comments 55
Appendix I Objectives, Scope, and Methodology 56
Appendix II Comments from the Board of Governors of the Federal Reserve
System 60
Appendix III GAO Contact and Staff Acknowledgments 62

Tables

Table 1: Definitions of Risk 10
Table 2: PCA Capital Categories 13
Table 3: Sampled Institutions with PCA Taken to Address Capital
Deficiencies 25
Table 4: Sampled Institutions Where Use of PCA Was Not Required 28
Table 5: Institutions with Material Losses and PCA to Address Capital
Adequacy, 1992-2005 35
Table 6: Distribution of Institutions among Risk Categories in FDIC's
Previous Deposit Insurance System, as of December 31, 2005 45
Table 7: Base Rate Premiums by Risk Category under FDIC's New Deposit
Insurance System 48

Figures

Figure 1: Total Assets, Total Net Income, Return on Assets, and Return on
Equity for Federally Insured Commercial Banks and Savings Institutions,
1992-2005 17
Figure 2: Number and Percentage of Institutions in PCA Capital Categories,
1992-2005 18
Figure 3: Number of Problem Institutions and Total Assets, 1992-2005 20
Figure 4: Failed Banks and Thrifts and Their Estimated Losses, 1992-2005
21
Figure 5: Section 38 Mandatory and Discretionary Requirements 24
Figure 6: Institutions on Regulator Watch Lists 30
Figure 7: Timeline of Enforcement Actions, FDIC Open Bank 1 31
Figure 8: Timeline of Enforcement Actions, New Century Bank 32
Figure 9: Timeline of Enforcement Actions, Compubank 33
Figure 10: Timeline of Enforcement Actions, Georgia Community Bank 34
Figure 11: Regulators Use of Section 8(e), 1992-2005 41
Figure 12: Regulators Use of Section 39, 1995-2005 43

Abbreviations

BSA Bank Secrecy Act
CAMELS capital, asset quality, management, earnings, liquidity,
sensitivity to market risk
FDIA Federal Deposit Insurance Act
FDIC Federal Deposit Insurance Corporation
FDICIA Federal Deposit Insurance Corporation Improvement Act of 1991
IG inspector general
OCC Office of the Comptroller of the Currency
OTS Office of Thrift Supervision
PCA prompt corrective action
Y2K Year 2000

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United States Government Accountability Office

Washington, DC 20548

February 15, 2007

The Honorable Christopher J. Dodd
Chairman
The Honorable Richard C. Shelby
Ranking Member
Committee on Banking, Housing, and Urban Affairs
United States Senate

The Honorable Barney Frank
Chairman
The Honorable Spencer Bachus
Ranking Member
Committee on Financial Services
House of Representatives

With the failure of more than 2,900 federally insured banks and thrifts in
the 1980s and early 1990s, federal regulators were criticized for failing
to take timely and forceful action to address the causes of these failures
and prevent losses to the deposit insurance fund and taxpayers.1 In
response to the federal banking regulators' failure to take appropriate
action, Congress passed the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA), implementing significant changes to the
way banking regulators supervise the nation's depository institutions.2
FDICIA created two new sections in the Federal Deposit Insurance Act
(FDIA)--sections 38 and 39--that required the federal banking regulators
to create a two-part framework to supplement their existing supervisory
authority to address capital deficiencies and unsafe or unsound conduct,
practices, or conditions.3 The addition of sections 38 and 39 to FDIA were
intended to improve the ability of regulators to identify and promptly
address deficiencies at an institution to better safeguard the deposit
insurance fund. Specifically, section 38 requires regulators to classify
depository institutions into one of five capital categories based on their
level of capital--well capitalized, adequately capitalized,
undercapitalized, significantly undercapitalized, and critically
undercapitalized--and take increasingly severe actions, known as prompt
corrective action (PCA), as an institution's capital deteriorates.4
Section 38 primarily focuses on capital as an indicator of trouble, thus
the supervisory actions authorized under it are almost exclusively
designed to address an institution's deteriorating capital level (for
example, requiring undercapitalized institutions to implement capital
restoration plans). However, section 38 also authorizes noncapital
supervisory actions (for example, removing officers and directors or
downgrading an institution's capital level).5 Section 39 required 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, and allows the
regulators to take action if an institution fails to meet one or more of
these standards.6 Since the passage of FDICIA, banks and thrifts have
benefited from a strong economy, but this has not diminished the
importance of the need for regulators to take early and forceful action to
address capital and noncapital deficiencies.

1Under the Federal Deposit Insurance Reform Act of 2005, title II,
subtitle B of Pub. L. No. 109-171, 120 Stat. 4, 9-21 (2006), the Bank
Insurance Fund and the Savings Association Insurance Fund, which insured
deposits in banks and thrifts, respectively, were merged into a combined
Deposit Insurance Fund effective March 31, 2006. Throughout this report we
use "deposit insurance fund" to refer to both funds individually and
collectively.

2Pub. L. No. 102-242, 105 Stat. 2236 (1991).

3Act of September 21, 1950, ch. 967, 64 Stat. 873 (1950).

FDICIA also granted the Federal Deposit Insurance Corporation (FDIC) the
authority to establish and maintain a system--the deposit insurance
system--to assess the relative risk of federally insured banks and thrifts
and charge them premiums based on that risk. In February 2006, Congress
granted FDIC the authority to make substantive changes to the deposit
insurance system, including the way the regulator assesses risk and
assigns premiums.7 FDIC issued its final rule implementing changes in
November 2006.

412 U.S.C. S 1831o.

5Although section 38 authorizes several noncapital supervisory actions
(such as restricting operational activities a regulator determines pose
excessive risk to an institution), the discussion of noncapital
supervisory actions in this report is limited to actions to dismiss
officers and directors under section 38(f)(2)(F) and to reclassify an
institution's capital category under section 38(g).

612 U.S.C. S 1831p-1.

7Federal Deposit Insurance Reform Act of 2005, Pub. L. No. 109-171, 120
Stat. 9 (2006); Federal Deposit Insurance Conforming Amendments Act of
2005, Pub. L. No. 109-173, 119 Stat. 3601 (2006).

This report responds to the mandate contained in section 6 of the Federal
Deposit Insurance Reform Conforming Amendments Act of 2005 requiring the
Comptroller General to report on issues relating to the federal banking
regulators' administration of the PCA program under section 38 of FDIA as
well as various aspects of FDIC's deposit insurance system.8 Because the
banking regulators also monitor the safety and soundness of depository
institutions using criteria other than capital levels, this report also
includes a review of the federal banking regulators' use of safety and
soundness standards under section 39. Specifically, this report (1)
describes trends in the financial condition of banks and thrifts and
federal regulators' oversight of these institutions since the passage of
FDICIA, (2) evaluates how federal regulators have used PCA to resolve
capital adequacy issues at the institutions they regulate, (3) evaluates
the extent to which federal regulators have used the noncapital
supervisory actions of sections 38 and 39 to address weaknesses at the
institutions they regulate, and (4) describes FDIC's deposit insurance
system and how recent changes to the system affect the determination of
institutions' risk and insurance premiums.

To address these objectives, we reviewed relevant laws, regulations, and
regulators' policies and procedures and interviewed officials from the
four federal banking regulators--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)--as well as
industry officials and academics. We also reviewed our previous reports on
PCA.9 To describe trends in the financial condition of banks and thrifts
and regulators' oversight of these institutions since the passage of
FDICIA, we reviewed relevant industry reports and analyses. We also
analyzed regulator and industry data to determine, among other things, the
number of well-capitalized, adequately capitalized, and undercapitalized
institutions and the number of institutions appearing on the problem
institutions list since 1992, the year regulators implemented FDICIA.10 To
assess how federal regulators have used PCA to resolve capital adequacy
issues at the institutions they regulate, we reviewed section 38 and its
implementing regulations, as well as regulators' policies and procedures.
We also examined reports of examination, informal and formal enforcement
actions, and institution-regulator correspondence for a nonprobability
sample of 24 institutions from a population of 157 institutions that fell
below one of the three lowest PCA capital thresholds at least once from
2001 through 2005. We chose this period for review based on the
availability of examination- and enforcement-related documents and to
reflect the most current policies and procedures used by the regulators.
The sample reflects a mix of institutions regulated by each of the four
regulators as well as a mix of the three lowest PCA capital categories. In
6 of these 24 cases, regulators did not implement PCA because they
determined that it was not warranted.11 In addition, we reviewed the
material loss reviews of all banks and thrifts that failed from 1992
through 2005 and in which the primary regulator implemented PCA to address
capital adequacy issues.12 To determine the extent to which federal
regulators have used the noncapital supervisory actions of sections 38 and
39 to address weaknesses at the institutions they regulate, we reviewed
regulators' policies and procedures related to sections 38(f)(2)(F) and
38(g) (the provisions for dismissal of officers and directors and
reclassification of a capital category, respectively) and section 39, as
well as data on the number of times and for what purposes they used these
noncapital authorities. To provide context on the extent of regulators'
use of these noncapital provisions, we also obtained data on the number of
times regulators used their authority under section 8(e) of FDIA to remove
officers and directors from office and section 8(b) to enforce compliance
with safety and soundness standards.13 Finally, to describe how changes in
FDIC's deposit insurance system affect the determination of institutions'
risk and insurance premiums, we reviewed FDIC's notice of proposed rule
making on deposit insurance assessments, selected comments to the proposed
rule, and FDIC's final rule on deposit insurance assessments.14 We also
interviewed representatives of five depository institutions (three large
and two small) and two trade groups representing large and small
institutions and two academics to obtain their views on the impact of
FDIC's changes to the system. Appendix I contains a more detailed
description of our scope and methodology. We conducted our work in
Washington, D.C., and Chicago from March 2006 through January 2007 in
accordance with generally accepted government auditing standards.

8Pub. L. No. 109-173, 119 Stat. 3601 (2006).

9GAO, Bank Supervision: Prompt and Forceful Regulatory Actions Needed,
[29]GAO/GGD-91-69 (Washington, D.C.: Apr. 16, 1991), and Bank and Thrift
Regulation: Implementation of FDICIA's Prompt Regulatory Action
Provisions, [30]GAO/GGD-97-18 (Washington, D.C.: Nov. 21, 1996).

10Problem institutions typically have severe asset quality, liquidity, and
earnings problems that make them potential candidates for failure. FDIC
reports the number of problem institutions on its problem institutions
list on a quarterly basis.

11In these six cases, regulators did not use PCA for reasons including the
following: the institution suffering a onetime drop in reported capital
information, the institution misreporting capital information, or the
institution failing to meet one or more of the PCA capital ratios by a
fraction of a percent.

12Section 38(k) of FDIA requires the inspector general of the applicable
federal regulator to issue reports on any depository institution whose
failure results in a "material loss"--generally losses that exceed $25
million or 2 percent of the institution's assets, whichever is greater--to
the deposit insurance fund. These material loss reports must assess why
the institution's failure resulted in a material loss and make
recommendations for preventing such losses in the future. 12 U.S.C. S
1831o(k).

Results in Brief

Since the enactment of FDICIA, the financial condition of federally
insured depository institutions generally has been strong and regulators
have increased their presence at banks and thrifts. Net income and total
assets exceeded $133 billion and $10 trillion, respectively, in 2005, and
the industry's two primary indicators of profitability--returns on assets
and equity--remained near highs at the end of 2005. In this strong
economic environment, the percentage of well-capitalized institutions
steadily has increased from 94 percent in 1992, the year regulators
implemented FDICIA, to just over 99 percent in 2005, while the percentage
of well-capitalized institutions with capital in excess of the
well-capitalized minimum increased from 84 percent in 1992 to 94 percent
in 2005. Over the period, the number of institutions in undercapitalized
and lower capital categories experienced a corresponding decline from
1,235 in 1992 to 14 in 2005, and the number of failed institutions also
fell dramatically. In addition to requiring regulators to take prompt
corrective action against institutions that fail to meet minimum capital
requirements, FDICIA also required examiners to conduct annual, on-site
examinations at all federally insured banks and thrifts to improve their
ability to identify and address problems in a more timely manner. Although
we did not evaluate the regulators' timeliness in conducting examinations,
regulatory data show that the average time between examinations fell from
a high of 609 days in 1986 to 373 in 1992. Based on information we
obtained from all four regulators, the average interval between
examinations for all institutions generally has remained from 12 to 18
months since 1993 (the year after FDICIA requirements were implemented)
and in many instances, has been even shorter, especially for problem
institutions (those with composite CAMELS ratings of 4 or 5).15

13Section 8(e) (codified at 12 U.S.C. S 1818(e)) gives regulators
authority to permanently ban certain institution-affiliated individuals
(including officers, directors, and shareholders of an institution) from
participating in the conduct of the affairs of any federally regulated
institution under certain circumstances involving egregious conduct on the
part of the individuals. Section 8(b) (codified at 12 U.S.C. 1818(b)) of
FDIA gives regulators authority to order an institution to cease and
desist from certain practices or violations.

14Federal Deposit Insurance Corporation--Assessments, 71 Fed. Reg. 41910
(2006) (proposed rule). Comments to the proposed rule making were due on
September 22, 2006. Federal Deposit Insurance Corporation--Assessments, 71
Fed. Reg. 69282 (2006) (final rule codified at 12 C.F.R. S 327.9, 327.10
and Appendixes A, B, and C of Subpart A).

For the sample of 18 banks and thrifts that were subject to PCA, we found
that regulators generally implemented PCA in accordance with section 38,
consistent with findings in our 1996 report.16 For example, regulators
identified when each of the institutions failed to meet minimum capital
requirements, required these institutions to implement capital restoration
plans or corrective actions outlined in enforcement orders, and took steps
to close or require the sale or merger of those institutions that were
unable to adequately recapitalize. Fifteen of the 18 institutions in our
sample remain open or were merged into other institutions or closed
without causing losses to the deposit insurance fund, and 3 failed causing
losses, one of which was a material loss (that is, a loss exceeding $25
million or 2 percent of an institution's assets, whichever is greater).
Although regulators appeared to have used PCA appropriately, capital is a
lagging indicator and thus not necessarily a timely predictor of problems
at banks and thrifts. All four regulators generally agreed that by design,
PCA is not a tool that can be used upon early recognition of a bank or
thrift's troubled status. In most cases we reviewed, regulators had
responded to safety and soundness problems in advance of a bank or
thrift's decline in PCA capital category. For example, each of the 18
institutions subject to PCA appeared on one or more regulatory watch lists
prior to or concurrent with experiencing a decline in its capital
category, and a majority of the 18 institutions had at least one
enforcement action in place prior to becoming undercapitalized. Finally,
the inspectors general (IG) of the federal banking agencies found that in
12 of 14 cases where regulators used PCA to resolve capital problems at an
institution that failed with material losses, the regulators' use of PCA
was appropriate. In two cases, the IG found that the regulator could have
used PCA sooner than it did.

15At each examination, examiners assign a supervisory CAMELS rating, which
assesses six components of an institution's financial health: capital,
asset quality, management, earnings, liquidity, and sensitivity to market
risk. An institution's CAMELS rating is known directly only by the
institution's senior management and appropriate regulatory staff.
Regulators never publicly release CAMELS ratings, even on a lagged basis.

16 [31]GAO/GGD-97-18 .

Regulators have made limited use of noncapital supervisory actions under
sections 38 and 39, which allow them to reclassify institutions' capital
categories, dismiss officers and directors from deteriorating banks and
thrifts, and require institutions to implement plans to address
deficiencies in their compliance with regulatory safety and soundness
standards. For example, since the implementation of FDICIA, only OCC has
used the authority granted under section 38 to reclassify an institution's
capital category. According to the regulators, section 38's
reclassification provision is of limited use because they can use other
enforcement actions to address deficiencies, including capital and
noncapital deficiencies (such as deficiencies in asset quality, risk
management, and the quality of bank management). These other enforcement
actions can be used even when an institution is well capitalized or
adequately capitalized by PCA standards. Similarly, since the
implementation of FDICIA, regulators made limited use of section 38's
dismissal authority--FDIC has made the most frequent use of the authority
(six times), while OCC used it once and the Federal Reserve and OTS have
never used it. Regulators told us that they often rely on moral suasion to
encourage problem officers and directors to resign from institutions, or
when an individual's misconduct is severe, they may use their authority
under section 8(e) of FDIA to remove that individual from an institution
and prohibit him or her from further employment in the industry. FDIC,
OCC, and OTS also used section 39 authority in limited circumstances to
address safety and soundness deficiencies at the institutions they
regulate. However, amendments to section 39 in 1994 increased regulator
flexibility over when and how to use the authority and regulators maintain
considerable discretion to choose how and when to address safety and
soundness weaknesses, as demonstrated by their varied use of noncapital
supervisory actions under sections 38 and 39 and other informal and formal
enforcement actions. Regulators have used section 39 predominantly to
address noncompliance with certain laws or requirements or when management
was willing and able to implement required corrective actions, but may not
have been responsive to prior informal regulatory criticisms. Regulators
told us that they prefer to use formal enforcement actions, such as
section 8(b) cease-and-desist orders, to address complex or multiple
deficiencies at an institution or in cases where management was not
willing or able to quickly implement the required corrective actions.

Recent changes to FDIC's deposit insurance system tie the premiums a bank
or thrift pays into the deposit insurance fund more directly to an
estimation of the risk that the institution poses to the fund than under
the previous system. To do so, FDIC created a system that generally (1)
differentiates between larger institutions with current credit agency
ratings and $10 billion or more in assets and all other, smaller
institutions; (2) for institutions without credit agency ratings,
forecasts the likelihood of a decline in financial health; (3) for
institutions with credit agency ratings, uses financial market information
to evaluate institutional risk; and (4) requires all institutions to pay
premiums based on their individual risk.17 However, FDIC did not
completely follow risk-based pricing tenets to set the premiums. Rather,
FDIC has chosen to set the base rate premium for the riskiest banks and
thrifts at 40 basis points, or 60 percent below the indicated premium of
100, the amount needed to cover expected losses in the event of failure.
In doing so, FDIC officials told us they sought to address long-standing
concerns of the industry, regulators, and others that premiums should not
be set so high as to prevent an institution that is troubled and seeking
to rebuild its health from doing so. Most bankers, industry groups, and
academics with whom we spoke and many of those organizations that
submitted comment letters to FDIC on its new system generally supported
FDIC's efforts to make the system more risk based, but many also expressed
concerns about certain elements and questioned whether the new system
might produce unintended consequences. For example, some were concerned
that what they said should be an objective calculation of premiums now
will give attention to such subjective factors as the quality of bank
management. Others noted that because a bank or thrift receiving a lower
CAMELS rating can now expect an increase in premiums, this could create
disincentives for bank and thrift management to be cooperative or
forthcoming during examinations. FDIC officials said that FDIC, along with
the other federal regulators, plans to monitor the new system for adverse
effects.

We provided a draft of this report to FDIC, the Federal Reserve, OCC, and
OTS for their review and comment. In written comments, the Federal Reserve
concurred with our findings relating to PCA (see app. II). In addition,
FDIC, the Federal Reserve, and OCC provided technical comments, which we
incorporated as appropriate.

17Credit rating agencies, such as Moody's Investors Services, Standard &
Poor's, and Fitch Ratings, evaluate an institution's ability to repay debt
and then publish a rating reflecting their opinion on that institution's
likelihood of default.

Background

Four federal banking regulators--FDIC, the Federal Reserve, OCC, and
OTS--oversee the nation's banks and thrifts to ensure they are operating
in a safe and sound manner. The failure of more than 2,900 depository
institutions during the 1980s and early 1990s led to the passage of
FDICIA, which amended FDIA to require regulators to take action against
institutions that failed to meet minimum capital levels and granted
regulators several authorities to address noncapital deficiencies at the
institutions they regulate. FDICIA also required FDIC to establish a
system to assess the risk of depository institutions insured by the
deposit insurance fund.

Federal Regulation of Banks and Thrifts

FDIC insures the deposits of all federally insured depository
institutions, generally up to $100,000 per depositor, and monitors their
risk to the deposit insurance fund. In addition, FDIC is the primary
regulator for state-chartered nonmember banks (that is, state-chartered
banks that are not members of the Federal Reserve System), the Federal
Reserve is the primary regulator for state-chartered member banks
(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.18

Federal regulators have defined several categories of risk to which
depository institutions are exposed--credit risk, compliance risk, legal
risk, liquidity risk, market risk, operational risk, reputational risk,
and strategic risk (see table 1).19

18This report only addresses the extent to which regulators used sections
38 and 39 to address problems at banks and thrifts. Bank and thrift
holding companies are excluded from all discussion and data. Under the
dual federal and state banking system, state-chartered banks are
supervised jointly by their state chartering authority and either FDIC or
the Federal Reserve. OCC and OTS are operating bureaus under the
Department of the Treasury.

Table 1: Definitions of Risk

Risk         Definition                                                    
Compliance   The risk arising from violations of or nonconformance with    
                laws, rules, regulations, prescribed practices, or ethical    
                standards.                                                    
Credit       The risk that a borrower or counterparty to a transaction     
                will default on an obligation.                                
Legal        The risk that potential unenforceable contracts, lawsuits, or 
                adverse legal judgments could negatively affect the           
                operations or condition of an institution.                    
Liquidity    The risk arising from an institution's inability to meet its  
                obligations when they come due because of an inability to     
                liquidate assets or obtain adequate funding.                  
Market       The risk arising from adverse movement in market rates or     
                prices, such as interest rates, foreign exchange rates, or    
                equity prices.                                                
Operational  The risk that inadequate information systems, operational     
                problems, breaches in internal controls, fraud, or unforeseen 
                catastrophes will result in losses.                           
Reputational The risk that potential negative publicity regarding an       
                institution's business practices could cause a decline in the 
                customer base, costly litigation, or revenue reductions.      
Strategic    The risk arising from adverse business decisions or improper  
                implementation of those decisions, improper business          
                planning, or inadequate responses to changes in the industry. 

Source: GAO.

Banks and thrifts, in conjunction with regulators, must continually manage
risks to ensure their safe and sound operation 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 institutions to engage
in lending and other activities. Regulators are responsible for
supervising the activities of banks and thrifts and taking corrective
action when these activities and their overall performance present
supervisory concerns or have the potential to result in financial losses
to the insurance fund or violations of law. Losses to the insurance fund
may occur when an institution does not have sufficient assets to reimburse
customers' insured deposits and FDIC's administrative expenses in the
event of closure or merger.

19Within these categories, we and others have identified and reported on
several specific risks currently facing the industry, including the growth
in alternative mortgage products and increasing concentrations of
commercial real estate holdings among certain institutions. See GAO,
Alternative Mortgage Products: Impact on Defaults Remains Unclear, but
Disclosure of Risks to Borrowers Could Be Improved, [32]GAO-06-1021
(Washington, D.C.: Sept. 19, 2006); Office of the Comptroller of the
Currency, Board of Governors of the Federal Reserve System, and Federal
Deposit Insurance Corporation, Concentrations in Commercial Real Estate
Lending, Sound Risk Management Practices, 71 Fed. Reg. 74585 (2006) (joint
final guidance); and Office of Thrift Supervision, Concentrations in
Commercial Real Estate Lending, Sound Risk Management Practices, 71 Fed.
Reg. 75298 (2006) (final guidance).

Regulators assess the condition of banks and thrifts through off-site
monitoring and on-site examinations. Examiners use Reports 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.20 As part of on-site examinations,
regulators more closely assess institutions' exposure to risk and assign
institutions ratings, known as CAMELS ratings, that reflect their
condition in six areas: capital, asset quality, management, earnings,
liquidity, and sensitivity to market risk.21 Each component is rated on a
scale of 1 to 5, with 1 the best and 5 the worst. The component ratings
then are used to develop a composite rating also ranging from 1 to 5.
Institutions with composite ratings of 1 or 2 are considered to be in
satisfactory condition, while institutions with composite ratings of 3, 4,
or 5 exhibit varying levels of safety and soundness problems. Also as part
of the examination and general supervision process, regulators may direct
an institution to address issues or deficiencies within specified time
frames.

When regulators determine that a bank or thrift's condition is
unsatisfactory, 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
institution is willing and able to implement changes. Informal actions
include, for example, commitment letters detailing an institution's
commitment to undertake specific remedial measures, board resolutions
adopted by the institution's board of directors at the request of its
regulator, and memorandums of understanding. Informal actions are not
public agreements (meaning, regulators do not make them public through
their Web sites or other channels) and are not enforceable by the
imposition of sanctions.22 In comparison, formal enforcement actions are
publicly disclosed by regulators and enforceable and are used to address
more severe deficiencies or when the regulator has limited confidence in
an institution's ability to implement changes. Formal enforcement actions
include, for example, PCA directives, cease-and-desist orders under
section 8(b) of FDIA, removal and prohibition orders under section 8(e) of
FDIA, civil money penalties, and termination of an institution's deposit
insurance.23

20All banks that FDIC insures must submit quarterly Call Reports, which
contain a variety of financial information, including capital ratios, that
show a bank's condition and income. Thrifts file similar reports, called
Thrift Financial Reports.

21Effective January 1, 1997, the Federal Financial Institutions
Examination Council added the "S" component of the CAMELS rating; prior to
1997, the rating was known as CAMEL.

All four regulators have policies and procedures that describe for
examiners the circumstances under which they should recommend the use of
informal and formal enforcement actions to address identified
deficiencies. Each federal banking regulator also has established a means
through which senior management of the applicable federal regulator
reviews all enforcement recommendations to ensure that the proposed
actions are the best and most efficient means to bring an institution back
into compliance with applicable laws, regulations, and best practices.

Capital and Noncapital Actions of FDIA

Section 38 of FDIA requires regulators to categorize depository
institutions into five categories on the basis of their capital levels.
Regulators use three different capital measures to determine an
institution's capital category: (1) a total risk-based capital measure,
(2) a tier 1 risk-based capital measure, and (3) a leverage (or
non-risk-based) capital measure (see table 2). To be considered well
capitalized or adequately capitalized, an institution must meet or exceed
all three ratios for the applicable capital category. Institutions are
considered undercapitalized or worse if they fail to meet just one of the
ratios necessary to be considered at least adequately capitalized. For
example, an institution 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.

22Noncompliance with an informal enforcement action can be addressed by a
formal action under section 8 of FDIA.

23PCA directives are formal actions that regulators issue to institutions
that fail to meet minimum capital requirements. Directives require
institutions to take one or more specified actions to return to required
minimum capital standards. Regulators typically use directives to specify
corrective actions for significantly and critically undercapitalized
institutions, as the restrictions and requirements specified in section 38
for undercapitalized institutions are automatic.

Table 2: PCA Capital Categories

                          Total risk-based   Tier 1 risk-based  Leverage      
Capital category       capitala           capital            capitalb      
Well capitalizedc      10% or more and    6% or more and     5% or more    
Adequately capitalized 8% or more and     4% or more and     4% or mored   
Undercapitalized       Less than 8% or    Less than 4% or    Less than 4%  
Significantly          Less than 6% or    Less than 3% or    Less than 3%  
undercapitalized                                                           
Critically             An institution is critically undercapitalized if
undercapitalized       its tangible equity is 2% or less regardless of its
                          other capital ratios.e

Sources: Capital measures and capital category definitions: FDIC--12
C.F.R. S 325.103 (2006), Federal Reserve--12 C.F.R. S 208.43 (2006),
OCC--12 C.F.R. S 6.4 (2006), and OTS--12 C.F.R. S 565.4 (2006).

aThe total risk-based capital ratio consists of the sum of tier 1 and tier
2 capital divided by risk-weighted assets. Tier 1 capital consists
primarily of tangible equity. Tier 2 capital includes subordinated debt,
loan loss reserves, and certain other instruments.

bLeverage capital is tier 1 capital divided by average total assets.

cAn institution that satisfies the capital measures for a well-capitalized
institution but is subject to a formal enforcement action that requires it
to meet and maintain a specific capital level is considered to be
adequately capitalized for purposes of PCA.

dCAMELS 1-rated institutions not experiencing or anticipating significant
growth need only have 3 percent leverage capital to be considered
adequately capitalized.

eTangible equity is equal to the amount of core capital elements plus
outstanding perpetual preferred stock minus all intangible assets not
previously deducted, except certain purchased mortgage-servicing rights.

Under section 38, regulators must take increasingly severe supervisory
actions as an institution's capital level deteriorates. For example, all
undercapitalized institutions are required to implement capital
restoration plans to restore capital to at least the adequately
capitalized level, and regulators are generally required to close
critically undercapitalized institutions within a 90-day period. Section
38 allows an exception to the 90-day closure rule if both the primary
regulator and FDIC concur and document why some other action would better
achieve the purpose of section 38--resolving the problems of institutions
at the least possible long-term cost to the deposit insurance fund.

Resolving failed or failing institutions is one of FDIC's primary
responsibilities under PCA. In selecting the least costly resolution
alternative, FDIC's process is to compare the estimated cost of
liquidation--basically, the amount of insured deposits paid out minus the
net realizable value of an institution's assets--with the amounts that
potential acquirers bid for the institution's assets and deposits. FDIC
has resolved failed or failing institutions using three basic methods: (1)
directly paying depositors the insured amount of their deposits and
disposing of the failed institution's assets (depositor payoff and asset
liquidation); (2) selling only the institution's insured deposits and
certain other liabilities, with some of its assets, to an acquirer
(insured deposit transfer); and (3) selling some or all of the failed
institution's deposits, certain other liabilities, and some or all of its
assets to an acquirer (purchase and assumption). Within this third
category, many variations exist based on specific assets that are offered
for sale. For example, some purchase and assumption resolutions also have
included loss-sharing agreements--an arrangement whereby FDIC, in order to
sell certain assets with the intent of limiting losses to the deposit
insurance fund, agrees to share with the acquirer the losses on those
assets.

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 are permitted to
reclassify or downgrade an institution's capital category to apply more
stringent operating restrictions or requirements if they determine, after
notice and opportunity for a hearing, that an institution is in an unsafe
and unsound condition or engaging in an unsafe or unsound practice. Under
section 38(f)(2)(F) regulators can require an institution to make
improvements in management, for example, by dismissing officers and
directors who are not able to materially strengthen an institution's
ability to become adequately capitalized.24

Section 39 directs regulatory attention to noncapital areas of an
institution's operations and activities in three main safety and soundness
areas: operations and management; compensation; and asset quality,
earnings, and stock valuation. As originally enacted under FDICIA, section
39 required regulators to develop and implement standards in these three
areas, as well as develop quantitative standards for asset quality and
earnings. However, in response to concerns about the potential regulatory
burden of section 39 on banks and thrifts, section 318 of the Riegle
Community Development and Regulatory Improvement Act of 1994 amended
section 39 to allow the standards to be issued either by regulation (as
originally specified in FDICIA) or by guideline and eliminated the
requirement to establish quantitative standards for asset quality and
earnings.25 The regulators chose to prescribe the standards through
guideline rather than regulation, essentially providing them with
flexibility in how and when they would take action against institutions
that failed to meet the standards.26 Under section 39, if a regulator
determines that an institution has failed to meet a prescribed standard,
the regulator may require that the institution file a safety and soundness
plan specifying the steps it will take to correct the deficiency.27 If the
institution 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 take other enforcement actions pending the correction
of the deficiency.

24Under section 38(f)(2)(F), regulators also may order a new election for
an institution's board of directors or require the institution to employ
qualified senior executive officers.

Deposit Insurance System

In addition to adding sections 38 and 39 to FDIA to address capital
inadequacy and safety and soundness problems at depository institutions,
FDICIA also required FDIC to establish a system--the deposit insurance
system--to assess the risk of federally insured depository institutions
and charge premiums to finance a deposit insurance fund meant to protect
depositors in the event of future bank and thrift failures.

At the urging of FDIC, in February 2006 Congress enacted legislation
granting the regulator authority to make substantive changes to the
deposit insurance system, including the way it assesses the risk of
institutions and determines their premiums. In July 2006, FDIC issued its
proposed rule outlining proposed changes to the deposit insurance system
and opened a public comment period. FDIC adopted a final rule in November
2006. Recalculated premiums and other changes reflected in the final rule
were effective January 1, 2007. As of September 30, 2006, FDIC insured
over 60 percent of all domestic deposits, totaling more than $4 trillion.

25Pub. L. No. 103-325, 18 Stat. 2160, 2223-2224 (1994).

26Interagency Guidelines Establishing Standards for Safety and Soundness,
60 Fed. Reg. 35680 (1995) (codified as amended as follows: FDIC--Appendix
A to 12 C.F.R. pt. 364 (2006); Federal Reserve--Appendix D-1 to 12 C.F.R.
pt. 208 (2006); OCC--Appendix A to 12 C.F.R. pt. 30 (2006); and
OTS--Appendix A to 12 C.F.R. pt. 570 (2006)).

2712 U.S.C. S 1831p-1(e).

Since the Enactment of FDICIA, the Financial Condition of Depository
Institutions Has Been Strong and Regulators' On-site Monitoring Has Been More
Frequent

The nation's banks and thrifts have benefited from a strong economy since
1992--as demonstrated by steady increases in several of the industry's
primary performance indicators and growing numbers of institutions meeting
or exceeding minimum capital levels. For example, in 2005, the industry
reported record total assets ($10 trillion in 2005) and net income ($133
billion in 2005) (see fig. 1). Similarly, the industry's two primary
indicators of profitability--returns on assets and equity--have improved
since 1992 and remain near record highs.

Figure 1: Total Assets, Total Net Income, Return on Assets, and Return on
Equity for Federally Insured Commercial Banks and Savings Institutions,
1992-2005

As a result of institutions' overall strong financial performance, few
have failed to meet minimum capital requirements since 1992, the year
regulators implemented PCA. The percentage of well-capitalized
institutions has increased from 93.99 percent in 1992 to 99.71 percent in
2005, while the percentage of undercapitalized and lower-rated
institutions generally has declined (see fig. 2). For example, the
percentage of significantly undercapitalized institutions declined from
2.74 percent (394 institutions) to 0.06 percent (5 institutions) in this
period, while the percentage of critically undercapitalized institutions
fell from 1.64 percent to 0.01 percent (236 to 1).28

Figure 2: Number and Percentage of Institutions in PCA Capital Categories,
1992-2005

28We counted the institutions in each PCA capital category by quarter
because institutions are required to report capital ratio information in
quarterly Call and Thrift Financial Reports. As a result, the number of
institutions in each category per year is more than the number of
institutions reporting in each year because an institution could appear in
more than one capital category in a year. Thus, the percentage of
institutions in all five capital categories in a given year is more than
100 percent.

Further, the percentage of institutions carrying capital in excess of the
well-capitalized leverage capital minimum (that is, 5 percent or more of
leverage capital) also increased from 84 percent of all reporting
institutions in 1992 to 94 percent in 2005.29 The percentage of
institutions carrying at least two times as much capital (200 percent or
more of the well-capitalized leverage capital minimum) increased from 25
percent to 41 percent over the period.

According to regulators, the improved financial condition of banks and
thrifts may have contributed to the sharp decline in the number of problem
institutions (those with composite CAMELS ratings of 4 or 5), from 1,063
in 1992 to 74 in 2005 (see fig. 3).

29To determine those institutions that held capital in excess of the
well-capitalized minimum, we first determined the number of institutions
that were well capitalized for all four quarters of each calendar year,
1992 through 2005, and then calculated the average amount of leverage
capital each of the institutions held during each calendar year.

Figure 3: Number of Problem Institutions and Total Assets, 1992-2005

Similarly, regulators said that institutions' improved financial condition
may have also contributed to the significant decline in the number of
failures and losses to the insurance fund since 1992 (see fig. 4). From
1992 through 2004, the number of failed banks and thrifts fell from 180
(with estimated losses to the insurance fund of $7.3 million) to 4 (with
no estimated losses). No bank or thrift failed from June 2004 through
January 2007. 30

30Metropolitan Savings Bank, Pittsburgh, Pennsylvania, failed on February
2, 2007; however, because this failure occurred after we completed our
audit work, we did not include this bank in our discussion of failed
institutions.

Figure 4: Failed Banks and Thrifts and Their Estimated Losses, 1992-2005

In addition, regulators' on-site presence at banks and thrifts increased
beginning in the early 1990s, in part as a result of reforms enacted as a
part of FDICIA that required regulators to conduct full-scope, on-site
examinations for most federally insured institutions at least annually to
help contain losses to the deposit insurance fund.31 Historical data show
that the interval between full-scope, on-site examinations for all
institutions peaked in 1986 when it reached 609 days. Subsequent to the
enactment of FDICIA in December 1991, the average interval between
examinations for all institutions declined to 373 days in 1992.32 Based on
information we obtained from all four regulators, the average interval
between examinations for all institutions generally has remained from 12
to 18 months since 1993 (the year after FDICIA requirements were
implemented) and in many instances has been even shorter, especially for
problem institutions.

31Pub. L. No. 102-242 S 111(a), 105 Stat. 2236, 2240 (1991) (codified as
amended at 12 U.S.C. S 1820(d)). Section 605 of the Financial Services
Regulatory Relief Act of 2006, Pub. L. No. 109-351, 120 Stat. 1966, 1981
(2006) amended section 10(d)(4)(A) of FDIA (codified at 12 U.S.C. S
1820(d)(4)(A)) to provide that for well-capitalized, well-managed
institutions with total assets of less than $500 million that are not
subject to an enforcement action or any change in control during the
12-month period in which a full-scope, on-site examination would be
required, regulators are only required to conduct an on-site examination
every 18 months.

Regulators Used PCA Appropriately in Cases We Reviewed and Other Enforcement
Actions Generally Preceded Declines in These Institutions' PCA Capital
Categories

For the sample of banks and thrifts we reviewed, we found that regulators
generally implemented PCA in accordance with section 38. For example, when
institutions failed to meet minimum capital requirements, regulators
required them to submit capital restoration plans or imposed restrictions
through PCA directives or other enforcement actions. Regulators generally
agreed that capital is a lagging indicator of poor performance and
therefore other measures are often used to address deficiencies upon
recognition of an institution's troubled status. This contention was
supported by the fact that in a majority of the cases we reviewed,
institutions had one or more informal or formal enforcement actions in
place prior to becoming undercapitalized. Most of the material loss
reviews conducted by IGs also found that regulators appropriately used PCA
provisions in most cases, although in two reviews they found that
regulators could have used PCA sooner.

Regulators Used PCA Appropriately to Resolve Capital Problems at Banks and
Thrifts We Reviewed

Based on a sample of cases, we found that regulators generally acted
appropriately to address problems at institutions that failed to meet
minimum capital requirements by taking increasingly severe enforcement
actions as these institutions' capital deteriorated, as required by
section 38.

32Federal Deposit Insurance Corporation, History of the Eighties--Lessons
for the Future (Washington, D.C.: 1997). FDIC data include only those
institutions that FDIC, the Federal Reserve, and OCC supervise. According
to OTS data, the average number of days between examinations was 461 in
1989, the year OTS was formed, and down to 309 days by 1992.

  PCA Requires Regulators to Take Specific Actions When Capital Declines

Institutions that fail to meet minimum capital levels face several
mandatory restrictions or requirements under section 38 (see fig. 5).33
Specifically, section 38 requires an undercapitalized institution to
submit a capital restoration plan detailing how it is going to become
adequately capitalized. When an institution becomes significantly
undercapitalized, regulators are required to take more forceful corrective
measures, including requiring the sale of equity or debt, or under certain
circumstances requiring an institution to be acquired by or merged with
another institution; restricting otherwise allowable transactions with
affiliates; and restricting the interest rates paid on deposits. In
addition to these actions, regulators also may impose other discretionary
restrictions or requirements outlined in section 38 that they deem
appropriate. After an institution becomes critically undercapitalized,
regulators have 90 days to either place the institution into receivership
or conservatorship (that is, close the institution) or to take other
actions that would better prevent or reduce long-term losses to the
insurance fund.34 Regulators also have some discretion in how they enforce
PCA restrictions and requirements--they may issue a PCA directive (a
formal action that requires an institution to take one or more specified
actions to return to required minimum capital standards) or delineate the
restrictions and requirements in a new or modified enforcement order, such
as a section 8(b) cease-and-desist order.

33With one exception, section 38 does not place restrictions on
institutions that are well capitalized or adequately capitalized. Namely,
all institutions, regardless of their capital level, are prohibited from
paying dividends or management fees that would drop them into the
undercapitalized category. Further, section 301 of FDICIA amended section
29 of FDIA (codified at 12 U.S.C. S 1831f) to allow adequately capitalized
institutions to accept or renew brokered deposits only if they receive
waivers from FDIC. (Brokered deposits are large-denomination deposits that
a broker divides into smaller pieces to sell to multiple depository
institutions on behalf of its customers.) Section 301 also imposes certain
interest rate restrictions for brokered deposits accepted by institutions
that are not well capitalized.

34Any determination to take other action in lieu of receivership or
conservatorship for a critically undercapitalized institution is effective
for no more than 90 days. After the 90-day period, the regulator must
place the institution in receivership or conservatorship or make a new
determination to take other action. Each new determination is subject to
the same 90-day restriction. If the institution is critically
undercapitalized, on average, during the calendar quarter beginning 270
days after the date on which the institution first became critically
undercapitalized, the regulator is required to appoint a receiver for the
institution. Section 38 contains an exception to this requirement, if,
among other things, the regulator and chair of the FDIC Board of Directors
both certify that the institution is viable and not expected to fail.

Figure 5: Section 38 Mandatory and Discretionary Requirements

  Regulators Used PCA Appropriately at the Banks and Thrifts We Reviewed

For the cases we reviewed, consistent with our 1996 report, we found that
regulators generally implemented PCA in accordance with section 38, the
implementing regulations, and their policies and procedures.35 Regulators
used PCA to address capital problems at 18 of 24 institutions we sampled
from among those that fell below one of the three lowest PCA capital
thresholds (that is, undercapitalized, significantly undercapitalized, or
critically undercapitalized based on Call or Thrift Financial Report
data). (See table 3.)

Table 3: Sampled Institutions with PCA Taken to Address Capital
Deficiencies

Institution name          Primary regulator PCA capital categorya          
Pulaski Savings Bank      FDIC              Critically undercapitalized    
Rock Hill Bank and Trust  FDIC              Critically undercapitalized    
FDIC Open Bank 1          FDIC              Significantly undercapitalized 
FDIC Open Bank 2          FDIC              Significantly undercapitalized 
CIB Bank                  FDIC              Undercapitalized               
Southern Pacific Bank     FDIC              Undercapitalized               
Deuel County State Bank   Federal Reserve   Critically undercapitalized    
New Century Bank          Federal Reserve   Critically undercapitalized    
Federal Reserve Open Bank Federal Reserve   Significantly undercapitalized 
1                                                                          
Federal Reserve Open Bank Federal Reserve   Significantly undercapitalized 
2                                                                          
Bank of Greenville        Federal Reserve   Undercapitalized               
Harbor Bank               OCC               Critically undercapitalized    
Compubank                 OCC               Significantly undercapitalized 
First National Bank       OCC               Undercapitalized               
(Lubbock)                                                                  
Georgia Community Bank    OTS               Critically undercapitalized    
OTS Open Thrift 1         OTS               Significantly undercapitalized 
First Heights Bank FSB    OTS               Significantly undercapitalized 
Enterprise FSB            OTS               Undercapitalized               

Source: GAO analysis of Call and Thrift Financial Report data.

35 [33]GAO/GGD-97-18 . Our 1996 report on the implementation of PCA found
that regulators generally took prescribed enforcement actions under
section 38, including obtaining and reviewing capital restoration plans
from undercapitalized institutions and closing critically undercapitalized
institutions within the required 90-day time frame.

aWe do not name institutions that are still active, but refer to them by
regulator and number. We selected institutions for our sample randomly by
regulator and by capital category (based on Call and Thrift Financial
Report data) so that the numbers of institutions regulated by each of the
regulators and numbers of institutions in each of the capital categories
generally were equal. An institution's capital category as listed in this
table does not necessarily reflect the only capital category in which it
appeared, based on Call or Thrift Financial Report data, during the period
of our review (2001-2005); rather it represents the capital category from
which it was selected for the sample.

In each of the 18 cases in which regulators used PCA to address capital
deficiencies, the relevant regulator identified the institution as having
fallen below one of the three lowest PCA capital thresholds and in most
cases required the institution to address deficiencies through a capital
restoration plan or a PCA directive or other enforcement order.

Regulators' use of PCA is illustrated by the following examples:

           o From the end of March 2002 to the end of June 2002, Rock Hill
           Bank and Trust's capital level declined from well capitalized to
           critically undercapitalized. In response, FDIC issued a notice
           informing the bank of the restrictions applicable to critically
           undercapitalized institutions under section 38. Within
           approximately 2 months of first becoming critically
           undercapitalized, the bank entered into a purchase and assumption
           agreement with another institution.

           o Federal Reserve examiners required Federal Reserve Open Bank 2
           to submit a capital restoration plan more than a year and a half
           prior to the bank's failure to meet minimum capital requirements.
           Federal Reserve examiners, prepared to issue a PCA directive when
           the bank's capital fell to significantly undercapitalized in March
           2005, noted in a June 2005 report of examination that the bank had
           taken steps to raise its capital level to undercapitalized, and
           then issued a PCA directive requiring the bank to submit a capital
           restoration plan. By September 2005, the bank was well capitalized
           by PCA standards.

           o OCC examiners notified First National Bank (Lubbock) of its
           critically undercapitalized status shortly after the closing date
           of the bank's June 30, 2003, Call Report filing. In November 2003,
           the bank was sold to a bank holding company and recapitalized.
           Concurrent with the bank's June 30, 2004, Call Report filing date,
           OCC conducted a full-scope examination and found the bank to be
           critically undercapitalized and directed it to file a capital
           restoration plan. The bank merged into an affiliate in early 2005,
           in accordance with its capital restoration plan.

           o After Enterprise FSB's capital level declined to
           undercapitalized in September 2001, OTS issued a PCA directive
           that required the institution to submit a capital restoration plan
           and make arrangements to sell or merge with another institution.
           On several occasions, OTS modified its original PCA directive to
           allow additional time to process the institution's merger
           application. With the exception of one quarter in which Enterprise
           FSB's capital level increased to well capitalized, the institution
           remained undercapitalized until the merger was completed in early
           2003.

           Regulators said that PCA was most effective when it was used to
           close or require the sale or merger of institutions as a means of
           minimizing or preventing losses to the insurance fund. Fifteen of
           the 18 institutions we reviewed were able to recapitalize or
           merged or closed without losses to the insurance fund. The
           remaining three institutions failed with losses to the insurance
           fund: Pulaski Savings Bank ($1 million), New Century Bank ($5
           million), and Southern Pacific Bank ($93 million). The failure of
           Southern Pacific Bank resulted in material losses to the insurance
           fund. In its material loss review for the bank, the FDIC IG noted
           that even though FDIC examiners applied PCA in accordance with
           regulatory guidelines, other factors, including the bank's failure
           to abide by FDIC recommendations related to the administration of
           its loan program, resulted in an overstatement of both net income
           and capital and limited PCA's effectiveness in minimizing losses
           to the insurance fund. In our review of FDIC's reports of
           examination and other information for the bank, we found that FDIC
           examiners continually informed the bank of its capital status and
           made repeated requests to management to recapitalize. However, the
           bank's reported capital level never fell to critically
           undercapitalized--the point at which FDIC has the authority to
           close an institution under section 38.

           In 6 of the 24 sampled cases we reviewed, we determined that use
           of PCA was not required to address declines in capital reported on
           quarterly Call and Thrift Financial Reports (see table 4).

Table 4: Sampled Institutions Where Use of PCA Was Not Required

                       Primary         Reason regulator did not use PCA to    
Institution name    regulator       address decline in capital category    
First Bank of Texas FDIC            First Bank of Texas was in the process 
                                       of merging into another institution    
                                       when it became undercapitalized for    
                                       one quarter. The bank did not present  
                                       any capital or supervisory concerns    
                                       prior to its merger.                   
Madison Bank        Federal Reserve Madison Bank experienced an operating  
                                       loss as a result of a pending merger,  
                                       which caused it to become              
                                       undercapitalized for one quarter. The  
                                       loss and impact on capital were        
                                       reported after the institution merged, 
                                       thus Federal Reserve examiners did not 
                                       apply PCA.                             
First National Bank OCC             First National Bank of Springdale      
of Springdale                       became critically undercapitalized for 
                                       one quarter that coincided with its    
                                       merger into another institution. The   
                                       bank presented no supervisory concerns 
                                       at that time.                          
Household Bank of   OCC             Household Bank of Nevada was           
Nevada                              significantly undercapitalized on two  
                                       occasions because it miscalculated     
                                       capital ratio information. OCC         
                                       officials told us that during this     
                                       period, the bank had other safety and  
                                       soundness weaknesses rather than       
                                       capital problems. Therefore, OCC, in   
                                       conjunction with FDIC and OTS, took    
                                       steps to consolidate Household Bank    
                                       and other subsidiaries of the bank's   
                                       parent company so that they could be   
                                       acquired by another institution.       
Century Bank        OCC             Century Bank failed to meet the total  
                                       risk-based capital requirement for     
                                       only one quarter and only by a         
                                       fraction of a percent (0.01 percent).  
                                       The bank was otherwise well            
                                       capitalized and did not have any other 
                                       indicators that it was a troubled      
                                       institution during this period.        
OTS Open Thrift 2   OTS             OTS Open Thrift 2 was undergoing a     
                                       reorganization that involved the       
                                       issuance of stock. The issuance was    
                                       oversubscribed, causing the thrift's   
                                       tier 1 leverage capital to fall below  
                                       the required minimum and appear as     
                                       undercapitalized for one quarter. The  
                                       thrift did not present any capital or  
                                       supervisory concerns before or after   
                                       the stock issuance.                    

Source: GAO analysis of regulatory data.

Regulators Used Other Enforcement Actions to Address Deficiencies in Sampled
Institutions Prior to Declines in Their PCA Capital Categories

Although PCA requires regulators to take regulatory action when an
institution fails to meet established minimum capital requirements,
capital is a lagging indicator and thus not necessarily a timely predictor
of problems at banks and thrifts. Although capital is an essential and
accepted measure of an institution's financial health, it does not
typically begin to decline until an institution has experienced
substantial deterioration in other areas, such as asset quality and the
quality of bank management. As a result, regulatory actions focused solely
on capital may have limited effects because of the extent of deterioration
that may have already occurred in other areas. All four regulators
generally agreed that by design, PCA is not a tool that can be used upon
early recognition of an institution's troubled status--in all of the cases
we examined, regulators took steps, in addition to PCA, to address
institutions' troubled conditions.

For example, 12 of the 18 banks and thrifts subject to PCA that we
examined experienced a decline in their CAMELS ratings to composite
ratings of 4 or 5 prior to or generally concurrent with becoming
undercapitalized. CAMELS ratings measure an institution's performance in
six areas--capital, asset quality, management, earnings, liquidity, and
sensitivity to market risk. These ratings are a key product of regulators'
on-site monitoring of institutions, providing information on the condition
and performance of banks and thrifts, and can be useful in predicting
their failure. The FDIC IG found a similar trend among the banks it
examined as part of an evaluation of FDIC's implementation of PCA.36

All of the 18 institutions we examined also appeared on at least one of
three regulator watch lists--the FDIC problem institutions list, the FDIC
resolution cases list, and the FDIC projected failure list--prior to or
concurrent with becoming undercapitalized (see fig. 6).37 Regulators use
these and their own watch lists to monitor the status of troubled
institutions and, in some cases, ensure their timely resolution (that is,
facilitating the merger or closure of institutions to prevent losses to
the insurance fund); the lists were another means through which regulators
monitored and addressed problems or potential problems at the 18
institutions prior to declines in PCA capital categories.

36Federal Deposit Insurance Corporation Office of the Inspector General,
The Role of Prompt Corrective Action as Part of the Enforcement Process,
Audit Report No. 03-038 (Washington, D.C.: Sept. 12, 2003).

37Institutions with CAMELS composite ratings of 4 or 5 are placed on the
problem institutions list. When FDIC's Division of Resolution and
Receivership becomes involved in the resolution of any institution, it
places that institution on the resolution cases list. Institutions that
are deemed likely to fail within 1 year are placed on the projected
failure list. FDIC is responsible for maintaining each of the lists.
Regulators also may maintain their own watch lists; however, we did not
determine whether any of the institutions in our sample appeared on any of
these lists.

Figure 6: Institutions on Regulator Watch Lists

Consistent with banks and thrifts exhibiting declining CAMELS ratings and
appearing on one or more watch lists prior to or concurrent with becoming
undercapitalized, at least 15 of the 18 banks and thrifts that we reviewed
had informal or formal enforcement actions in place prior to becoming
undercapitalized.38 Although we did not examine the effectiveness of these
prior actions in addressing deficiencies, the following examples
illustrate the types and numbers of enforcement actions regulators took at
some of the institutions in our sample.39

Although FDIC Open Bank 1 and FDIC examiners disagreed over the bank's
capital status, FDIC required the bank's board of directors to execute a
board resolution to address certain safety and soundness deficiencies
identified as part of an examination (see fig. 7). When the

38Because we only examined enforcement-related documents for the four
quarters prior to when these institutions became undercapitalized or worse
by PCA standards, the number of institutions with prior enforcement action
actually may be greater than 15.

39The enforcement actions detailed in the following examples may not
represent all the enforcement actions regulators took against these
institutions because we only reviewed documents for the four quarters
prior to the institutions becoming undercapitalized or worse.

Figure 8: Timeline of Enforcement Actions, New Century Bank

OCC examiners identified Compubank as posing serious safety and soundness
concerns related to earnings when the bank was well capitalized by PCA
standards (see fig. 9). The bank had high operating losses because of high
overhead expenses caused by expanding operations in anticipation of high
growth. As a result, OCC required the bank to enter into a written
agreement, which stipulated that the bank implement a capital restoration
plan and develop a contingency plan to sell, merge, or liquidate. Five
months later, the bank reported that it was critically undercapitalized by
PCA standards. The bank began the self-liquidation process and closed in
June 2002.

Figure 9: Timeline of Enforcement Actions, Compubank

Approximately 5 months before Georgia Community Bank became
undercapitalized, OTS and the institution entered into a supervisory
agreement in response to regulator concerns about the institution's asset
quality and management (see fig. 10). When the institution reported it was
significantly undercapitalized, OTS issued a PCA directive; however, the
institution was unable to recapitalize and as a result, it merged into
another institution in July 2005.

Figure 10: Timeline of Enforcement Actions, Georgia Community Bank

Most Material Loss Reviews Also Found Appropriate Use of PCA, but Some Reviews
Found Regulators Could Have Used PCA Sooner

We also reviewed material loss reviews of all institutions that failed
with material losses to the insurance fund--losses that exceed $25 million
or 2 percent of an institution's assets, whichever is greater--from 1992
through 2005 and in which regulators used PCA to address capital problems
(see table 5).40 In 12 of these 14 cases, the relevant IG found that PCA
was applied appropriately--meaning that when institutions failed to meet
minimum capital requirements, regulators required that they submit capital
restoration plans and adhere to restrictions and requirements in PCA
directives or other enforcement orders.

Table 5: Institutions with Material Losses and PCA to Address Capital
Adequacy, 1992-2005

Institution               Regulator Year of failure Appropriate use of PCA 
Bank of Harford           FDIC      1994            Yes                    
The Bank of San Pedro     FDIC      1994            Yes                    
Bank of Newport           FDIC      1994            Yes                    
First Trust Bank          FDIC      1995            Yes                    
Pacific Heritage Bank     FDIC      1995            Yes                    
BestBank                  FDIC      1998            Yes                    
Pacific Thrift and Loan   FDIC      1999            Yes                    
Company                                                                    
Connecticut Bank of       FDIC      2002            Yes                    
Commerce                                                                   
Pioneer Bank              FRB       1994            Yes                    
Mechanics National Bank   OCC       1995            Yes                    
First National Bank of    OCC       1999            No                     
Keystone                                                                   
Hamilton Bank             OCC       2002            Yes                    
NextBank                  OCC       2002            Yes                    
Superior Bank             OTS       2001            No                     

Source: GAO analysis of regulatory data.

Regulators appropriate use of PCA in institutions that failed with
material losses are demonstrated by the following examples:

40Since 1992, 19 banks and thrifts failed with material losses. We
excluded 4 of these institutions from our review because they either did
not suffer from capital deficiencies that required the use of PCA or
because their capital deficiencies predated the implementation of FDICIA.
In one case (Southern Pacific Bank), the bank was selected as part of our
sample of 24 institutions.

           o According to the FDIC IG's material loss review on Connecticut
           Bank of Commerce, FDIC used enforcement actions other than PCA
           directives to address the bank's capital and other problems.
           Connecticut Bank of Commerce experienced capital deficiencies from
           1991 through 1996 as a result of its poor asset quality. The bank
           operated under several cease-and-desist orders (1991, 1993, and
           2001) and a memorandum of understanding, each of which contained
           requirements that the bank hold capital in excess of the required
           PCA minimums. Upon the detection of fraud in April 2002, the
           bank's capital was immediately exhausted and it became critically
           undercapitalized. On June 25, 2002, FDIC issued a PCA directive
           ordering the dismissal of the bank's chairman and president. On
           June 26, 2002, the Banking Commissioner for the State of
           Connecticut declared Connecticut Bank of Commerce insolvent,
           ordered it closed, and appointed FDIC as receiver.

           o Prior to the implementation of legislation implementing PCA,
           Federal Reserve examiners attempted to restore Pioneer Bank to a
           safe and sound operating condition through written agreements
           entered into in 1986 and 1991. Despite these enforcement actions,
           the bank's condition continued to deteriorate and in June 1994,
           the Federal Reserve issued a PCA directive requiring Pioneer Bank
           to become adequately capitalized though the sale of stock or to be
           acquired by or merge into another institution. When the bank was
           unable to comply with the terms of the PCA directive, the
           California State Banking Department issued a capital impairment
           order on July 6, 1994, and closed the bank on July 8, 1994. In its
           material loss review of Pioneer Bank, the Federal Reserve IG
           concluded that the level of supervisory actions taken by the
           Federal Reserve was within the range of acceptable actions for the
           problems the bank experienced.

           o In October 2001, NextBank's capital level dropped from well
           capitalized to significantly undercapitalized based on findings
           from an examination conducted by OCC's Special Supervision and
           Fraud Division. The Department of the Treasury (Treasury) IG noted
           in its material loss review that the bank was at that point
           automatically subject to restrictions under PCA. In November 2001,
           OCC issued a PCA directive requiring the bank, among other things,
           to develop a capital restoration plan; file amended Call Reports;
           restrict new credit card account originations to prime lenders;
           and restrict asset growth, management fees, and brokered deposits.
           By December 2001, NextBank advised OCC that it would not be able
           to address its capital deficiency. In January 2002, NextBank and
           its parent company took steps to liquidate the bank. OCC appointed
           FDIC as receiver on February 7, 2002. While the Treasury IG did
           not find fault with OCC's use of PCA to address NextBank's capital
           deficiencies, it found that PCA's effectiveness in NextBank's
           situation was difficult to assess given the short amount of time
           that passed between when the bank's capital declined below PCA
           minimum requirements and when the bank failed.

           In two cases, the relevant IG determined that the regulator's use
           of PCA was not appropriate--First National Bank of Keystone
           (Keystone) and Superior Bank, regulated by OCC and OTS,
           respectively. In both cases, the Treasury IG found that the
           regulator failed to identify the institution's true financial
           condition in a timely manner and thus could not apply PCA's
           capital-based restrictions because the institution's reported
           capital levels met or exceeded the minimum required levels.
           Because PCA was not implemented timely in these cases, it was not
           effective in containing losses to the deposit insurance fund.41

           o According to the Treasury IG, Keystone's operating strategy
           entailed growth into the high-risk areas of subprime lending and
           selling loans for securitization.42 The bank's growth in these
           areas occurred without adequate management systems and controls,
           and inaccurate financial records masked the bank's true financial
           condition. At the time of the bank's failure, allegations of fraud
           were under investigation. In its material loss review of the bank,
           the IG noted that if OCC had reclassified the bank's capital
           category from well capitalized to adequately capitalized following
           an examination in late 1997, OCC could have restricted the bank's
           use of brokered deposits and applied certain interest-rate
           restrictions in an effort to curb the bank's growth 6 months
           before its capital levels showed serious signs of decline.
           Instead, these restrictions were not put in place until June 1998
           when OCC required the bank to adjust its reported capital based on
           examination findings--this adjustment resulted in a downgrade in
           the bank's capital category from well capitalized to
           undercapitalized and trigged PCA restrictions. Despite this
           finding, the IG noted that it was unclear whether reclassification
           would have actually had its desired effect--after the restrictions
           were trigged in June 1998, the bank continued to intentionally
           violate them.

           o The Treasury IG's material loss report on Superior Bank notes
           that while the immediate causes of the bank's insolvency in 2001
           appeared to be improper accounting and inflated valuations of
           residual assets, the causes could be attributed to a confluence of
           factors going back as early as 1993, including asset
           concentration, rapid growth into a new high-risk activity,
           deficient risk management systems, liberal underwriting of
           subprime loans, unreliable loan loss provisioning, economic
           factors affecting asset valuation, and lack of management response
           to supervisory concerns.43 Our 2002 testimony on the failure of
           Superior Bank and the IG's material loss review suggested that had
           OTS acknowledged problems at Superior Bank when examiners became
           aware of them in 1993, PCA would have been triggered sooner and
           might have slowed the bank's growth and contained its losses to
           the deposit insurance fund.44 The IG further noted that OTS's
           delayed detection of so many critical problems suggests that the
           advantage of PCA as an early intervention tool depends as much on
           timely supervisory detection of actual, if not developing,
           problems as it does on capital.
			  
			  Regulators Have Made Limited and Targeted Use of the Noncapital
			  Supervisory Actions Available under Sections 38 and 39

           Under section 38 regulators have the ability to reclassify an
           institution's capital category and dismiss officers and directors
           from deteriorating banks and thrifts. However, regulators have
           made limited use of these authorities, preferring instead to use
           moral suasion (as part of or separate from the examination
           process) or other enforcement actions to address deficiencies.
           Under section 39, regulators can require institutions to implement
           plans to address deficiencies in their compliance with regulatory
           safety and soundness standards. Regulators have used section 39
           with varying frequency to address noncapital deficiencies;
           however, those that use the provision use it to address targeted
           deficiencies, such as noncompliance with certain laws or
           requirements, and when an institution's management generally is
           willing and able to comply with required corrective actions.
			  
			  Regulators Prefer to Use Other Informal and Formal Enforcement
			  Powers over PCAï¿½s Reclassification and Dismissal Authorities

           In addition to their authority under PCA to reclassify an
           institution's PCA capital category or require improvements in
           management at significantly undercapitalized institutions,
           regulators also can use other means--such as moral suasion or more
           formal enforcement actions--to address deficiencies or effect
           change at an institution. Under section 38(g), regulators have the
           authority to reclassify or downgrade an institution's PCA capital
           category to apply PCA restrictions and requirements in advance of
           a decline (or further decline) in capital if the regulator
           determines that the institution is operating in an unsafe or
           unsound manner or engaging in an unsafe or unsound practice.45
           Regulators also may treat an undercapitalized institution as if it
           were significantly undercapitalized if they determine that doing
           so is "necessary to carry out the purpose" of PCA. In practice,
           this means that regulators may, in certain circumstances, treat a
           well-capitalized institution as if it were adequately capitalized,
           an adequately capitalized institution as if it were
           undercapitalized, and an undercapitalized institution as if it
           were significantly undercapitalized. Regulators are prohibited
           from reclassifying or downgrading an institution more than one
           capital category and cannot downgrade a significantly
           undercapitalized institution to critically undercapitalized.
           Regulators also may require improvements in the management of a
           significantly undercapitalized institution--for example, through
           the dismissal of officers and directors. This provision can be
           used alone or in conjunction with the reclassification provision.
           In the latter case, a regulator can require the dismissal of
           officers and directors from an undercapitalized institution.

           All four regulators said that they generally prefer other means of
           addressing problems to PCA. According to the regulators, the
           authority to reclassify an institution's capital category is of
           limited use on its own because regulators' ability to address both
           noncapital (such as management) and capital deficiencies through
           other informal and formal enforcement actions prior to a decline
           in capital effectively negates the need to reclassify an
           institution to apply operating restrictions or requirements.
           Regulators' use of section 38's reclassification authority is
           consistent with their views on it--since 1992, FDIC, the Federal
           Reserve, and OTS have never reclassified an institution's capital
           category. OCC has used the authority twice.

           All four regulators said that section 38's dismissal authority
           under section 38(f)(2)(F) is valuable as a deterrent and a
           potential tool, despite their infrequent use of it--FDIC has used
           the authority six times since 1992 and OCC once; the Federal
           Reserve and OTS have never used the authority. They said that the
           PCA authority occupies the middle ground between moral suasion and
           the removal and prohibition authority under section 8(e) of FDIA.
           According to the regulators, the first step in confronting problem
           officers and directors is moral suasion--that is, reminding the
           board of directors that it has an obligation to ensure that the
           institution is competently managed. In many cases, we were told
           that this reminder often is enough to force the resignations of
           problem individuals.46 Dismissal under section 38 represents a
           "middle of the road" option--it results in a ban from serving as
           an officer or director in the institution in question. In order to
           be reinstated, the dismissed individual must demonstrate that he
           or she has the capacity to materially strengthen the institution's
           ability to become adequately capitalized or correct unsafe or
           unsound conditions or practices. Regulators also have a more
           severe option--removal under section 8(e), which results in an
           industrywide prohibition and consequently, requires proof of a
           high degree of misconduct or malfeasance.47 Data show that
           regulators have used section 8(e) with some regularity (see fig.
           11). The regulators said that if an individual's misconduct rises
           to the level required to support removal and prohibition under
           section 8(e), use of that authority generally is preferable to
           dismissal under section 38.

           Figure 11: Regulators Use of Section 8(e), 1992-2005

           The regulators also noted that moral suasion and section 8(e) are
           not necessarily capital based, meaning that both can be used at
           times when PCA cannot. The regulators acknowledged that section 38
           permits them to reclassify an institution's capital category to
           dismiss an officer or director; however, they said that because
           section 38 only allows them to dismiss individuals from
           institutions that are undercapitalized or worse by PCA standards,
           the tool generally is not available to them in these good economic
           times when all or most of the institutions they regulate are well
           capitalized. OCC was of the view that section 38's dismissal
           authority could be more useful if it were uncoupled from capital
           and instead triggered by less-than-satisfactory ratings in the
           management component of the CAMELS rating. In particular, OCC
           officials said that linking the authority to the CAMELS rating
           could provide regulators with the authority to dismiss individuals
           who did not meet the criteria for removal and prohibition under
           section 8(e) and from institutions with boards that were
           unresponsive to regulators' moral suasion.
			  
			  Regulators Use Section 39 to Address Targeted Safety and
			  Soundness Deficiencies

           Changes to section 39 in 1994 gave regulators considerable
           flexibility over how and when to use their authority under the
           section to address safety and soundness deficiencies at the
           institutions they regulate.48 Like section 38's dismissal
           authority, section 39 represents a "middle of the road" option
           between informal enforcement actions (such as a commitment letter)
           and formal enforcement actions (such as a cease-and-desist order).
           In varying degrees, they have used section 39 to address
           deficiencies in the three broad categories defined under the
           section: operations and management; compensation; and asset
           quality, earnings, and stock valuation (see fig. 12). Finally,
           regulators said that they prefer to use section 39 when regulators
           are certain that management is willing and able to address
           identified deficiencies, even if management has not been
           responsive to informal regulatory criticisms in the past. For
           example, FDIC, OCC, and OTS have all used section 39 to require
           institutions to achieve compliance with Year 2000 (Y2K) or Bank
           Secrecy Act (BSA) requirements (both of which relate to
           institutions' operations).

41The FDIC IG made similar findings in its report on the effectiveness of
PCA in preventing losses to the deposit insurance fund. See Federal
Deposit Insurance Corporation Office of the Inspector General, The
Effectiveness of Prompt Corrective Action Provisions in Preventing or
Reducing Losses to the Deposit Insurance Funds, Audit Report No. 02-013
(Washington, D.C.: Mar. 26, 2002).

42Typically, subprime loans are for persons with poor or limited credit
histories and carry a higher rate of interest than prime loans to
compensate for increased credit risk. Securitization is the process of
selling to investors (public or private) asset-backed securities that
represent an interest in the cash flow generated by the loans.

Regulators Have Made Limited and Targeted Use of the Noncapital Supervisory
Actions Available under Sections 38 and 39

43Residual assets are assets remaining after sufficient assets are
dedicated to meet all [34]senior debtholders' claims in full.

44GAO, Bank Regulation: Analysis of the Failure of Superior Bank, FSB,
Hinsdale, Illinois, [35]GAO-02-419T (Washington, D.C.: Feb. 7, 2002).

Regulators Prefer to Use Other Informal and Formal Enforcement Powers over PCA's
Reclassification and Dismissal Authorities

45FDIA does not define unsafe and unsound practice or condition--such
determinations are to be made by the appropriate regulator based on the
facts and circumstances of each case. For purposes of the cease-and-desist
authority under section 8(b)(8) of FDIA, an institution with a
less-than-satisfactory rating (CAMELS 3, 4, or 5) for asset quality,
management, earnings, or liquidity may be deemed by the appropriate
federal regulator to be engaging in an unsafe and unsound practice.

46Data were not available on the frequency with which regulators were able
to informally persuade individuals to resign from institutions.

47Under section 8(e) of FDIA, regulators must make three determinations to
institute an action for removal or prohibition: misconduct, the effect of
the misconduct, and the individual's culpability for the misconduct.
Misconduct includes (1) violation of any law, regulation, or final section
8(b) order; (2) violation of any condition imposed in writing by the
appropriate federal agency in connection with the grant of any application
or other request by the institution; (3) violation of any written
agreement between the institution and the appropriate federal agency; (4)
engagement or participation in any unsafe or unsound practice; or (5)
engagement in any act, omission, or practice that constitutes a breach of
fiduciary duty. The regulator then must demonstrate that as a result of
the individual's misconduct any of the following occurred: (1) the
institution suffered or probably will suffer financial loss or other
damage, (2) the interests of the institution's depositors have been or
could be prejudiced, or (3) the individual in question received financial
gain or other benefit as a result of his or her conduct. To assess
culpability, regulators must determine whether the individual's conduct
involved personal dishonesty or demonstrated a willful or continuing
disregard for the safety and soundness of the institution.

Regulators Use Section 39 to Address Targeted Safety and Soundness Deficiencies

48The Federal Reserve has established safety and soundness standards under
section 39, but has not used the enforcement mechanisms under the section
to address deficiencies in favor of using other supervisory authorities.
The following discussion about regulators use of section 39 is therefore
limited to FDIC, OCC, and OTS.

Figure 12: Regulators Use of Section 39, 1995-2005

Officials from the Federal Reserve told us that they use memorandums of
understanding in the same way that the other three regulators use section
39--that is, to address targeted deficiencies at institutions that are
willing and able to make required changes.

According to the regulators, formal enforcement actions, such as section
8(b) cease-and-desist orders or written agreements, are better reserved
for institutions that have multiple or complex problems and in cases where
management is unable to define what steps must be taken to address
problems independent of the regulator or is unwilling to take action.
Since 1995 (the year regulators issued the section 39 guidelines),
regulators have made frequent use of section 8(b) of FDIA to address
problems associated with operations and management; compensation; and
asset quality, earnings, and stock valuation. From 1995 through 2005, FDIC
and the Federal Reserve issued 288 and 98 cease-and-desist orders or
written agreements, respectively, to address deficiencies in these three
areas. OTS issued 47 cease-and-desist orders related to deficiencies in
operations.49

FDIC Has More Tightly Linked Deposit Insurance Premiums to Institutional Risk,
but Some Expressed Concerns about Certain Aspects of the New System

Under authority provided by the Federal Deposit Insurance Reform Act of
2005, FDIC now prices its deposit insurance more closely to the risk FDIC
officials judge an individual bank or thrift presents to the insurance
fund. To do this, FDIC has created a system in which it evaluates a number
of financial and regulatory factors specific to an individual bank or
thrift. This replaces a system that was also risk based, but which
differentiated risk less finely. Industry officials and academics to whom
we spoke and selected organizations that submitted comment letters to FDIC
generally supported the concept of the new system. However, several voiced
concern about what they saw as the new system's subjectivity and
complexity and questioned whether the new system might produce unintended
consequences, including upsetting relations between bankers and their
regulators.

Changes to FDIC's Deposit Insurance System More Closely Tie Premiums to the Risk
Institutions Present to the Deposit Insurance Fund, but Stop Short of Completely
Risk-Based Pricing

FDIC's recent changes to the deposit insurance system more closely tie an
individual bank or thrift's deposit insurance premium to the risk it
presents to the insurance fund. In general, FDIC does this by considering
three sets of factors--supervisory (CAMELS) ratings and financial ratios
or credit agency ratings--while also distinguishing between large
institutions with credit agency ratings and all other institutions.
However, the system stops short of completely risk-based pricing.

  Old System Relied on Two Factors to Determine Risk and Premiums

FDIC's previous method for determining premiums relied on two
factors--capital levels and supervisory ratings--to determine
institutions' risk and premiums.50 FDIC established three capital
groups--termed 1, 2, and 3 for well-capitalized, adequately capitalized,
and undercapitalized institutions, respectively--based on leverage ratios
and risk-based capital ratios.51 Three supervisory groups--termed A, B,
and C--reflected, respectively, financially sound institutions with only a
few minor weaknesses; institutions with weaknesses, which if not corrected
could result in significant deterioration and increased risk of loss to
the insurance fund; and institutions that pose a substantial probability
of loss to the insurance fund unless effective corrective action is taken.
Based on its capital levels and supervisory ratings, an institution fell
into one of nine risk categories (see table 6). However, the vast majority
of institutions--95 percent at year-end 2005--fell into category 1A, even
though, according to FDIC officials, there were significant differences
among individual institutions' risk profiles within the category.

49OCC was unable to segregate orders covering operations and management;
compensation; and asset quality, earnings, and stock valuation from all
cease-and-desist orders issued over the period. According to data obtained
from OCC's Web site, the regulator issued 240 cease-and-desist orders from
1995 through 2005.

50See Assessments, 71 Fed. Reg. 69282, 69283-84 (2006).

Table 6: Distribution of Institutions among Risk Categories in FDIC's
Previous Deposit Insurance System, as of December 31, 2005

                                     Supervisory category  
Capital group                   A            B        C
1: Well capitalized            1A           1B       1C
                                                          
                             (8,358)        (373)     (50)
2: Adequately capitalized      2A           2B       2C
                                                          
                                (54)          (7)      (1)
3: Undercapitalized            3A           3B       3C
                                                          
                                 (0)          (0)      (2)

Source: FDIC.

Further, according to FDIC, in 2005, 95 percent of institutions did not
pay premiums into the insurance fund because the agency was barred from
charging premiums to well-managed and well-capitalized institutions when
the deposit insurance fund was at or above its designated reserve ratio,
and was expected to remain there.52 Because nearly all institutions paid
the same rate under the old system, lower-risk institutions effectively
subsidized higher-risk institutions.53

51These capital categories are different from the PCA capital categories
discussed elsewhere in this report. Where PCA divides institutions into
five capital categories, the previous insurance system used three.

52Deposit Insurance Funds Act of 1996, title II, subtitle G of Pub. L. No.
104-208, S 2708(c), 110 Stat. 3009, 3009-497 (1996) (codified at 12 U.S.C.
S 1817(b)(2)(A)(v)). The repeal of section 1817(b)(2)(A)(v) was effective
on January 1, 2007, the date that FDIC's final regulations under Section
2109(a)(5) of the Federal Deposit Insurance Reform Act of 2005 took
effect. See Federal Deposit Insurance Reform Act of 2005, supra note 1, S
2104(e). The designated reserve ratio is the insurance fund's reserve
level, expressed as a fraction of total estimated insured deposits.

  The New System Links Risk and Premiums More Closely

To tie institutions' insurance premiums more directly to the risk each
presents to the insurance fund, FDIC created a system that generally (1)
differentiates between large and small institutions, specifically between
institutions with current credit agency ratings and $10 billion or more in
assets and all other institutions; (2) for institutions without credit
agency ratings, forecasts the likelihood of a decline in financial health
(referred to throughout this report as the general method); (3) for
institutions with credit agency ratings, uses those ratings, plus
potentially other financial market information, to evaluate institutional
risk (referred to throughout this report as the large-institution method);
and (4) requires all institutions to pay premiums based on their
individual risk.54

Premiums under the general method and the large-institution method are
calculated differently, based on the availability of relevant information
for institutions in each category. The general method uses two sources of
information as inputs to a statistical model designed to predict the
probability of a downgrade in an institution's CAMELS rating: (1)
financial ratios (such as an institution's capital, past-due loans, and
income) and (2) CAMELS ratings. According to FDIC officials, little other
information is readily available to assess risk for these institutions.
However, FDIC data show that the higher on the CAMELS scale institutions
are rated, the higher the rate of failure--the 5-year failure rate is 0.39
percent for CAMELS 1-rated banks, 3.84 percent for 3-rated banks, and
46.92 percent for 5-rated banks--thus making CAMELS ratings and financial
ratios a reasonable basis for assessing risk.55

The large-institution method also uses CAMELS ratings. But rather than
employ financial ratios, it incorporates market-based information--credit
agency ratings of an institution's debt offerings. FDIC officials told us
that incorporating debt ratings provides a fuller, market-based picture of
an institution's condition than do financial ratios. For example, some
large institutions concentrate in certain activities, such as transactions
processing or credit cards, while others provide more general services.
According to FDIC officials, financial ratios may not adequately
distinguish among such different activities. Also, credit ratings
determine how much institutions must pay to obtain funds in capital
markets--well-rated banks and thrifts will pay less, while institutions
the market judges as riskier will pay more. Thus, according to FDIC
officials, it makes sense to align premiums with these market-based
funding costs. In addition to its ability to use the CAMELS and credit
ratings, FDIC also has the flexibility to adjust premiums for large
institutions up to 0.5 basis points up or down based on other relevant
information (such as market analyst reports, rating-agency watch lists,
and rates paid on subordinated debt) as well as stress considerations
(such as how an institution would be expected to react to a sudden and
significant change in interest rates).56 If a large institution does not
have an available credit agency rating, its premium is calculated
according to the general method.57

53According to FDIC officials, although most institutions paid no premiums
in recent years, lower-risk institutions implicitly subsidized the
premiums of higher-risk institutions--even when the premium rate charged
to most institutions was zero, the activities of higher-risk institutions
raised the chances of insurance fund losses and thus higher premiums for
all institutions.

54FDIC officials refer to the general method as the financial ratio method
and the large-institution method as the debt rating method.

55These data are only for banks and do not include thrifts. Also excluded
are failures in which fraud was determined to be a primary contributing
factor.

The new insurance system places banks and thrifts into one of four risk
categories, each of which has a corresponding premium or range of
premiums. These "base rate" premiums range from 2 to 4 basis points for
banks and thrifts in the best-rated category, risk category I, to 40 basis
points for institutions in the bottom category, risk category IV (see
table 7).58 Thus, for example, under the base rate schedule the riskiest
institutions (risk category IV) pay a premium rate 20 times greater than
the best-rated banks and thrifts (minimum rate, risk category I). Even
within the best category, riskier institutions pay twice the rate paid by
the safest banks and thrifts, reducing the tendency for subsidies under
the old system.59 The same premium schedule applies to all institutions,
regardless of their premium assessment method.

56Subordinated debt is repayable only after other debts with higher claim
priority have been satisfied.

57According to FDIC, approximately 10 to 15 percent of the 120
institutions with assets of at least $10 billion do not have available
credit agency ratings. As with large institutions with credit agency
ratings, FDIC may use other financial market information to evaluate these
institutions' risk.

58With some minor adjustments, premiums are assessed on total domestic
deposits.

Table 7: Base Rate Premiums by Risk Category under FDIC's New Deposit
Insurance System

                                                   Risk category
                                               I           II III IV 
Annual base rate (premiums in basis points) Minimum - 2  7  25 40 
                                                                     
                                               Maximum - 4           

Source: FDIC.

Under the new system, FDIC has limited authority, without resorting to new
rule making, to vary premiums from the base rates as necessary and
appropriate. For assessments beginning in 2007, FDIC has used this
flexibility to increase premiums by 3 basis points over the base rates.
Thus, the current rate for risk category I is 5 to 7 basis points, rather
than 2 to 4 basis points; for risk category II, the premium is 10 basis
points; for risk category III, the premium is 28 basis points; and for
risk category IV, the premium is 43 basis points. According to FDIC, the
increase in premiums for 2007 was necessary because of strong growth in
insured deposits and the availability of premium credits to many
institutions under the terms of the Federal Deposit Insurance Reform Act
of 2005.

In general, to set the premium rates for each of the four risk categories,
FDIC officials told us they considered both what the differences should be
in premiums among risk categories and, taking those differences into
account, the level at which the premiums should be established.
Considering the two together, the goal was to create a schedule of rates
with the best chance of maintaining the insurance fund with a designated
reserve ratio from 1.15 percent to 1.35 percent of insured deposits, with
the former representing the required minimum under the Federal Deposit
Insurance Reform Act of 2005, and the latter being the level at which
mandated rebates of premiums to banks and thrifts must begin.60 FDIC
officials told us they established the level of premiums based on four
factors: (1) historical data on insurance losses, (2) FDIC operating
expenses, (3) projected interest rates and their effect on FDIC investment
portfolio income, and (4) expected growth of insured deposits.61

59Section 2107(a) of the Federal Deposit Insurance Reform Act of 2005
amended section 7(e)(3) of FDIA (codified at 12 U.S.C. S 1817(e)(3)) to
require that FDIC's Board provide by regulation a onetime premium credit
to eligible banks and thrifts to offset future premiums based on certain
previous payments into the deposit insurance fund. The aggregate amount of
funds available for such onetime credits is capped at the amount FDIC
could have collected if it had imposed an assessment of 10.5 basis points
on the combined assessment base of the Bank Insurance Fund and the Savings
Association Insurance Fund as of December 31, 2001. FDIC has calculated
this amount to be approximately $4.7 billion. See One-Time Assessment
Credit, 71 Fed. Reg. 61374, 61375 (2006) (final rule). While their credits
are drawn down, some institutions will pay lower premiums; however, when
the credits are exhausted, all institutions will be assessed full
premiums.

While Focusing More on Risk, the New System Stops Short of
Completely Risk-Based Pricing

Although the new system ties premiums more specifically to the risk
an individual institution presents to the insurance fund, it does not
represent completely risk-based pricing. As a result, some degree of
cross-subsidy still exists in the new system. In particular, as estimated
by FDIC, institutions in risk category IV would need to pay premiums of
about 100 basis points to cover the expected losses of the group. However,
FDIC has chosen to set the base rate premium for these banks and thrifts
at 40 basis points, or 60 percent below the indicated premium. In doing so,
FDIC officials told us they sought to address long-standing concerns of the
industry, regulators, and others that premiums should not be set so high as
to prevent an institution that is troubled and seeking to rebuild its health
from doing so. In contrast, some have suggested that capping premiums to
address such concerns ultimately may cost the insurance fund more in the
long runï¿½lower premiums for riskier institutions may allow them to
remain open longer, resulting in greater losses if and when they eventually
fail. FDIC officials said that the number of institutions in category IV is
small and thus the trade-off between lower premiums for troubled
institutions and potentially larger losses later is not significant. Further,
they said that the 40 basis point base rate applicable to the highest risk
institutions represents a sizable increase over the assessment rate for
these institutions under the previous system.

Another way FDIC's new premium pricing system stops short of being
completely risk based is that it does not take into account "systemic
risk." In a fully risk-based system, premiums would be set to reflect two
major components: expected losses plus a premium for systemwide risk of
failure or default. According to academics we spoke to, FDIC's new system
reflects the first component, but not the second. Incorporating the notion
of systemic risk into the premium calculation would acknowledge that
failure of some banks could have repercussions to the financial system as
a whole and that such failures are more likely during economic downturns.
FDIC officials told us that the new system does not reflect systemic risk
for several reasons. First, there is an alternative mechanism for
capturing what is effectively a systemic risk premium.62 Second, FDIC
officials said that charging an up-front premium for systemic risk could
prevent institutions from getting the best premium rate on the basis of
their size, which is not permitted under the 2005 Federal Deposit
Insurance Reform Act.63 And finally, FDIC officials said that FDIC has
other sources of financing available to address losses resulting from
large-scale failures, including borrowing from the industry, a $30 billion
line of credit with Treasury, and the ability to borrow from the Federal
Financing Bank and the Federal Home Loan Bank system.

62Section 13 of FDIA (codified at 12 U.S.C. S 1823) authorizes FDIC to
undertake various actions or provide assistance to a failing institution.
FDIC is obligated to pursue a course of resolution that is the least
costly to the insurance fund, except in cases involving systemic risk. 12
U.S.C. S 1823(c)(4). Under the "systemic risk" exception, if upon
recommendation of FDIC's Board of Directors and the Board of Governors of
the Federal Reserve System (in each case by a two-thirds vote of the
members of the boards), the Secretary of the Treasury, in consultation
with the President, determines that pursuing the least costly alternative
would have serious adverse effects on economic conditions or financial
stability, then FDIC may take any action or provide any assistance
authorized under section 13 that would avoid or mitigate such adverse
effects. In such cases, the loss to the insurance fund arising from such
action or assistance is recaptured by special assessment on all insured
institutions. This assessment effectively amounts to a systemic risk
premium. Because the assessment is not levied on insured deposits, but
rather on nonsubordinated liabilities, the effect is to shift the burden
to larger institutions--the institutions that pose the greatest systemic
risks.

63Section 2104(a)(2) of the Federal Deposit Insurance Reform Act (codified
at 12 U.S.C. S 1817(b)(2)(D)) specifically prohibits barring an
institution from obtaining the lowest premium solely because of size. Pub.
L. No. 109-171, 120 Stat. 12. Large institutions generally pose the
greatest systemic risk, so according to FDIC officials, charging a
systemic risk premium could effectively amount to a surcharge based on
size, improperly disqualifying them from the lowest rate.

Industry Officials and Academics Generally Support the New System, but Have
Voiced Concerns about Certain Aspects

In our review of selected comments to FDIC's proposed rule and interviews
with bankers, industry trade groups, and academics, we found that the
industry generally supported the concept of a more risk-based insurance
premium system.64 However, several of those to whom we spoke and many
organizations that submitted comments to FDIC raised several concerns
about the new system. First, many said that the new system places too much
weight on subjective factors, which could result in incorrect assessments
of institutions' actual risk. Specifically, officials from two trade
associations and one small bank who we interviewed questioned the
inclusion of, or the weight given to, the management component of the
CAMELS ratings.65 One considered this component to be the most subjective
of the CAMELS component areas. Six additional organizations noted in
comment letters their concern with FDIC's plan to assign different weights
to the CAMELS components, noting in at least one case that FDIC had
provided no evidence to support using a weighted rating in place of the
composite rating. FDIC officials said that the weights were set in
consultation with the other federal banking regulators and represent the
relative importance of each component as it pertains to the risk an
institution presents to the insurance fund. Specifically, FDIC officials
said that asset quality, management, and capital are often key factors in
an institution's failure and any subsequent losses to the insurance fund,
and thus warrant more consideration than other factors in the calculation
of risk.

Similarly, in comment letters to FDIC, five large banks, three trade
groups, and one financial services company expressed concern with the part
of the rule that gives FDIC flexibility to adjust large institutions'
premiums up or down based on other information, including other market
information and financial performance and conditions measures (such as
market analyst reports, assessments of the severity of potential losses,
and stress factors). All of these organizations cautioned that to do so
would undermine the assessments of institutions' primary regulators
regarding their performance and health (as expressed in CAMELS ratings, a
primary component of FDIC's system). According to FDIC, this authority to
adjust ratings in consultation with other federal regulators is necessary
to ensure consistency, fairness, and the consideration of all available
information. FDIC officials said that the agency plans to clarify its
processes for making any adjustments to ensure transparency and plans to
propose and seek comments on additional guidelines for evaluating whether
premium adjustments are warranted and the size of the adjustments.

64A majority of comments submitted to FDIC in response to its initial
proposal for the new insurance system addressed two issues: (1) the
automatic assessment of de novo institutions at the ceiling rate (4 basis
points under the base rate schedule) in Risk Category I and (2) the
possible treatment of Federal Home Loan Bank advances as volatile
liabilities. FDIC's final rule relaxed treatment of de novo institutions
and dropped volatile liabilities as a factor in the determination of
premiums. Thirty-two organizations and individuals, including 6 we
interviewed, provided comments to FDIC on issues and concerns with other
aspects of FDIC's deposit insurance system. The comments of these
institutions are reflected in our discussion.

65According to FDIC, CAMELS ratings capture information on an
institution's risk management practices that is not otherwise reflected in
premium calculations. Under the new system, FDIC generally will consider
an institution's ratings in each of the CAMELS components in determining
risk. Each component will receive the following weight: C, 25 percent; A,
20 percent; M, 25 percent; and E, L, and S, 10 percent each.

Related to these concerns, officials from one large bank, one small bank,
and one trade association and one of the academics with whom we spoke said
that FDIC's new system is overly complicated and that it might not be
readily apparent to bank or thrift management how activities at their
respective institutions could affect the calculation of their insurance
premiums. Seven others expressed similar concerns in comment letters to
FDIC. In its final rule, FDIC stated that while the pricing method is
complex, its application is straightforward. For example, if an
institution's capital declines, its premium will likely increase. Further,
FDIC officials said that the FDIC Web site contains a rate calculator that
allows an institution to determine its premium and to simulate how a
change in the value of debt ratings, supervisory ratings, or financial
ratios would affect its premium.

Officials we interviewed from all three of the large banks said that the
level and range of premiums for top-rated institutions generally was too
high, given the actual risk they believe their institutions pose to the
insurance fund. Officials from one large bank and one trade association we
spoke with said that the best-rated banks and thrifts should pay no
premiums, or that the base rate range of premiums should be reduced from 2
to 4 to 1 to 3 basis points. An additional nine organizations supported
similar changes in their comment letters. Risk category I, the top-rated
premium category, accounts for the majority of total deposits, meaning
that even small changes in premium assessment rates could produce a
significant difference in revenue to the insurance fund, and hence
assessments to the industry. FDIC officials said that the 2 to 4 basis
point spread is more likely to satisfy the insurance fund's long-term
revenue needs than a 1 to 3 basis point spread. FDIC officials also said
that FDIC could, based on authority in the final rule, reduce rates below
the current base rate "floor" of 2 to 4 basis points if the agency
determined that such a reduction was warranted.

Further, one bank official we spoke to said that the new system was
incorrectly based in the idea of institutions failing, rather than on the
more nuanced notion of actual losses expected to be suffered by the
deposit insurance fund if failures occurred. As a result, he said, FDIC
failed to give appropriate credit to how large banks handle risk. Three
organizations that submitted comments on FDIC's new system supported this
notion, saying that FDIC should not assess premiums on all domestic
deposits because losses suffered by uninsured depositors should impose no
burden on the insurance fund--the magnitude of any loss would be lessened
to the extent that depositors in foreign branches, other uninsured
depositors, general creditors, and holders of subordinated debt absorbed
such losses.66 FDIC officials, citing research the agency has done on
failures and losses, said that the differences in rates and categories
were empirically based, and thus adequately reflected all institutions'
risk. Further, FDIC officials said that loss severity is one of the many
factors the agency is permitted to consider as part of its assessment of
the risk of large institutions.

Officials from the two small banks, one large bank, and both industry
trade groups and the academics with whom we spoke questioned FDIC's choice
on initial placement of institutions into risk categories. Because most
institutions are now healthy, FDIC placed them into the best-rated premium
category, risk category I, for which base rate premium charges range from
2 to 4 basis points. Within this top-rated category, FDIC initially
assigned approximately 45 percent of institutions to receive the minimum
rate of 2 basis points, and 5 percent of institutions to receive the
highest rate of 4 basis points. The remainder fell in the middle of the
range. These officials and academics generally agreed that FDIC should
establish risk criteria, and then assign institutions to appropriate
groups based on those criteria, rather than start with a predetermined
distribution in mind. Three additional organizations expressed similar
concerns in comment letters to FDIC. Further, officials from the other two
large banks with whom we spoke said that given the economic good times and
institutional good health, the 45 percent of institutions with the lowest
rate was too small a grouping and, as a result, healthy institutions
arbitrarily would be bumped into higher premiums. FDIC officials said that
based on the agency's experience, a range of 40 to 50 percent appeared to
be a natural breaking point in the distribution of institutions by risk,
and that over time, the percentage of institutions assigned the lowest
premium in the top-rated category may vary.

66FDIC officials said that such changes were not within the scope of this
redesign of the deposit insurance system.

Some also thought the new system had the potential to create tension or
discourage cooperative relations between bank management and federal
examiners. Under the old system, there was no difference in premiums for
well-capitalized, 1-rated institutions and well-capitalized 2-rated
institutions. However, under the new system, such a difference could lead
to higher premiums because CAMELS ratings are factored into premium
calculations. As a result, according to officials we interviewed from one
trade group, management might be less willing to discuss with examiners
issues or problems that could prompt a lower rating, although raising and
resolving such problems ultimately might be good for both the institution
and the insurance fund. FDIC officials acknowledged the concern, and said
that FDIC and the other federal regulators plan to monitor the new system
for adverse effects. However, they said that it was important to include
CAMELS ratings in the assessment of risk because the ratings provide
valuable information about institutions' financial and operational health.

Finally, officials from one trade association and one of the large banks
with whom we spoke also expressed concern that regional or smaller
institutions could be disadvantaged under the new system. Officials from
two credit rating agencies echoed this view, saying that larger, more
diverse institutions (by virtue of factors such as revenue, geography, or
range of activities) typically have steadier income, which increases
security and decreases risk. In contrast, regional or smaller institutions
can have geographic or line-of-business concentrations in their lending
portfolios that could hurt supervisory or credit ratings, leading to
higher deposit insurance premiums. FDIC said that while size or geography
could affect an institution's risk profile, management could offset that
risk by maintaining superior earnings or capital reserves, requiring
higher collateral requirements on loans, or using hedging vehicles.

FDIC officials told us that the agency plans to monitor the new deposit
insurance system to ensure its proper functioning and the fair treatment
of the institutions that pay premiums into the deposit insurance fund. For
example, in addition to assessing whether the new system creates friction
between examiners and bank and thrift management, as discussed above, FDIC
officials also said that the agency will, among other things, assess over
time whether the percentage of institutions paying the lowest rate in risk
category I--those receiving the best premium rate--should be increased and
whether different financial ratios should be considered in the calculation
of premiums.

Agency Comments

We provided FDIC, the Federal Reserve, OCC, and OTS with a draft of this
report for their review and comment. In written comments, the Federal
Reserve concurred with our findings related to PCA. These comments are
reprinted in appendix II. The Federal Reserve noted that PCA has
substantively enhanced the agency's authority to resolve serious problems
expeditiously and that PCA has generally worked effectively in the problem
situations where its use became applicable. In addition, FDIC, the Federal
Reserve, and OCC provided technical comments, which we incorporated as
appropriate.

We are sending copies of this report to the Chairmen of the Federal
Deposit Insurance Corporation and the Board of Governors of the Federal
Reserve System, the Comptroller of the Currency, the Director of the
Office of Thrift Supervision, and interested congressional committees. We
will also make copies available to others upon request. In addition, the
report will be available at no charge on the GAO Web site at
http://www.gao.gov .

If you or your staff have any questions concerning this report, please
contact me at (202) 512-8678 or at [email protected] . Contact points for
our Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. Key contributors to this report are listed
in appendix III.

Yvonne D. Jones
Director, Financial Markets and Community Investment

Appendix I: Objectives, Scope, and Methodology

The objectives of this report were to (1) describe trends in the financial
condition of banks and thrifts and federal regulators' oversight of these
institutions since the passage of the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA), (2) evaluate how federal
regulators used the capital or prompt corrective action (PCA) provisions
of FDICIA to resolve capital adequacy issues at the institutions they
regulate, (3) evaluate the extent to which federal regulators use the
noncapital provisions of FDICIA to identify and address weaknesses at the
institutions they regulate, and (4) describe the Federal Deposit Insurance
Corporation's (FDIC) deposit insurance system and how recent changes to
the system affect the determination of depository institutions' risk and
insurance premiums. Our review focused on 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) and was limited to depository institutions.

To describe trends in the financial condition of banks and thrifts, we
summarized financial data (including total assets, net income, returns on
assets, returns on equity, the number of problem institutions, and the
number of bank and thrift failures) from 1992, the year FDICIA was
implemented, through 2005. We obtained this information from FDIC
Quarterly Banking Reports, which publish industry statistics derived from
Reports on Condition and Income (Call Report) and Thrift Financial
Reports. All banks and thrifts must file Call Reports and Thrift Financial
Reports, respectively, with FDIC every quarter. We also analyzed Call and
Thrift Financial Report data for 1992 through 2005 that FDIC provided to
determine (1) the number of well-capitalized, adequately capitalized,
undercapitalized, significantly capitalized, and critically
undercapitalized depository institutions from 1992 through 2005 and (2)
the amount of capital well-capitalized banks and thrifts carried in excess
of the well-capitalized leverage capital minimum for each year from 1992
through 2005.1 We chose to use Call and Thrift Financial Report data
because the data are designed to provide information on all federally
insured depository institutions' financial condition, and FDIC collects
and reports the data in a standardized format. We have tested the
reliability of FDIC's Call and Thrift Financial Report databases as part
of previous studies and found the data to be reliable.2 In addition, we
performed various electronic tests of the specific data extraction we
obtained from FDIC and interviewed FDIC officials responsible for
providing the data to us. Based on the results of these tests and the
information we obtained from FDIC officials, we found these data to be
sufficiently reliable for purposes of this report.

1Leverage capital is tier 1 capital computed without risk weights and in
most cases closely matches an institution's reported tangible equity. If
an institution's tangible equity is 2 percent or less, it is considered
critically undercapitalized for PCA purposes.

To describe federal regulators' oversight of banks and thrifts since the
passage of FDICIA, we reviewed the provisions of the Federal Deposit
Insurance Act (FDIA) requiring regulators to conduct annual, on-site,
full-scope examinations of depository institutions as well as several GAO
and industry reports discussing the federal regulators' oversight of
depository institutions prior to the failures of the 1980s and early 1990s
and after the enactment of FDICIA, including their use of PCA to address
capital deficiencies.3 We also obtained data from each of the four federal
regulators on the interval between examinations for each year, from 1992
through 2005. We interviewed officials from FDIC, the Federal Reserve,
OCC, and OTS to assess the reliability of these data. Based on their
responses to our questions, we determined these data to be reliable for
purposes of this report.

To determine how federal regulators used PCA to address capital adequacy
issues at the institutions they regulate, we reviewed section 38 of FDIA,
related regulations, regulators' policies and procedures, and past GAO
reports on PCA to determine the actions regulators are required to take
when institutions fail to meet minimum capital requirements.4 We then
analyzed Call and Thrift Financial Report data to identify all banks and
thrifts that were undercapitalized, significantly undercapitalized, or
critically undercapitalized (the three lowest PCA capital categories)
during at least one quarter from 2001 through 2005. We chose this period
for review based on the availability of examination- and
enforcement-related documents and to reflect the regulators' most current
policies and procedures. From the 157 institutions we identified as being
undercapitalized or lower from 2001 to 2005, we selected a nonprobablity
sample of 24 institutions, reflecting a mix of institutions supervised by
each of the four regulators and institutions in each of the three lowest
PCA capital categories. We reviewed their reports of examination, informal
and formal enforcement actions, and institution-regulator correspondence
for a period covering four quarters prior to and four quarters following
the first and last quarters in which each institution failed to meet
minimum capital requirements to determine how regulators used PCA to
address their capital deficiencies. As discussed above, we have tested the
reliability of Call and Thrift Financial Report data and found the data to
be reliable. To supplement our sample, we also reviewed material loss
reviews from 14 banks and thrifts that failed with material losses from
1992 through 2005 and in which regulators used PCA to address capital
deficiencies.5 Because of the limited nature of our sample, we were unable
to generalize our findings to all institutions that were or should have
been subject to PCA since 1992.

2For example, see GAO, Industrial Loan Corporations: Recent Asset Growth
and Commercial Interest Highlight Differences in Regulatory Authority,
[38]GAO-05-621 (Washington, D.C.: Sept. 15, 2005), 87. In addition, we
confirmed that no significant changes occurred to the way in which banks
and thrifts report information on their financial condition and how FDIC
maintains the data since the release of this report.

3Pub. L. No. 102-242 S 111(a), 105 Stat. 2236, 2240 (1991) (codified as
amended at 12 U.S.C. S 1820(d)). GAO, Bank Supervision: Prompt and
Forceful Regulatory Actions Needed, [39]GAO/GGD-91-69 (Washington, D.C.:
Apr. 16, 1991); GAO, Bank and Thrift Regulation: Implementation of
FDICIA's Prompt Regulatory Action Provisions, [40]GAO/GGD-97-18
(Washington, D.C.: Nov. 21, 1996); Federal Deposit Insurance Corporation
Office of the Inspector General, The Role of Prompt Corrective Action as
Part of the Enforcement Process, Audit Report No. 03-038 (Washington,
D.C.: Sept. 12, 2003); and Federal Deposit Insurance Corporation, History
of the Eighties--Lessons for the Future (Washington, D.C.: 1997).

4 [41]GAO/GGD-91-69 and [42]GAO/GGD-97-18 .

To determine the extent to which federal regulators have used the
noncapital supervisory actions of sections 38 and 39 of FDIA to address
weaknesses at the institutions they regulate, we reviewed regulators'
policies and procedures related to sections 38(f)(2)(F) and 38(g)--the
provisions for dismissal of officers and directors and reclassification of
a capital category, respectively--and section 39, which gives regulators
authority to address safety and soundness deficiencies. We analyzed
regulator data on the number of times and for what purposes the regulators
used these noncapital authorities. To provide context on the extent of
regulators' use of these noncapital provisions, we also obtained data on
the number of times regulators used their authority under section 8(e) of
FDIA to remove officers and directors from office and section 8(b) of FDIA
to enforce compliance with safety and soundness standards. Based on
regulators' responses to our questions related to these data, we
determined the data to be reliable for purposes of this report.

5Section 38(k) of FDIA requires the federal regulators' respective
inspectors general to issue reports on each depository institution whose
failure results in a "material loss"--losses that exceed $25 million or 2
percent of an institution's assets, whichever is greater--to the insurance
fund. These material loss reports must assess why the institution's
failure resulted in a material loss and make recommendations for
preventing such losses in the future.

Finally, to describe how changes in FDIC's deposit insurance system affect
the determination of institutions' risk and insurance premiums, we
reviewed FDIC's notice of proposed rule making on deposit insurance
assessments, selected comments to the proposed rule, and FDIC's final rule
on deposit insurance assessments.6 We also interviewed representatives of
three large institutions, two small institutions, and two trade groups
representing large and small institutions and two academics to obtain
their views on the impact of FDIC's changes to the system. We selected the
large institutions based on geographic location and size and the small
institutions based on input from the Independent Community Bankers
Association on which of its member organizations were familiar with FDIC's
proposed changes to the deposit insurance system. We also interviewed
officials from two credit rating agencies on the factors--financial,
management, and operational--they consider when rating institutions' debt
offerings.

We conducted our work in Washington, D.C., and Chicago from March 2006
through January 2007 in accordance with generally accepted government
auditing standards.

6Federal Deposit Insurance Corporation--Assessments, 71 Fed. Reg. 41910
(2006) (proposed rule). Comments to the proposed rule making were due on
September 22, 2006. Federal Deposit Insurance Corporation--Assessments, 71
Fed. Reg. 69282 (2006) (final rule codified at 12 C.F.R. pt. 327.9, 327.10
and Appendixes A, B, and C of Subpart A).

Appendix II: Comments from the Board of Governors of the Federal Reserve
System

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Yvonne D. Jones, (202) 512-8678 or [email protected]

Acknowledgments

In addition to the contact named above, Kay Kuhlman, Assistant Director;
Gloria Hernandez-Saunders; Wil Holloway; Tiffani Humble; Bettye
Massenburg; Marc Molino; Carl Ramirez; Omyra Ramsingh; Barbara Roesmann;
Cory Roman; and Christopher Schmitt made key contributions to this report.

(250289)

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Highlights of [50]GAO-07-242 , a report to congressional committees

February 2007

DEPOSIT INSURANCE

Assessment of Regulators' Use of Prompt Corrective Action Provisions and
FDIC's New Deposit Insurance System

The Federal Deposit Insurance Reform Conforming Amendments Act of 2005
required GAO to report on the federal banking regulators' administration
of the prompt corrective action (PCA) program under section 38 of the
Federal Deposit Insurance Act (FDIA). Congress created section 38 as well
as section 39, which required regulators to prescribe safety and soundness
standards related to noncapital criteria, to address weaknesses in
regulatory oversight during the bank and thrift crisis of the 1980s that
contributed to deposit insurance losses. The 2005 act also required GAO to
report on changes to the Federal Deposit Insurance Corporation's (FDIC)
deposit insurance system. This report (1) examines how regulators have
used PCA to resolve capital adequacy issues at depository institutions,
(2) assesses the extent to which regulators have used noncapital
supervisory actions under sections 38 and 39, and

(3) describes how recent changes to FDIC's deposit insurance system affect
the determination of institutions' insurance premiums.

GAO reviewed regulators' PCA procedures and actions taken on a sample of
undercapitalized institutions. GAO also reviewed the final rule on changes
to the insurance system and comments from industry and academic experts.

In recent years, the financial condition of depository institutions
generally has been strong, which has resulted in the regulators'
infrequent use of PCA provisions to resolve capital adequacy issues of
troubled institutions. Partly because they benefited from a strong economy
in the last decade, banks and thrifts in undercapitalized and lower
capital categories decreased from 1,235 in 1992, the year regulators
implemented PCA, to 14 in 2005, and none failed from June 2004 through
January 2007. For the banks and thrifts GAO reviewed, regulators generally
implemented PCA in accordance with section 38. For example, regulators
identified when institutions failed to meet minimum capital requirements,
required them to implement capital restoration plans or corrective actions
outlined in enforcement orders, and took steps to close or require the
sale or merger of those institutions that were unable to recapitalize.
Although regulators generally used PCA appropriately, capital is a lagging
indicator and thus not necessarily a timely predictor of problems at banks
and thrifts. In most cases GAO reviewed, regulators had responded to
safety and soundness problems in advance of a bank or thrift's decline in
required PCA capital levels.

Under section 38 regulators can take noncapital supervisory actions to
reclassify an institution's capital category or dismiss officers and
directors from deteriorating institutions, and under section 39 regulators
can require institutions to implement plans to address deficiencies in
their compliance with regulatory safety and soundness standards.
Regulators generally have made limited use of these authorities, in part
because they have chosen other informal and formal actions to address
problems at troubled institutions. According to the regulators, other
tools, such as cease-and-desist orders, may provide more flexibility than
those available under sections 38 and 39 because they are not tied to an
institution's capital level and may allow them to address more complex or
multiple deficiencies with one action. Regulators' discretion to choose
how and when to address safety and soundness weaknesses is demonstrated by
their limited use of section 38 and 39 provisions and more frequent use of
other informal and formal actions.

Recent changes to FDIC's deposit insurance system tie the premiums a bank
or thrift pays into the insurance fund more directly to the estimated risk
the institution poses to the fund. In the revised system, FDIC generally
(1) differentiates between larger institutions with current credit agency
ratings and $10 billion or more in assets and all other, smaller
institutions and (2) requires all institutions to pay premiums based on
their individual risk. Most bankers, industry groups, and academics GAO
interviewed and many of the organizations and individuals that submitted
comment letters to FDIC on the new system generally supported making the
system more risk based, but also had some concerns about unintended
effects. FDIC and the other federal banking regulators intend to monitor
the new system for any adverse impacts.

References

Visible links
  29. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-91-69
  30. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  31. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  32. http://www.gao.gov/cgi-bin/getrpt?GAO-06-1021
  33. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  34. http://financial-dictionary.thefreedictionary.com/Senior debt
  35. http://www.gao.gov/cgi-bin/getrpt?GAO-02-419T
  37. file:///home/webmaster/infomgt/d07242.htm#mailto:[email protected]
  38. http://www.gao.gov/cgi-bin/getrpt?GAO-05-621
  39. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-91-69
  40. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  41. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-91-69
  42. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-97-18
  50. http://www.gao.gov/cgi-bin/getrpt?GAO-07-242
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