Bank Insider Activities: Insider Problems and Violations Indicate Broader
Management Deficiencies (Chapter Report, 03/30/94, GAO/GGD-94-88).
Insider fraud and other problems were evident in 61 percent of 286 bank
failures in 1990 and 1991, according to investigations of those failures
by the Federal Deposit Insurance Corporation (FDIC). GAO found that in
26 percent of the failures, FDIC investigators cited insider problems as
one of the major causes. During the three years before these banks
failed, federal bank examiners cited the banks for a total of 561
insider violations. Even though insider violations were cited and
enforcement actions were taken, the banks still went under. In a review
of federal examination reports for 13 open and relatively healthy banks,
GAO discovered insider violations similar to those found in the failed
banks. In general, GAO found that examiners were not as effective in
spotting insider problems at the failed banks when the banks were
operating as investigators were after the banks had failed. GAO also
found that examiners often failed to adequately communicate to bank
boards and management the potential seriousness of problems and
violations; as a result, the problems went uncorrected and became more
serious. At the same time, bank boards of directors and bank management
often failed to take steps to understand the depth of the problems
examiners were trying to explain.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-94-88
TITLE: Bank Insider Activities: Insider Problems and Violations
Indicate Broader Management Deficiencies
DATE: 03/30/94
SUBJECT: Insured commercial banks
Bank management
Bank failures
Bank examination
Banking regulation
Fraud
Lending institutions
Embezzlement
Internal controls
Banking law
IDENTIFIER: Bank Insurance Fund
FDIC Liquidation Asset Management Information System
BIF
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Cover
================================================================ COVER
Report to Congressional Requesters
March 1994
BANK INSIDER ACTIVITIES - INSIDER
PROBLEMS AND VIOLATIONS INDICATE
BROADER MANAGEMENT DEFICIENCIES
GAO/GGD-94-88
Bank Insider Activities
Abbreviations
=============================================================== ABBREV
AABD - American Association of Bank Directors
BIF - Bank Insurance Fund
CFR - Code of Federal Regulations
CMP - Civil Money Penalties
D&O - Directors and Officers
DCI - Data Collection Instrument
DOL - Division of Liquidation
FDIC - Federal Deposit Insurance Corporation
FDICIA - Federal Deposit Insurance Corporation Improvement Act of
1991
FIRREA - Financial Institutions Reform, Recovery and Enforcement
Act of 1989
FRA - Federal Reserve Act
LAMIS - Liquidation Asset Management Information System
MOU - Memorandum of Understanding
NCUA - National Credit Union Administration
OCC - Office of the Comptroller of the Currency
OTS - Office of Thrift Supervision
PCR - Post-Closing Report
PLS - Professional Liability Section
SEC - Securities and Exchange Commission
Letter
=============================================================== LETTER
B-247879
March 30, 1994
The Honorable Donald W. Riegle, Jr.
Chairman, Committee on Banking,
Housing and Urban Affairs
United States Senate
The Honorable Henry Gonzalez
Chairman, Committee on Banking,
Finance and Urban Affairs
House of Representatives
This report responds to your separate requests that we review the
role of insider activities in, and their effects on the health of,
financial institutions. The report discusses the nature of insider
problems, such as insider fraud, insider abuse, and loan losses to
insiders at failed banks, and violations of insider laws and
regulations at both failed and open banks. It also discusses the
underlying causes of these problems and ways in which federal bank
regulators could improve their oversight of these problems.
We are sending copies of this report to the Chairman of the Board of
Governors of the Federal Reserve System, the Comptroller of the
Currency, and the Acting Chairman of the Federal Deposit Insurance
Corporation. We are also sending copies to members of the banking
committees, interested committees and subcommittees, and other
interested parties.
This report was prepared under the direction of Mark J. Gillen,
Assistant Director. Other major contributors are listed in appendix
X. If you have any questions, please call me on (202) 512-8678.
James L. Bothwell, Director
Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
Officers and directors of a bank have fiduciary responsibilities to
the bank, its customers, and its shareholders to ensure the safe and
sound management of bank operations. They are also responsible for
putting the bank's interests before their own in business dealings
affecting the bank. Congress has long recognized in legislation that
because of these responsibilities bank insiders, such as officers and
directors, who obtain loans from their banks must be treated the same
as anyone from the general public obtaining loans. When insider
lending violates these laws, the bank may suffer financially. Even
without major financial effects, such violations may indicate serious
problems with the management and board oversight of bank operations.
This report responds to separate requests from the Chairman of the
Senate Committee on Banking, Housing, and Urban Affairs and the
Chairman of the House Committee on Banking, Finance and Urban
Affairs. Both Chairmen asked that GAO review insider activities at
failed and open banks; the underlying reasons for insider problems,
such as insider fraud, insider abuse, and loan losses to insiders;
and the way federal bank regulators supervise such activities. The
Chairman of the House Banking Committee also asked GAO to determine
the overall amount of insider lending in the United States banking
industry.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Federal Reserve Regulation O generally provides that bank loans to
insiders--officers, directors, and principal shareholders--must be
made on the same terms that are available to other bank customers.
Such loans also must not be any riskier than loans to other bank
customers. Regulation O also provides for both individual lending
limits for any one insider and aggregate lending limits for all
insiders, and it requires prior board approval for loans to insiders.
Sections 23A and 23B of the Federal Reserve Act provide rules for
transactions between banks and their affiliates. For the purposes of
this report, an insider violation is defined as a violation of either
Regulation O or sections 23A or 23B of the Federal Reserve Act.
Insider problems, such as loan losses to insiders, may occur with or
without insider violations. For example, loans to a director may
have been made on the same terms as those available to other bank
customers. However, if the insiders' loans go bad, this can
potentially affect the financial health of the bank. On the other
hand, insider violations can occur--for example, a loan to an officer
made at reduced interest rates--even though the loan is current and
is not affecting the health of the bank. In such cases, however,
insider violations may indicate a lack of control or effective
management of the loan policies set down by the bank's board of
directors.
The 3 federal bank regulators--the Federal Deposit Insurance
Corporation (FDIC), Office of the Comptroller of the Currency (OCC),
and the Federal Reserve System--are each responsible for supervising
a portion of the almost 12,000 banks in the United States. Their
examinations will often include a review of insider activities to
ensure, for example, that insider loans are being made on the same
terms and conditions as loans to other bank customers. When the
regulators identify insider violations, they may take enforcement
actions to get the banks to correct the problems.
Banks may fail for a variety of reasons, including insider problems.
When a bank fails, FDIC investigators determine the major reasons for
the failure and whether recoveries should be pursued against
directors, officers, or others if these individuals were found
negligent in overseeing bank operations.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
In reviewing FDIC investigations of 286 bank failures that occurred
in calendar years 1990 and 1991, GAO found that investigators cited
evidence of insider problems, such as fraud or loan losses, to
insiders in 175, or 61 percent, of the banks. Further, GAO found
that investigators had cited insider problems as one of the major
causes for failure in 74, or 26 percent, of the banks. During the 3
years before these banks eventually failed, federal bank examiners
cited the banks for a total of 561 insider violations. Many of these
violations were repeated in more than one bank examination. Federal
and state regulators also took 235 separate enforcement actions in
the 3-year periods. Even though insider violations were cited and
enforcement actions were taken, the banks failed.
In a review of federal examination reports for 13 judgmentally
selected open and relatively healthy banks, GAO found insider
violations similar to those found in the failed banks. In both the
failed and open banks, GAO found a strong association between these
insider violations and the larger problems of poor administration by
bank management and inadequate oversight by bank boards of directors.
In general, GAO found that examiners were not as effective in
identifying insider problems at the failed banks when the banks were
open as investigators were after the banks had failed. Although
there are several reasons for the examiners identifying fewer insider
problems, GAO believes examiners should take steps to improve their
abilities to identify problems.
GAO further found that examiners often failed to adequately
communicate to bank boards and management the potential seriousness
of problems and violations; as a result, the problems went
uncorrected and became more serious. At the same time, GAO believes
that bank boards of directors and bank management often failed to
take steps to understand the depth of the problems examiners were
attempting to explain.
Because no comprehensive data sources exist, GAO was unable to
identify the aggregate amount of insider lending at failed banks.
For open banks, newly required bank data showed the aggregate amount
of insider lending for all banks was $24 billion as of March 1993.
PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
INSIDER PROBLEMS AND INSIDER
VIOLATIONS EXISTED AT FAILED
BANKS
-------------------------------------------------------- Chapter 0:4.1
GAO found evidence of insider problems cited in investigations of 175
of 286 banks that failed in 1990 and 1991. Insider fraud, a type of
criminal activity, was identified by FDIC investigators in 36 percent
of the 286 bank failures. Insider abuse--that is, any abusive action
taken for self-gain on the part of insiders that falls short of
criminal fraud--was identified by FDIC investigators in 41 percent of
the 286 bank failures. Loan losses to insiders were identified by
FDIC investigators in 28 percent of the 286 bank failures. Overall,
for the 175 banks with evidence of insider problems, losses to the
FDIC's Bank Insurance Fund, which insures deposits in commercial and
saving banks, were estimated to be $5.4 billion, or about 55 percent
of total losses, during the 2-year period. The assets of these 175
banks totaled $33.7 billion, or about 43 percent, of the total assets
of all 286 banks that failed in 1990 and 1991. During the 3 years
before the 175 banks failed, federal examiners cited the banks for
561 insider violations. The most common violations were exceeding
the lending limits for insiders and giving loans to insiders with
preferential terms that were not available to the general public.
GAO found that small banks (those with assets of less than $100
million) were more likely to be cited for insider violations than
were large banks (those with assets of $100 million or more). (See
pp. 31-49.)
INSIDER VIOLATIONS WERE ALSO
PRESENT IN OPEN BANKS
-------------------------------------------------------- Chapter 0:4.2
In GAO's review of federal examinations of 13 open banks, 10 banks
had been cited for insider violations. As they had been in the
failed banks, preferential interest rates on loans to insiders and
insider loans that exceeded the legal lending limit were the most
frequently cited insider violations in the examination reports GAO
reviewed. For example, one report cited two loans to insiders that
were made at preferential interest rates of 9 and 10.5 percent when
regular bank customers were charged 12 and 13.5 percent,
respectively, for identical loans. (See pp. 49-51.)
INSIDER PROBLEMS ARE
INDICATIVE OF POOR
MANAGEMENT AND OVERSIGHT
-------------------------------------------------------- Chapter 0:4.3
GAO found that insider violations were strongly associated with
management problems, such as the failure of management to respond to
regulatory criticisms, poor and/or negligent management, and passive
or negligent boards of directors. In 141 of the 175 failed banks
that were cited by federal regulators for insider violations, GAO
found banks cited for insider violations more likely to also be
criticized by federal regulators for various management problems.
For example, when examiners cited loans to insiders that exceeded the
loan limits, they were four times more likely to identify the
management problem of a dominant board member than when they did not
cite such an insider violation. Also, when examiners cited a bank's
failure to maintain records relating to insider activities, they were
2.8 times more likely to identify poor and/or negligent management.
(See pp. 52-54.)
Although the federal regulators cited these banks for insider
violations and associated management problems, these banks still
failed. On the basis of its analysis, GAO believes the failure of a
bank's management to correct insider problems and violations
indicates a much larger problem of poor management and inadequate
oversight by the bank's board and individual directors. (See pp.
54-55.)
EXAMINERS COULD IMPROVE
THEIR ABILITY TO IDENTIFY
INSIDER PROBLEMS
-------------------------------------------------------- Chapter 0:4.4
In cases of banks with problems of insider fraud and abuse, FDIC
investigators were more likely to have identified the problems after
the banks failed than were the examiners when the banks were open.
Examiners did a better job in identifying insider loan losses, but
they still were not as effective as investigators on identifying
other insider issues. One reason for the identification of fewer
insider problems is that examiners face many obstacles, and
investigators have several advantages in identifying insider
problems. For example, former bank employees are more likely to be
willing to talk to investigators about insider problems after a bank
has failed and their jobs can no longer be jeopardized by such
discussions. Even so, GAO believes that by focusing more on the
recordkeeping requirements of Regulation O, examiners could ensure
that more information would be available to enable them to spot
insider problems when they occur. (See ch. 5.)
FAILURE TO COMMUNICATE
PROBLEMS AND FAILURE OF BANK
BOARDS TO UNDERSTAND
PROBLEMS MAY EXACERBATE
PROBLEMS
-------------------------------------------------------- Chapter 0:4.5
In both failed and open banks, GAO found that problems identified by
examiners often went uncorrected from one examination to the next.
The problems examiners identified in the open banks were not as
severe as those in the failed banks. However, it is troubling that
both the federal bank examiners and bank directors and management did
not better ensure that problems in both open and failed banks were
corrected. When examiners fail to take timely forceful enforcement
actions, bank boards of directors may fail to understand the
potential seriousness of repeated violations and problems. Even so,
bank boards of directors also have major responsibilities to listen
to examiners and ensure that bank management takes the necessary
steps to correct problems.
In discussions with outside bank directors (i.e., directors who are
not employees of their banks), GAO noted that many of the directors
expressed frustration about their interaction with their banks'
primary federal regulator. These frustrations varied. However, most
centered on the directors' need for examiners to work more closely
with them to better ensure that they understand the problems
examiners identified. Their frustrations also centered on the
directors' need for examiners to prioritize the problems they
identify.
In its analysis of the 286 banks that failed in 1990 and 1991, GAO
found that investigators cited about 90 percent of the banks for
having passive or negligent directors as a factor contributing to the
banks' failure. In these cases, it appears that directors of some
banks seem not to have understood their roles and responsibilities in
maintaining or returning the bank to a financially sound position.
In addition, GAO found instances of passive boards of directors cited
in the examination reports for several of the 13 open, healthy banks
it reviewed. In these instances, federal examiners noted that the
boards of directors or individual directors had failed to either
understand the seriousness of the examination findings or take
corrective actions on identified problems. For directors to fully
understand the seriousness of examination findings, training may be
appropriate.
Bank directors have a responsibility to carefully listen and fully
understand what examiners are informing them about a bank's
identified problems. When bank directors do not fully understand
examination findings, it is their responsibility to either seek
further clarification from examiners or obtain additional knowledge
on a particular aspect of banking. Repeated violations or problems
should send a sufficient signal to a bank's board of directors that
either (1) the bank's management is not taking adequate corrective
actions or (2) the directors do not understand what is necessary to
correct the problems. (See ch. 6.)
THE AGGREGATE AMOUNT OF
INSIDER LENDING AT FAILED
BANKS IS UNKNOWN
-------------------------------------------------------- Chapter 0:4.6
GAO used several approaches but was unable to identify the aggregate
amount of lending to insiders at failed banks. One reason for this
is that FDIC investigators generally do not seek to identify the
aggregate amount of insider lending that occurred in a failed bank or
even the full extent of losses caused by insider lending. Until
March 1993 all banks were required to file quarterly reports--bank
call reports--that included only the amount of lending to officers
and shareholders but omitted the amount of lending to bank directors.
Consequently, there has been no aggregate reporting of insider
lending activities by banks.
Lending to bank directors was added for the March 1993 call report.
For this call report, the aggregate amount of insider lending was $24
billion, with an average aggregate amount per bank of $2 million,
ranging from no insider lending to $623 million. Historically, it
has often taken several reporting cycles for new data to be reliably
reported by banks; therefore, with the new reporting requirement
future reports should more accurately reflect aggregate insider
lending activity. If banks adhere to the reporting requirements,
then reporting will eventually enable regulators to determine the
aggregate amount of insider lending. This requirement makes it
easier for examiners to determine whether banks are violating
Regulation O, which governs aggregate lending to insiders. However,
such reporting will be only as good as the records kept by banks.
Given that 61, or 35 percent, of the 175 failed banks with evidence
of insider problems were cited for violations of insider
recordkeeping requirements, GAO believes it is important for federal
examiners to reemphasize the importance of banks keeping and
reporting accurate information on insider activities. (See ch. 4.)
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5
GAO recommends that federal bank regulators include a thorough review
of insider activities in their next examination of each bank under
their authority. This review should include a comparison of data
that banks provide examiners with information as reported by each
bank in its quarterly call report, an evaluation of bank insurance
policies, and an increased emphasis on Regulation O recordkeeping
requirements. (See ch. 5.)
To improve the communication between examiners and bank directors and
increase the likelihood that directors will initiate appropriate
corrective actions, GAO is making a further recommendation. GAO also
recommends that federal bank regulators direct examiners to better
ensure--through examination reports, exit conferences, and other
means (including recommending training to directors when
appropriate)--that all directors understand (1) the primary issues in
need of directors' attention, (2) that the problems facing a bank are
most often a consequence of deficiencies in the overall management
and oversight by the directors, and (3) that directors must see that
effective corrective action is taken. (See ch. 6.)
AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6
GAO requested comments on a draft of this report from OCC, FDIC, and
the Federal Reserve. These written comments appear along with GAO's
responses in appendixes VII, VIII, and IX.
OCC officials agreed with GAO's recommendations, saying it plans to
take corrective actions. These include revising the section of the
Comptroller's Handbook for National Bank Examiners for reviewing
insider activities and including a discussion of call report
requirements and a reemphasis of the importance of recordkeeping and
reporting requirements.
FDIC and the Federal Reserve, while in substantial agreement with
GAO's findings and conclusions, stated that they already have
policies in place to address these recommendations. GAO believes
that there are additional opportunities for improving communication
between regulators and bank boards and management that are not
included in FDIC's and the Federal Reserve's policies. Further,
based on GAO's review of federal regulators' examination files for
failed and open banks, GAO found that FDIC has not consistently
adhered to its policies. In a subsequent letter (see app. VIII),
FDIC agreed to reemphasize to its field staff the importance of a
thorough analysis of insider activities, effective communication with
boards of directors, and adherence to established policies and
procedures.
INTRODUCTION
============================================================ Chapter 1
Insider activities at banks, such as loans to bank directors,
officers, or principal shareholders, should pose no greater risk to a
bank's financial health than transactions with other bank customers
when these insider activities are conducted under applicable laws and
regulations. However, when insider activities become abusive, they
can be among the most insidious of reasons for the deterioration of
the health of a bank. When insider fraud,\1 excessive compensation,
self-dealing, or other abusive activities occur, the very individuals
who have a fiduciary duty to ensure the sound operations of a bank
can benefit from violations of laws or regulations and thus may be
motivated to conceal these activities. Consequently, such abuses can
be difficult for federal bank regulators to detect.
In addition, repeated insider problems and violations of laws and
regulations governing insider activities can indicate poor internal
controls. They can also indicate the failure of a bank's management
and board of directors to effectively ensure that the bank operates
in a safe and sound manner. Such problems put the health of
individual institutions at risk and pose a threat of loss to the Bank
Insurance Fund (BIF), which insures deposits in both commercial and
savings banks.
This report responds to separate requests from the Chairman of the
Senate Committee on Banking, Housing and Urban Affairs and the
Chairman of the House Committee on Banking, Finance and Urban
Affairs. The Chairmen requested that we review the role of insider
activities in, and their effects on the health of, financial
institutions.\2 Both Chairmen were also interested in the efforts of
federal financial institution regulators to identify, monitor, and
supervise insider activities.
--------------------
\1 Fraud, a criminal act, generally can be defined as intentional
actions, omissions, or concealments meant to deceive and get
advantage over another.
\2 As agreed with the requesters, our work concentrated on commercial
banks. In appendix II, we present a summary of our prior work that
addressed insider issues in thrifts and credit unions, which we
updated through discussions with officials at the Office of Thrift
Supervision and the National Credit Union Administration.
CONGRESSIONAL CONCERNS ABOUT
INSIDER PROBLEMS PROMPTED
LEGISLATION
---------------------------------------------------------- Chapter 1:1
Sections 22(g) and 22(h) of the Federal Reserve Act (FRA)\3 are two
of the key statutory provisions governing loans\4 to bank insiders.
A review of the history of these sections demonstrates Congress'
long-standing concern about the effects of insider activities on the
health of financial institutions. For example, section 22(g) of FRA,
as added by the Banking Act of 1933,\5
prohibited loans to executive officers of banks outright and required
the officers to submit written reports to the chairman of a bank's
board of directors containing the dates and amounts of loans made to
those officers by other banks. The Banking Act of 1935 eliminated
the absolute bar on loans by a bank to its officers and authorized a
bank to extend credit to its executive officers. However, the credit
is not to exceed $2,500, without prior approval of a majority of the
bank's board of directors.
In 1967, Congress further amended section 22(g) of FRA, increasing
the amounts that banks could lend to their executive officers. That
legislation authorized banks to make loans of up to $5,000 to
executive officers and separately authorized specific-purpose loans
for education and home mortgages. However, safeguard provisions were
added, including a requirement that such loans be made on terms that
were no more favorable than those extended to other borrowers. The
provisions also contained a requirement that the borrowing officer
submit a detailed financial statement.
Congress substantially increased insider restrictions in the
Financial Institutions Regulatory and Interest Rate Control Act of
1978.\6 Before this act, restrictions applied solely to executive
officers. This act added a new provision, section 22(h) of FRA,
which, in conjunction with section 22(g), expanded the definition of
insiders to include officers, directors, and major shareholders and
their related interests. Congress was concerned that "[p]roblem
banks and insider abuses have been virtually synonymous."\7 As a
response to the problems associated with insider abuses at financial
institutions and with the "recognition that insiders have a special
duty with respect to their institutions," in the same session
Congress placed restrictions on insider loans and provided statutory
language spelling out the board of directors' responsibilities with
respect to insider loans.
Further restrictions and amendments relating to insider transactions
were added by the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA).\8 Congress again expressed its concern with
reports of "serious abuses by bank and thrift insiders, with
resultant costs to the deposit insurance system."\9 In the same
session, Congress was also concerned with how such abuses could
affect public confidence in the banking industry as a whole.
Therefore, Congress added additional provisions, including overall
limits on loans to all bank insiders "to help combat such abuses, and
prohibitions on excessive compensation."
--------------------
\3 12 U.S.C. 375a, 375b.
\4 Law and regulations governing insider transactions refer to
extensions of credit to insiders. The term extensions of credit
includes loans, standby letters of credit, overdrafts, advances
against unearned salary, etc. For purposes of this report, we will
use the term loans to insiders to mean all extensions of credit to
insiders.
\5 Pub. L. No. 73-66, 48 Stat. 162 (1933).
\6 Pub. L. No. 95-630, 92 Stat. 3641 (1978).
\7 H. Rep. No. 1383, 95th Cong., 2d Sess. 10 (1978).
\8 Pub. L. No. 102-242, 105 Stat. 2236 (1991).
\9 S. Rep. No. 167, 102nd Cong., 1st Sess. 55 (1991).
SECTIONS 23A AND 23B:
RESTRICTIONS ON AFFILIATE
TRANSACTIONS
-------------------------------------------------------- Chapter 1:1.1
In addition to improper loans, insider abuse can occur through
transactions between a member bank\10 and its affiliates, which
generally are any companies that control the member bank and any
other company that is controlled by a company that controls the
member bank. For example, an officer of a bank may also own, in
part, a data processing company that is affiliated with the bank. An
abuse would result if the officer used his or her influence to direct
bank business to this company and the company then charged exorbitant
fees for its data processing services. Congress enacted Section 23A
of FRA\11 to (1) restrict transactions between member banks and their
affiliates, (2) prohibit the purchase of low-quality assets by banks
from affiliates without independent credit evaluation, and (3)
require permissible loans or extensions of credit between banks and
affiliates to be adequately collateralized. Congress designed
section 23A to prevent the misuse of commercial bank resources
stemming from nonarm's length financial transactions with affiliated
companies.\12
Section 23A limits the amount of transactions between a member bank
and its affiliates. Transactions with any one affiliate are
generally limited to 10 percent of the bank's capital and surplus.
An overall limit of 20 percent is applied to all affiliate
transactions.
Section 23B of FRA\13 was specifically intended to authorize certain
transactions (including loans and purchases of assets) between member
banks and their affiliates. However, it was to authorize
transactions only if their terms and conditions, including credit
standards, were substantially the same as or at least as favorable to
the bank as those prevailing at the time for comparable transactions
with nonaffiliated companies.\14
--------------------
\10 The term member bank refers to banks that are members of the
Federal Reserve System. Sections 23A and 23B of FRA apply with
respect to a nonmember insured bank in the same manner and to the
same extent as if it were a member bank (12 U.S.C. 1828(j)(2)).
Implementing regulations generally subject nonmember banks to
Regulation O's controls on credit extensions to insiders (12 C.F.R.
section 337.3).
\11 12 U.S.C. 371c.
\12 See S. Rep. No. 536, 97th Cong., 1st Sess. 31 (1982).
\13 12 U.S.C. 371c-1.
\14 S. Rep. No. 19, 100th Cong., 2d Sess. 36 (1987) (Legislative
History of the Competitive Equality Banking Act of 1987, Pub. L. No
100-86, 101 Stat. 552 (1987)).
INSIDER ACTIVITIES PERMITTED
AND PROHIBITED BY REGULATION O
---------------------------------------------------------- Chapter 1:2
Federal Reserve Regulation O\15 implements the provisions of FRA
sections 22(g) and 22(h), which concern loans to executive officers,
directors, and principal shareholders of member banks. Insiders
generally are defined by Regulation O as including bank officers in a
major policymaking position, bank directors, and major shareholders
and their related interests. Table 1.1 provides more specific
information on the definition of insiders. We present the complete
text of Regulation O in appendix III.
Table 1.1
Insiders as Defined by Regulation O
Insider Definition
------------------------- -----------------------------------------------------
Executive Any person who participates in or has the authority
Officers to participate in major policymaking functions of a
bank. Also includes executive officers of the bank's
holding company or of any other subsidiary of the
bank's holding company.
Directors All individuals who serve on the bank's elected board
of directors, whether or not they receive
compensation. Also includes directors of the bank's
holding company and the directors of any other
subsidiary of the bank's holding company.
Principal Any bank shareholder who directly or indirectly
Shareholders controls at least 10 percent of the voting shares of
any class of stock. Shares owned by a shareholder's
spouse, minor children, or adult children who reside
at the shareholder's house must be included in the
10-percent calculation. Also includes shareholders
meeting the 10-percent criterion of the bank's
holding company and/or any individual who controls 10
percent of any subsidiaries of the bank's holding
company.
--------------------------------------------------------------------------------
Regulation O defines insiders as a bank's executive officers,
directors, principal shareholders, and their related interests. The
term related interest refers to any entity that the insider controls.
Control is defined as ownership, control or the power to vote 25
percent or more of any class of voting securities of the company or
bank, control over the election of the majority of the directors of
the company or bank, or the power to exercise a controlling interest
over the management or policies of a company or bank. Control is
presumed to exist if the insider (1) is an executive officer or
director of the company or bank and owns or controls more than 10
percent of any class of voting securities, or (2) owns or controls
more than 10 percent of any class of voting securities and no other
person owns or controls a greater percentage.
Related interests do not automatically by definition include the
immediate family of the insider. Entities owned or controlled by
these individuals could fall under the umbrella of "related
interests" if the insider "controlled" the entity in accordance with
the definitions above. For example, if the spouse of a bank director
owned 80 percent of the voting stock of a private company not
affiliated with the bank or bank holding company, the director owned
20 percent of the stock and served as the spouse's treasurer, the
spouse's company would be, by definition, a "related interest" of the
director.
--------------------
\15 12 C.F.R. Part 215
MAJOR PROVISIONS OF
REGULATION O
-------------------------------------------------------- Chapter 1:2.1
Regulation O contains an assortment of controls on loans to insiders.
It prohibits preferential lending, which requires that loans to
insiders be made on substantially the same terms and conditions as to
noninsiders and not involve more than the normal risk of repayment or
present other unfavorable features. Prior approval by a bank's board
of directors is required when the aggregate amount of credit extended
to an insider and his/her related interests exceeds--whichever is
greater--$25,000 or 5 percent of the bank's unimpaired capital and
unimpaired surplus. When the aggregate amount of loans extended will
exceed $500,000, prior approval is required regardless of whether or
not the loan amount exceeds 5 percent of the bank's unimpaired
capital and unimpaired surplus balance.
Regulation O also includes both individual and aggregate lending
limits to insiders. In general, insiders are subject to the same
individual limits as noninsiders.\16 Aggregate lending limits on
loans to all insiders generally may not exceed 100 percent of a
bank's unimpaired capital and unimpaired surplus.\17 Under certain
circumstances, member banks with deposits of less than $100,000,000
may by resolution of their boards of directors increase the general
limit on aggregate loans. Such increases must be approved by the
bank's board and are limited to two times the bank's unimpaired
capital and unimpaired surplus. As of January 30, 1994, the Federal
Reserve had received 54 notifications for using the higher aggregate
lending limit available for small banks under FDICIA.
Additional restrictions and reporting requirements, particular to
loans to executive officers and implementing section 22(g) of FRA,
are set out in the Code of Federal Regulations.\18
Overdraft payment limitations that apply to executive officers and
directors of a bank are set out in Regulation O.\19
However, these limits are not applicable to payments by a member bank
of overdrafts of a principal shareholder or to payments of overdrafts
of an insider's related interests.
Banks are required to maintain all necessary records to comply with
Regulation O, including records that identify all executive officers,
directors, principal shareholders, and their related interests.
Banks must also maintain specific information on the amount and terms
of each loan to insiders. In addition, at least annually, a bank
must ask its executive officers, directors, and principal
shareholders to identify their related interests. Other Regulation O
provisions set out requirements for public disclosure of credit from
member banks to executive officers and principal shareholders. These
provisions also require reports on indebtedness of executive officers
and principal shareholders to correspondent banks.
Subpart B of Regulation O deals specifically with correspondent banks
and implements requirements set out at l2 U.S.C. A correspondent
bank is a bank that maintains one or more correspondent accounts for
a member bank during a calendar year that in the aggregate exceed an
average daily balance of the smaller of $100,000 or 0.5 percent of
such banks' total deposits, as reported on its first quarter call
report. (Call report is the common name for the Consolidated Report
of Condition and Income, which banks are generally required to file
with their primary federal regulator on a quarterly basis.)
For the purposes of this report, an insider violation is defined as a
violation of either Regulation O or sections 23A or 23B of FRA.
--------------------
\16 This lending limit is an amount equal to the limit of loans to a
single borrower established by section 5200 of the Revised Statutes
(12 U.S.C. 84). This amount is 15 percent of the bank's unimpaired
capital and unimpaired surplus in the case of loans that are not
fully secured and an additional 10 percent of the bank's unimpaired
capital and unimpaired surplus in the case of loans that are fully
secured (12 C.F.R. 215.2(h)). The lending limit also includes any
higher amounts that are permitted by section 5200 of the Revised
Statutes for the types of obligations listed in the statutes as
exceptions to the limit. For more detail, refer to the full text of
Regulation O in appendix III.
\17 Aggregate lending limits to insiders were enacted as part of
FDICIA in 1991.
\18 12 C.F.R. 215.5, 215.9 and 215.10.
\19 12 C.F.R. 215.4(e). 12 C.F.R. 215.11 and 12 C.F.R.
215.20-215.23, respectively. 1972(2)(G).
BANK REGULATION AND SUPERVISION
---------------------------------------------------------- Chapter 1:3
There are almost 12,000 federally insured banks in the United States.
These banks are supervised at the federal level by three agencies.
The Office of the Comptroller of the Currency (OCC) supervises 3,598
nationally chartered banks.\22 OCC-supervised banks include many of
the large, money-center banks, such as Citibank, N.A. The Federal
Reserve supervises 957 state-chartered banks that are members of the
Federal Reserve System. These banks are commonly known as state
member banks. The Federal Deposit Insurance Corporation (FDIC)
supervises the 7,431 state-chartered banks that are not members of
the Federal Reserve. These banks are commonly known as state
nonmember banks. State banking agencies are also responsible for
supervising state-chartered banks.
--------------------
\22 Data for all regulators are as of December 31, 1992.
BANK EXAMINATIONS AND
REPORTS
-------------------------------------------------------- Chapter 1:3.1
Federal bank regulators conduct examinations as a means of
supervising banks. The three federal regulators use similar
procedures in examining banks. The results of an examination by any
of the regulators are summarized in an examination report addressed
to the board of directors of the bank. The examination usually
results in the examiner assigning a numerical rating to each of these
bank components--capital, assets, management, earnings, liquidity
(CAMEL). The examiner is to assign a composite CAMEL rating to the
bank. CAMEL ratings range from a 1, the best rating and the lowest
level of supervisory concern, to a 5, the worst rating and the most
serious level of supervisory concern.
Examinations may be of several types. Examinations that focus on the
financial "health" of the institution are called safety and soundness
examinations. Safety and soundness examinations are generally done
on-site at the bank, although some off-site analysis may be done
through the use of quarterly call report data that banks are required
to submit to the regulators. The examinations may be targeted (that
is, focused on one or more bank activities, such as the loan
portfolio), or they may be full-scope.
Federal regulators conduct separate examinations to measure
compliance with various consumer protection laws, such as the
Truth-In-Lending Act or the Community Reinvestment Act. Regulators
review various other bank activities either in their safety and
soundness examinations, their compliance examinations, or in separate
examinations. These activities relate to the Bank Secrecy Act, the
bank's trust department, or electronic data processing. For example,
OCC reviewed insider activities in the past as part of compliance
examinations, but it now reviews them as part of its safety and
soundness examinations.
For those banks that are not nationally chartered, state regulators
also conduct examinations. For those banks, the Federal Reserve and
FDIC may do separate examinations, in addition to these state
examinations, or they may do joint or concurrent examinations with
the state regulators. In joint examinations, the federal and state
supervisory agencies issue one joint report; for concurrent
examinations, separate reports are issued.
FDICIA required federal bank supervisory agencies to conduct annual
safety and soundness examinations of all banks. However, banks that
meet capital and other management and control standards may be
examined once every 18 months. In addition, the Federal Reserve and
FDIC may rely on state examinations instead of federal examinations
in alternate years.
Bank examiners generally notify bank management and directors of
financial weaknesses, operational problems, or violations of banking
laws or regulations that they identified. Often, examiners notify a
bank's management and board of directors at "exit" conferences held
at the end of an examination. In addition, a report of examination
findings is to be provided to the bank's board of directors. Exit
conferences, meetings, and examination reports enable regulators to
convey their supervisory concerns as well as to impress upon bank
managers and directors the need to address those areas that adversely
affect the bank's continued viability.
ENFORCEMENT ACTIONS
AVAILABLE TO BANK REGULATORS
-------------------------------------------------------- Chapter 1:3.2
An examination may result in the regulator taking informal or formal
enforcement actions to get the bank management to correct
deficiencies that were identified in the examination. According to
agency guidelines, regulators are to use informal actions for banks
in which--despite examiner-identified problems and weaknesses--the
overall strength and financial condition reduce failure to a remote
possibility and bank management has demonstrated a willingness to
address supervisory concerns. Regulators are to use informal actions
to advise banks of noted weaknesses, supervisory concerns, and the
need for corrective action.
Informal actions include
meeting with bank officers or boards of directors to obtain
agreement on improvements needed in the safety and soundness of
the bank's activities,
having banks issue commitment letters to the regulators specifying
corrective actions that will be taken,
having bank boards issue resolutions specifying corrective actions
that will be taken, and
initiating a memorandum of understanding\23 between regulators and
a bank's board of directors on actions that are required to be
taken.
While informal actions communicate supervisory concerns and actions
needed to address those concerns, they are not administratively or
judicially enforceable if agreed-upon corrective actions are not
taken by bank management.
Regulators are to use formal enforcement actions if (1) informal
actions have not been successful in getting bank management to
address supervisory concerns, (2) bank management is uncooperative,
or (3) the bank's financial and operating weaknesses are serious and
failure is more than a remote possibility. Formal actions are
legally enforceable tools that regulators can use to compel bank
management to take corrective actions in order to address such
supervisory concerns as increasing capital and maintaining adequate
reserves, discontinuing abusive lending practices, or strengthening
underwriting policies. These actions include
formal written agreements between regulators and bankers;
orders to cease and desist unsafe practices and/or violations;
assessments of civil money penalties, of up to $1 million a day,
against officers or directors;
orders for removal, prohibition, or suspension of individuals from
bank operations;
termination of insurance proceedings; and
capital directives to increase a bank's capital.
Formal actions are authorized by statute and may be taken by all
three federal regulators against the banks they supervise. FDIC has
the sole legal authority to terminate deposit insurance. If banks do
not consent to a formal action or fail to comply with its provisions
once they are agreed upon, regulators may enforce the action through
administrative or legal proceedings.
--------------------
\23 A memorandum of understanding is a voluntary agreement by a bank,
negotiated with its regulator, to refrain from a particular activity
deemed by the regulator to be an unsound banking practice.
BANK DIRECTORS' ROLES AND
RESPONSIBILITIES
---------------------------------------------------------- Chapter 1:4
A bank, like any other corporation, has shareholders and a board of
directors elected by the shareholders. The board is responsible for
overseeing the management of the bank's activities. Unlike other
corporate board members, however, bank board members, or directors,
are subject to additional laws and sanctions, which serve to
emphasize that under the law a higher level of performance is
expected from bank directors than from other business directors. For
example, many bank directors are required to take an oath of office;
business corporation directors generally do not. Bank directors can
be removed from office for unsound practices and can be held
statutorily liable for damages resulting from willful violations of
the law. Vague or less automatic procedures, if any at all, for
removal of directors of other corporations appear in typical
corporation codes. Part of the reason for this higher standard of
conduct is that most of the funds the bank puts at risk belong to
others, namely depositors. In addition, failure of a bank can result
in FDIC using deposit insurance fees collected from other banks.
Each of the regulators has issued comparable guidance on directors'
duties and responsibilities. For example, OCC's Handbook for
National Bank Examiners states that directors have a responsibility
to
select competent officers;
effectively supervise the bank's affairs;
adopt sound policies and objectives;
avoid self-serving practices;
be informed of the bank's condition and management policies;
maintain reasonable capitalization;
observe banking laws, rulings, and regulations; and
ensure that the bank has a beneficial influence on the economy of
its community.
As part of their responsibilities, bank directors attend board
meetings (for which they generally receive compensation), receive and
review reports from management on bank performance, review and
approve bank policies, and receive and review examination reports
from federal bank regulatory agencies.
FDIC HAS SEVERAL
RESPONSIBILITIES WHEN A BANK
FAILS
---------------------------------------------------------- Chapter 1:5
When a bank fails, FDIC, as receiver, may utilize one of a number of
methods to resolve the institution. The assets of the bank may be
sold as a single transaction or in parcels to other healthy banks.
FDIC will also contract out the servicing of some of the larger bank
loan portfolios it retains to outside loan servicers. However, in
any case, FDIC is likely to retain some percentage of the failed
bank's assets; an acquiring bank generally will not want to purchase
all of the problem loans of the failed bank. Except for assets sold
and those asset pools\24
FDIC retains but contracts out for servicing, information on all
assets FDIC assumes is maintained on the Liquidation Asset Management
Information System (LAMIS) of FDIC's Division of Liquidation
(DOL).\25 LAMIS is an FDIC automated system designed to support the
management and sale of failed bank assets. LAMIS supports such
activities as the servicing of loans; collections; the reporting of
loan inventories; and disbursements to taxing authorities, insurers,
and others.
Within 90 days of a bank's failure, it is FDIC policy to have DOL
investigators complete a Post-Closing Report (PCR). A PCR provides
more specific information on the causes of the bank's failure and
potential sources of recovery of funds. If DOL investigators find
evidence of abuse, fraud, or negligence on the part of bank
directors, officers, or others, FDIC investigators seek to determine
whether there are sufficient sources of recovery to justify the
pursuit of a claim against any individuals identified as contributing
to the bank's failure. In general, six potential sources of
recoveries are available: (1) blanket bond insurance, which covers
actual fraud on the part of directors and officers; (2) directors'
and officers' (D&O) liability insurance policies, which cover
negligence or insider abuse that is not criminal in nature; (3)
directors' and officers' personal assets; (4) attorney malpractice
suits; (5) appraisers' malpractice suits; and (6) accountants'
malpractice suits.
--------------------
\24 Asset pools are mortgages, commercial loans, real estate loans,
or other loans managed as a group.
\25 In October 1993, DOL was reorganized and renamed the Division of
Depositor and Asset Services.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:6
For this review we had five objectives:
Determine the frequency of various insider activities at selected
failed and open banks and the potential impact of insider
activities on the safety and soundness of bank operations.
Evaluate the effectiveness of the federal financial institutions'
regulators to identify and supervise insider activities at
banks.
Determine the underlying causes of insider problems-- specifically,
whether there is an association between insider problems and
broader managerial or operational problems in failed and open
banks.
Determine the overall extent of loans to insiders at failed and
open banks.
Compare state banking laws and regulations with federal Regulation
O and analyze state examination policies and procedures
governing insider activities.
Our first objective was to determine the frequency of various insider
activities at selected failed and open banks and the potential impact
of insider activities on the safety and soundness of bank operations.
To address this objective, we evaluated insider activities and other
problems at both failed and open banks. In chapters 2 and 3 we
present the results of our review of these activities. A discussion
of the general methodologies we used for the work in both of these
chapters follows, and more specific information on our methodologies
is presented in appendix I.
OUR EVALUATION OF FAILED
BANKS
-------------------------------------------------------- Chapter 1:6.1
To evaluate failed banks, we reviewed information on 286 banks;\26
these are all the banks that failed in calendar years 1990 and 1991
for which DOL had done an investigation. Our objectives were to (1)
determine the frequency with which insider problems contributed to
the failure of the banks and (2) determine the extent to which the
banks' primary regulators had identified and acted upon the same
problems when the banks were open. Figure 1.1 explains our approach
to examining the failed banks in our review.
Figure 1.1: Flowchart of
Failed Bank Methodology
(See figure in printed
edition.)
For each of the 286 banks, we reviewed DOL investigator files and
bank- and FDIC-generated financial information. To clarify and
confirm the information, when necessary, we interviewed the
investigators in charge of the failed banks.
We collected the information on a two-part form, or data collection
instrument (DCI), we designed and pretested. To address the
requesters' question about the frequency of insider activities, we
completed part I of the DCI for the 286 failed banks. Part I focused
on the reasons for a bank's failure. These reasons include an
assessment by the investigator as to whether insider problems played
a role in the bank's failure; the types and nature of the insider
problems identified by the investigator; and the extent to which
recoveries from directors, officers, and others are likely. We then
completed part II only for those cases where investigators identified
insider problems as being a factor in the failure of the bank. Of
the 286 cases, 175 (61 percent) required the completion of part
II.\27 Part II focused on the federal and state supervisory
examinations and related enforcement actions that were taken when the
bank was open and the financial information developed by the FDIC
investigator from bank records. Of the 286 failed banks, 74 (26
percent) met 1 or both of 2 conditions. The first condition was
whether the investigator in his/her own words concluded that insider
fraud, abuse, and/or loan losses to insiders were major factors in
the bank's failure. The second (when the major factors contributing
to failure were not specifically listed) was whether the investigator
identified losses from insiders amounting to at least 2.5 percent of
assets.\28 If the banks met one or both conditions, we considered
them to be banks where insider problems were a major factor in the
banks' failure.
We collected specific information on the types of insider activities
identified by the investigator and the other management and economic
problems that led to the banks' failures.\29 We also collected the
same information from the examination reports and accompanying
workpapers of the 175 banks for the 3 years before the banks failed.
In addition, we collected information on enforcement actions taken
through June 1993 by bank regulators while the banks were open and
after they failed.
--------------------
\26 FDIC's DOL had a total of 297 cases opened in 1990 and 1991. Two
of these were not banks but rather were residual asset pools from
failed banks that were sold. Three of the cases were bridge banks
that had been created at the time of the failure of the Bank of New
England Corporation. The original three Bank of New England
Corporation bank failures are included in the cases we reviewed.
However, to avoid double counting, we did not include the bridge
banks. Normally, DOL conducts one investigation for each bank
failure. However, the group of nine NBC bank failures in Texas were
represented by three investigations and therefore were treated as
three bank failures for purposes of our analysis. Taking into
account these adjustments, we reviewed a total of 286 cases of bank
failures.
\27 Because of the large amount of documentation and files required
to complete part II, we limited our review to only those cases in
which the investigator had indicated the presence of insider abuse,
insider fraud, or loan losses to insiders. Therefore, part II was
completed at the 14 DOL consolidated field offices around the
country.
\28 We used this number as a conservative measure. Before the
passage of the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA) (Pub. L. 101-73, Aug. 9, 1989),
capital standards were set at a minimum of 6 percent of assets.
Therefore, loan losses to insiders totaling 2.5 percent of assets
would approach half of the bank's capital. This is probably a
conservative estimate, since many of these troubled banks had less
than the minimum capital. FDIC DOL officials agreed that the 2.5
percent measure represented a significant amount of losses to
insiders.
\29 In addition to wanting to capture all the reasons a bank may have
failed, we focused on these problems in addition to the specific
problems of insider fraud, insider abuse, loan losses to insiders,
and Regulation O violations, because field testing of our DCI
indicated they were important.
OUR EVALUATION OF OPEN BANKS
-------------------------------------------------------- Chapter 1:6.2
We also reviewed a judgmentally selected sample of 13 open banks.
(See app. I for a discussion of our criteria for sample selection.)
Our objectives were to determine whether the same types of insider
and management problems we found in the failed banks were also
present in open banks.
For each bank, we prepared a case study based on our review of the
federal regulators' examinations. For each case study, we collected
information on insider activities as defined by Regulation O,
affiliate transactions, and the efforts of each bank's management and
board to operate and manage the bank with due care. We collected
this information from the most recent examination and all the
examinations completed in the 5 years before the most recent one.
Our second objective was to evaluate the effectiveness of the
regulators to identify and supervise insider activities at banks. To
address this objective, we analyzed the results of our data
collection efforts at failed and open banks. We compared the numbers
and types of insider problems identified by investigators after the
banks failed with the same information identified by examiners when
the banks were open. We also analyzed the enforcement actions taken
by regulators to get banks' boards and management to correct
examiner-identified problems. The results of our analysis for this
objective are presented in chapters 2 and 5.
Our third objective was to determine the underlying causes of insider
problems and, specifically, whether there was an association between
insider problems and broader managerial or operational problems in
failed and open banks. During our work on the 286 failed banks, we
initially concentrated on insider violations, insider fraud, insider
abuse, and loan losses to insiders to identify why the banks failed.
However, our initial testing of our DCI led us to believe that these
problems, particularly when they continued without correction,
indicated broader problems of poor bank management and poor oversight
of bank management by the board of directors. Consequently, we
expanded the scope of our DCI, as we discussed earlier, to collect
more details on these management and board problems. To assess the
underlying causes of insider problems, we used odds and odds ratios.
Odds indicate the tendency for an outcome to occur, and odds ratios
show how much that tendency is affected by different factors. The
results of our analysis for this objective are presented in chapter
3.
Also, to gain further perspective on insider problems and why they
occur, we conducted interviews and focus groups with bank directors.
The interviews and focus groups are discussed in chapter 6. Our
methodologies for these interviews and focus groups are discussed in
detail in appendix I. We also collected some additional information
on training that is available for bank directors. Our approach to
collecting this information is also presented in appendix I.
Our fourth objective was to determine the overall extent of
extensions of credit to insiders at failed and open banks. To
address this objective, we compared data that we collected on insider
loans in the failed banks with data on FDIC's LAMIS database. By
doing this comparison, we expected to be able to estimate the amount
of loans to insiders. Specifically, we expected to estimate the
amounts of loan losses (as indicated by "charge-offs" on the LAMIS
database) due to insiders. Because of the difficulties we
encountered in using LAMIS, we were unable to estimate the overall
amount of loans to insiders and losses for all failed banks. As an
alternative, we then attempted to estimate insider lending at 10
judgmentally selected failed banks. We discuss the results of our
analysis for this objective in chapter 4 and appendix IV.
For open banks we relied on quarterly bank call report data.
Additional information on our approach is presented in appendix I.
Our final objective was to compare state banking laws and regulations
with federal Regulation O and analyze state examination policies and
procedures governing insider transactions. To address this
objective, we surveyed 54 state and territorial banking agencies to
determine whether their laws and regulations were more stringent than
federal laws and regulations. We then visited 10 state agencies to
obtain more in-depth information on their state bank examination
procedures, processes, and oversight mechanisms for insider
activities. We also conducted in-depth telephone interviews with
officials in three additional states. In total, we obtained in-depth
information from 13 state banking agencies. The results of our
analysis for this objective are discussed in appendix V, and specific
methodologies we used are discussed in appendix I.
We did our work for all the objectives at the headquarters and field
offices of OCC and FDIC; at the Federal Reserve Board in Washington,
D.C.; and the Federal Reserve banks in New York, Philadelphia, and
San Francisco; and at the state banking agencies listed in appendix I
from January 1992 through June 1993, in accordance with generally
accepted government auditing standards. We requested comments on a
draft of this report from OCC, FDIC, and the Federal Reserve. Their
written comments along with our evaluation are summarized at the end
of chapters 5 and 6 and are presented in appendixes VII, VIII, and
IX.
INSIDER PROBLEMS FREQUENTLY
CONTRIBUTED TO BANK FAILURES AND
WERE ALSO EVIDENT IN OPEN BANKS
============================================================ Chapter 2
As we discussed earlier, in our analysis of the 286 banks that failed
in 1990 and 1991, we found that insider problems--specifically
insider fraud, insider abuse, and loan losses to insiders--were
contributing factors in 175, or 61 percent, of the bank failures. In
addition, we found 74 of these banks had insider problems so severe
that they were the major or one of a few major causes of failure.
For the 175 banks, federal examiners cited a total of 561 insider
violations. Many of these violations were repeated in more than one
bank examination. Federal and state regulators also took 235
separate enforcement actions. Even though insider violations were
cited and enforcement actions were taken, the banks failed.
In our review of federal examination workpapers and reports of 13
relatively healthy open banks, we found that federal examiners did
not identify any instances of insider fraud, insider abuse, or loan
losses to insiders. However, federal examiners cited several insider
violations that were in most cases quite similar to the insider
violations cited in the failed banks. Some of these insider
violations were also repeated in more than one bank examination. In
addition, enforcement actions similar to those taken in the failed
banks were taken by federal examiners in these banks.
286 BANKS FAILED IN CALENDAR
YEARS 1990 AND 1991
---------------------------------------------------------- Chapter 2:1
As we indicated in chapter 1, when a bank fails, FDIC's DOL conducts
an investigation, generally within 90 days of the date of failure, to
complete a PCR, which provides specific information on the causes of
the bank's failure. We reviewed the PCRs for all 286 banks that
failed in 1990 and 1991 to determine the reasons for the failures of
the banks.
Table 2.1 provides the reasons cited by FDIC investigators as
contributing to the failure of the banks. The table shows the most
common types of problems were a passive and/or negligent board, loan
losses due to lax lending, poor and/or negligent management, and
failure to respond to regulatory criticism.
In most cases FDIC investigators cited several reasons for a bank's
failure. For example, while an economic downturn was cited in over
44 percent of the total bank failures, we found it was seldom cited
alone; instead, it was cited in conjunction with other management and
insider problems.
Table 2.1
Most Common Reasons Cited by FDIC
Investigators for the 286 Bank Failures
in 1990-1991
Percentage
Number of of total
banks bank
Reasons for bank failures cited failures
------------------------------------ ---------- ----------
Passive and/or negligent board 258 90%
Loan losses due to lax lending 236 83
practices
Poor and/or negligent management 230 80
Failure to respond to regulatory 170 59
criticisms
Economic downturn 127 44
Inadequate credit administration 125 44
Insider abuse 117 41
Insider fraud 104 36
Lack of or inadequate lending 89 31
policies
Loan losses to insiders 81 28
Excessive growth 80 28
Dominant board member(s) 75 26
Operating losses 70 25
High risk exposure 65 23
Dominant executive 63 22
Lack of or inadequate systems to 55 19
ensure compliance with laws/
regulations
Lack of expertise (officer) 55 19
Lack of expertise (board) 44 15
Ineffective loan workout 34 12
Excessive dividends 33 12
------------------------------------------------------------
Note: Investigators frequently cited several reasons for each
failure.
Source: FDIC PCR data.
Figure 2.1 illustrates the location of the 286 banks that failed in
1990 and 1991. Although Texas had by far the most failures, the map
reflects the increasing number of failures in the Northeast in the
1990s.
Figure 2.1: Number of Failed
Banks by State for 1990-1991
(See figure in printed
edition.)
Source: FDIC PCR data.
(See figure in printed
edition.)
GENERAL CHARACTERISTICS OF THE
286 FAILED BANKS
---------------------------------------------------------- Chapter 2:2
The majority of the failed banks were small banks with assets of less
than $100 million. The median asset size was $33 million. Table 2.2
shows the general characteristics of all 286 failed banks, the 175
banks with insider problems, and the 74 banks with major insider
problems.
Table 2.2
Characteristics of the 286 Banks That
Failed
Banks
with Banks with
Smal Larg no D & criminal
Ba l e Range O Estimate referrals
nk bank bank Median of Median insuranc d loss of
s s s size size Total age e to BIF insiders
-- ---- ---- -------- ------ ========== ------ -------- -------- ----------
Al 76% 24% $33MM $3MM $78B 15 30% $9.9B 49%
l to years
f $14B
a
i
l
e
d
Wi 79% 21% $33MM $4MM $34B 11 26% $5.4B 70%
th to years
i $14B
n
s
i
d
e
r
p
r
o
b
l
e
m
s
Wi 80% 20% $30MM $4MM $7B 10 23% $1.8B 74%
th to $1B years
m
a
j
o
r
i
n
s
i
d
e
r
p
r
o
b
l
e
m
s
------------------------------------------------------------------------------------
Note: The median age represents 256 banks; we could not determine
the charter dates from the PCRs for 30 of the failed banks.
Source: GAO analysis of FDIC data and PCRs.
Of the 175 banks with insider problems and the 74 banks with major
insider problems, the majority were small banks with a median age
between 10 and 11 years. In addition, these banks had a high
percentage of criminal referrals involving the directors and
officers. Overall, the assets of the 175 banks with evidence of
insider problems totaled $33.7 billion, or about 43 percent of the
total assets of all of the 286 banks that failed in 1990 and 1991.
FDIC INVESTIGATORS FOUND
EVIDENCE OF INSIDER PROBLEMS IN
175 OF THE 1990 TO 1991 BANK
FAILURES
---------------------------------------------------------- Chapter 2:3
From our review of the PCRs completed for the 286 banks that failed
in 1990 and 1991, we determined that FDIC investigators found
evidence of insider problems--specifically, insider fraud, insider
abuse, or loan losses to insiders--in 61 percent, or 175, of the bank
failures. Of these 175 banks, FDIC investigators found 74 banks with
insider problems so severe that they were the major or one of a few
major causes of failure. These 74 banks represent 26 percent of the
286 banks that failed in 1990 and 1991.
Figure 2.2: Frequency of
Insider Fraud, Insider Abuse,
and Loan Losses to Insiders
(See figure in printed
edition.)
Note: Each bank could have had
more than one insider problem;
therefore, numbers do not total
175.
(See figure in printed
edition.)
Source: FDIC PCR data.
(See figure in printed
edition.)
INSIDER PROBLEMS COMPRISE
INSIDER FRAUD, INSIDER
ABUSE, AND LOAN LOSSES TO
INSIDERS
-------------------------------------------------------- Chapter 2:3.1
INSIDER FRAUD
------------------------------------------------------ Chapter 2:3.1.1
Fraud, a criminal act, can generally be defined as intentional
actions, omissions, or concealments meant to deceive and get
advantage over another. This includes such acts as embezzling,
falsifying documents, and check kiting. Insider fraud was identified
by FDIC investigators in 36 percent of the 286 bank failures. In the
cases we reviewed, we found a variety of insider fraud. In one case,
the chairman of the board and the president of a bank were suspected
of granting loans to an international fugitive with strong ties to an
organized crime syndicate. This individual would influence public
officials to invest in real estate, have the real estate rezoned,
allow the taxpayers to pay for upgrading the streets and the water
and sewer systems, then sell the upgraded real estate at a profit.
Most of the board of directors were county commissioners. The
chairman of the board was the mayor and was suspected of receiving
payoffs from the real estate deals. The chairman later committed
suicide. All of the board members and several bank officers are
currently under FBI investigation for their roles in the allegedly
fraudulent activities.
In another case, a fraudulent scheme involving several bank
employees, including the vice-chairman, the chief executive officer,
the senior vice-president, the controller, and the cashier, was
discovered. These employees opened a checking account in the name of
a corporation. During the first month of activity, this account was
overdrawn on eight different occasions with the largest overdraft
exceeding $71,000. From that point to the discovery of the scheme
almost a year later, the number of monthly overdrafts in the account
never fell below 15. The largest overdraft amount was $312,000. The
overdrafts were approved by all of the employees involved in the
scheme. These employees concealed the overdrawn status of this
account by giving written instructions to the bookkeeper to place the
account on "close to posting" status. The significance of this
action was that such status meant that subsequent transactions to the
account had to be manually posted. As a result, these transactions
did not appear on the routine computer-generated reports reviewed by
management on the overdrawn status of accounts.
INSIDER ABUSE
------------------------------------------------------ Chapter 2:3.1.2
Insider abuse is abuse that falls short of being a criminal act. It
occurs when an insider receives personal benefit from some abusive
action he/she takes as part of his/her position at the bank. FDIC
investigators identified insider abuse in 41 percent of the 286 bank
failures. We found a variety of insider abuses in the cases we
reviewed. In one case, the chairman of a bank and the bank's holding
company used the bank for his own benefit. He introduced borrowers
to the bank and then used his position with these borrowers to help
develop personal relationships and referrals to his other business
ventures. The bank experienced heavy loan losses as a result of
lending to these borrowers. Although the chairman did not draw a
salary from the bank, he did receive director fees. He also
benefited by charging the bank legal fees, consulting fees, capital
raising commissions, finders fees, expense allotments, auto
allowances, and travel expenses. His spouse also drew legal fees
from the bank. They drew a total of $400,000 annually from the bank
for these fees. In another case, the executive officers of a bank
used the nonexecutive officers to enhance their personal investments
in two interrelated activities. Once a week the nonexecutive bank
officers would perform various services at a property owned by the
chairman of the board, the president, and other executive officers of
the bank. These duties included mending fences, clearing fields,
picking up rocks, and tending cattle. All of these services were
performed with no financial remuneration to either the nonexecutive
officers or the bank, even though these duties were performed by bank
employees during normal business hours. During these work details,
the most unpleasant tasks were assigned to the newest employee, much
like a fraternity hazing. These services were all part of the
chairman of the board's management theory, which was that if he could
successfully order an individual to do menial tasks, this person
would be an obedient employee. The second activity involved
additional harassment by the chairman of the board. In this
activity, the chairman forced the nonexecutive officers to become
owners in an entity that was previously owned by several of the
executive officers. The investments appear to have consisted of
interest in rental properties, apartments, and houses in need of
repair. The nonexecutive officers understood clearly that a decision
to participate in these investments would be advantageous to their
careers at the bank and a refusal could prove detrimental. The
nonexecutive officers were required to make contributions of $40 to
$80 per month to an entity that as far as they were concerned was
nothing more than a mere shell. In addition, because of the poor
condition of the properties, the nonexecutive officers were required
to leave the bank at noon 1 day a week for 3 months to perform repair
work on the subject properties. The bank was never reimbursed for
the loss of these employees' services; the officers never asked the
board for permission to perform these tasks, nor was the board ever
informed such activities were taking place.
LOAN LOSSES TO INSIDERS
------------------------------------------------------ Chapter 2:3.1.3
Loan losses to insiders refers to loan losses to individuals defined
as insiders by Regulation O. FDIC investigators identified loan
losses to insiders in 28 percent of the 286 bank failures. In our
review we found a variety of cases involving loan losses to insiders.
In one of the cases we reviewed, federal regulators cited a bank for
several Regulation O violations involving the legal lending limit to
insiders in 1985. At that time, loans to directors, officers, and
their related interests were excessive at $1.6 million, or 104
percent of the banks's capital and reserves. In 1986, the cochairman
resigned from the board because of classified loans (i.e, that were
at risk) at the bank, including a foreclosure on a deed of trust to
him for $750,000. In 1987, the bank was again cited for violations
of the legal lending limit because it extended a credit line to a
related interest of a member of the board of directors. In 1988,
adversely classified assets represented 250 percent of total capital
and reserves; $1.3 million, or 79 percent, was attributed to
directors and officers. In another case at a 1985 board meeting, a
bank adopted the policy of authorizing its directors to borrow up to
10 percent of their unsecured net worth. The bank was first examined
by federal regulators later in 1985 and was cited for several
Regulation O violations. In an explanation of the numerous
Regulation O violations cited, one of the bank's directors said that
because of low loan demand, some directors received loans to create
needed income for the bank. The bank was examined again in 1986, and
examiners cited the bank for lack of corrective action on weaknesses
disclosed at the previous examination. Regulators again examined the
bank in 1987. At that time, the examiner noted that three directors'
lines of credit were classified,\1
and that lending 10 percent of a director's unsecured net worth was
"not considered a prudent practice." In the next two examinations,
the bank still had not corrected the Regulation O violations cited in
previous examinations. In 1990, another examination was completed,
and Regulation O violations were still not corrected. In addition,
at that time examiners asked bank management to submit a
reimbursement plan for losses sustained on one director's line of
credit, as it had exceeded the legal lending limit. The bank closed
in 1991 with loan losses to insiders totaling $299,000.
--------------------
\1 Classified loans are loans that are at risk to some degree. Such
loans fail to meet acceptable credit standards.
CRIMINAL REFERRALS INVOLVING
INSIDERS WERE MADE IN 70
PERCENT OF THE 175 BANKS
WITH INSIDER PROBLEMS
-------------------------------------------------------- Chapter 2:3.2
FDIC investigators identified criminal referrals made by bank
employees or examiners or recommended criminal referrals themselves
related to insider activities in 49 percent of all 286 failed banks.
Of the 175 banks with evidence of insider problems, 70 percent had
criminal referrals involving insiders. Of the 74 banks with major
insider problems, 74 percent had criminal referrals involving
insiders. Those criminal referrals included referrals made
throughout the history of the banks and therefore may have included
referrals made several years before the banks' failures. We did not
contact the Department of Justice to request information about the
results of any investigations initiated based on these referrals. We
did not do so because some of our other studies of such
investigations suggest that they take years before results are
finalized.
AN ESTIMATED $5 BILLION IN
LOSSES TO THE BIF FOR THOSE
BANKS WITH INSIDER PROBLEMS
-------------------------------------------------------- Chapter 2:3.3
FDIC estimates its corporate insurance obligation, or its initial
insurance outlay, will be about $59.4 billion for all of the 286
failed banks. An estimated $25.2 billion will be obligated for the
175 banks with insider problems, and $6.6 billion will be obligated
for the 74 banks with major insider problems. In resolving the 1990
and 1991 bank failures, FDIC will recover money from the sales of
bank assets and as a result, the ultimate losses generally will be
less than the corporate insurance obligation. The final losses are
estimated to be about $9.9 billion for all of the failed banks, $5.4
billion for the 175 banks with insider problems, and $1.8 billion for
the 74 banks with major insider problems.\2 The $5.4 billion for the
175 banks with evidence of insider problems is about 55 percent of
total estimated losses for the 286 banks during the 1990 to 1991
period. FDIC's estimates, however, are not broken down by bank
activities, so we could not determine the amount related to insider
activities. These loss estimates are subject to change as additional
assets are sold.
--------------------
\2 In our report, Bank and Thrift Criminal Fraud: The Federal
Commitment Could Be Broadened (GAO/GGD-93-48, Jan. 8, 1993), we
found that in major financial institution fraud cases between October
1988 and June 1992, losses to the federal government were estimated
to be more than $11.5 billion. See the report for additional
information on criminal referrals and fraud in financial
institutions.
SMALL BANKS HAD A HIGHER
INCIDENCE OF LOAN LOSSES TO
INSIDERS
-------------------------------------------------------- Chapter 2:3.4
We found no significant differences between small and large banks
where FDIC investigators identified insider abuse or insider fraud.
However, investigators found loan losses to insiders at a much higher
rate in small banks than in large banks. In the small banks, loan
losses to insiders were identified in 32 percent of the banks, while
in the large banks they were identified in only 16 percent of the
banks.
FEDERAL EXAMINERS CITED INSIDER
VIOLATIONS AND TOOK ENFORCEMENT
ACTIONS WHEN THE 175 BANKS WERE
OPEN
---------------------------------------------------------- Chapter 2:4
EXAMINATION HISTORIES OF THE
175 FAILED BANKS
-------------------------------------------------------- Chapter 2:4.1
To further our analysis of activities at the 175 banks, we collected
additional information from federal and state examinations that were
completed the 3 years before the banks failed.\3 In general, we
collected information on the type of examination, the composite CAMEL
rating, the date of the examination report, and the types of
management and insider problems identified, insider violations cited,
and enforcement actions taken.
We reviewed a total of 656 examinations that were completed for all
175 banks, with an average of 4 examinations completed for each bank.
Table 2.3 shows the type and number of examinations completed by
regulator.
Table 2.3
Type and Number of Examinations by
Federal and State Regulators in the 175
Banks With Insider Problems
Average
number
of
safety
Number Safety and
Federal of banks and soundnes Consumer Federal/
regulat supervis soundnes s exams complian Stat state Off- Tota
or ed s per bank ce e concurrent site l
------- -------- -------- -------- -------- ---- ----------- ------ ----
OCC 82 236 2.9 20 1\a 0 21 278
FDIC 81 146 1.8 18 114 36 1 315
FRS 12 30 2.5 2 27 4 0 63
================================================================================
Total 175 412 40 142 40 22 656
--------------------------------------------------------------------------------
Note: The data in this table include those from all examinations
completed in the 3 years before the banks failed.
\a OCC-supervised banks are nationally chartered. Therefore, they
are normally not also supervised by state banking agencies. In this
one case, a nationally chartered bank was planning to convert to a
state charter. In preparation for this conversion, the state banking
agency conducted an examination of the bank. After the examination,
the state charter was disapproved.
Source: Federal bank regulator examination report data.
Most of the examinations that regulators completed were federal
safety and soundness examinations, of which we reviewed a total of
412. Other examinations we reviewed included state examinations,
concurrent federal and state examinations (where both the state and
federal regulators are conducting examinations simultaneously), and
examinations not completed at the bank location (referred to as
off-site examinations). We also reviewed 40 consumer compliance
examinations.\4
--------------------
\3 Of the 175 banks, OCC supervised 82 banks, FDIC supervised 81, and
the Federal Reserve supervised 12.
\4 As we noted in chapter 1, in some instances reviews of a bank's
insider activities may have been done as part of a consumer
compliance examination.
DISTRIBUTION OF COMPOSITE
CAMEL RATINGS AMONG THE 175
BANKS WITH INSIDER PROBLEMS
-------------------------------------------------------- Chapter 2:4.2
Figure 2.3 shows how the CAMEL ratings were distributed among the 175
banks with insider problems in the 3 years before the banks failed.
Seventy-four percent of the banks had a composite CAMEL rating of 5
from the examination preceding the failures.
Figure 2.3: Distribution of
CAMEL Ratings 3 Years Before
the Banks Failed
(See figure in printed
edition.)
Note 1: Percentages do not total to 100 for each examination because
several examinations were in process at the time of failure and some
CAMEL ratings for prior examinations were not available.
Note 2: Because there were so few banks with more than five
examinations completed in the 3 years before they failed, we included
for each bank only the five examinations preceding failure. Some
banks had less than five examinations.
Note 3: The examination numbers refer to the chronological placement
of the examinations. For example, examination 1 refers to the last
examination completed before the bank's failure, examination 2 refers
to the second to last examination completed before the bank's
failure.
Overall, most of the banks followed a predictable pattern of steadily
worsening CAMEL ratings. Most of the banks received a rating of 5 in
the examination preceding their failure, 6 percent never received a
composite CAMEL rating better than 5, and 30 percent never received a
composite CAMEL rating better than 4.
We found a few anomalies. For example, two banks received a
composite CAMEL rating of 3 without any intervening examinations
before they failed, and two additional banks went from a rating of 2
to failure. For example, although examiners cited many problems in
one bank's loan portfolio 2 years before the bank failed, they
apparently had not realized the severity of the conditions at the
bank. When they returned 2 years later, the bank was insolvent.
FEDERAL REGULATORS CITED 561
INSIDER VIOLATIONS IN THE
175 BANKS WITH INSIDER
PROBLEMS
-------------------------------------------------------- Chapter 2:4.3
We focused our review of insider violations on the following six
major provisions:
loans to insiders exceeding loan limits,\5
loans to insiders with preferential terms,
failure to maintain required records,
failure to obtain required prior board approval for loans,
overdraft payments exceeding limits, and
exceeding restrictions on transactions to affiliates.\6
Table 2.4 shows the number and type of insider violations cited by
the federal regulators in the 175 banks with insider problems.
Table 2.4
Type and Number of Regulation O
Violations Cited by Federal Regulators
in the 175 Banks With Insider Problems
Number of
Number Regulation
of O
Regulation O violations banks violations
--------------------------------------- ------- ----------
Loans to insiders exceeding loan limits 82 148
Loans to insiders with preferential 70 103
terms
Failure to maintain required records 61 81
Failure to obtain prior board approval 52 83
for loans
Overdraft payments exceeding limits 52 68
Exceeding restrictions on 49 78
transactions to
affiliates\a
============================================================
Total 561
------------------------------------------------------------
Note 1: The number of banks does not total 175 because 1 bank could
have more than 1 type of Regulation O violation.
Note 2: The data included in this table include those from all
examinations completed in the 3 years before the bank failed.
\a As we explained in chapter 1, these rules are not a part of the
Federal Reserve's Regulation O but are located in sections 23A and
23B of FRA.
Source: Federal bank regulator examination report data.
As table 2.4 shows, the most common insider violation cited by
federal regulators was loans to insiders exceeding the loan limits.
Examiners cited this violation 148 times in 82 of the 175 banks. In
addition, this was the most repeated insider violation cited by
examiners. The second most common insider violation cited was loans
to insiders with preferential terms. This violation was cited 103
times in 70 of the 175 banks.
Overall, of the 175 banks, federal regulators cited 141 banks, or 81
percent, for a total of 561 insider violations with an average of 4
violations per bank. One hundred twenty-six, or 72 percent, of the
banks had insider violations that occurred in more than one
examination. This high percentage of repeated insider violations may
be attributable to bank management not having developed effective
internal controls to prevent recurrent violations.
--------------------
\5 Before FDICIA, which was passed in 1991, there was no aggregate
lending limit for insiders. Thus, these violations, which were
pre-FDICIA, were violations of the individual lending limits for any
one insider as we described in chapter 1.
\6 As we explained in chapter 1, restrictions on transactions with
affiliates are not a part of the Federal Reserve's Regulation O but
are located in sections 23A and 23B of FRA. The five other
provisions we focused on are part of Regulation O.
INSIDER VIOLATIONS WERE
CITED MORE FREQUENTLY IN
SMALL BANKS
-------------------------------------------------------- Chapter 2:4.4
Our analysis showed that federal regulators more frequently cited
small banks with assets of less than $100 million for insider
violations than large banks with assets of $100 million or more.
Federal regulators cited 464 insider violations in the small banks,
with an average of 3.36 violations per bank. Regulators cited 97
insider violations in the large banks, with an average of 2.62
violations per bank. Table 2.5 shows the number of insider
violations in small banks compared with those in large banks.
Table 2.5
Insider Violations by Small and Large
Banks for the 175 Banks With Insider
Problems
Percentage Total Percentage Total
of all number of of all number of
Insider violations small banks violations large banks violations
---------------------------- ----------- ----------- ----------- -----------
Loans to insiders
exceeding loan limits 49% 125 37% 23
Loans to insiders with
preferential terms 43 89 30 14
Failure to maintain
required records 36 65 30 16
Failure to obtain prior
board 29 60 32 23
approval for loans
Overdraft payments
exceeding limits 31 55 24 13
Exceeding restrictions on
transactions to 32 70 14 8
affiliates\a
================================================================================
Total (561) 464 97
--------------------------------------------------------------------------------
Note 1: Small banks are those banks with assets less than $100
million. Large banks are those banks with assets greater than $100
million. Of the 175 banks with insider problems, 138 were small
banks and 37 were large banks.
Note 2: The percentages do not add up to 100 percent because one
bank could have more than one type of insider violation.
Note 3: This table includes those data from all examinations
completed the 3 years before a bank failed.
\a As we explained in chapter 1, these provisions are not a part of
the Federal Reserve's Regulation O but are located in sections 23A
and 23B of FRA.
Source: Federal bank regulator examination report data.
Federal regulators may be citing insider violations more frequently
in smaller banks for a number of reasons. First, because of the
lower absolute dollar amount of their capital, small banks may be
more susceptible to exceeding the limitations set for insider loans.
Second, because there are fewer loans to review in small banks they
may be subject to a higher level of scrutiny by the federal
regulators and, therefore, more vulnerable to criticism.
OUR REGULATION O FINDINGS
SUPPORT CONTINUED STRONG
REGULATORY MECHANISMS FOR
OVERSIGHT OF INSIDER
ACTIVITIES
-------------------------------------------------------- Chapter 2:4.5
One of the purposes of sections 22(g) and 22(h) of FRA and the
implementation of Regulation O was to give a higher degree of
regulatory scrutiny to insider activities because such activities
have a greater chance of affecting the safety and soundness of the
bank compared with other bank activities. As we discussed in chapter
1, Congress has at various times strengthened laws and regulations on
insider activities. For example, in FDICIA, enacted in 1991,
Congress provided for an aggregate lending limit for loans to
insiders of 100 percent of capital for well-capitalized banks and
authorized the Federal Reserve to make regulatory exceptions to this
aggregate lending limit, up to a maximum of 200 percent of capital
for qualifying smaller banks.
Our work indicates that several key provisions of Regulation O are
crucial for maintaining strong oversight of insider activities.
First, we found that the most commonly violated provision of
Regulation O was the violation of lending limits. Second, we found
that the second most violated provision was preferential terms on
loans to insiders. Finally, because so much of the oversight of
insider activities depends on accurate recordkeeping and reporting by
banks, the recordkeeping requirements of Regulation O are critical
for the enforcement of other Regulation O provisions.
FEDERAL REGULATORS TOOK 187
FEDERAL ENFORCEMENT ACTIONS
FOR THE 175 BANKS WITH
INSIDER PROBLEMS
-------------------------------------------------------- Chapter 2:4.6
We reviewed the enforcement actions taken by federal regulators when
the banks were open. For the 175 banks with insider problems,
federal regulators took a total of 187 federal formal and informal
enforcement actions.\7 We show the types and number of actions in
table 2.6.
Table 2.6
Type and Number of Enforcement Actions
Taken by Federal Regulators in the 175
Banks With Insider Problems
Number
of
actions
taken by
federal
regulato
Type of action rs
-------------------------------------------------- --------
Formal actions
Cease and desist orders 74
Written agreement 30
Temporary cease and desist orders 9
Civil money penalties 8
Removal/prohibition 7
============================================================
Subtotal 128
Informal actions
MOU 33
Board resolution 13
Commitment letter 13
============================================================
Subtotal 59
============================================================
Total 187
------------------------------------------------------------
Note: The data included in this table include those from all
examinations completed in the 3 years before the bank failed.
Source: Federal bank regulator examination report data.
In table 2.7 we show the types and number of federal enforcement
actions that were taken by each of the federal regulators. OCC was
more prone to initiate a formal enforcement action against bank
management than were the other federal regulators. Of the
enforcement actions taken by OCC examiners, 76 percent were formal
actions, 64 percent of FDIC's enforcement actions were formal
actions, and 57 percent of the Federal Reserve's enforcement actions
were formal actions.
Table 2.7
Types of Enforcement Actions Taken by
Federal Regulators in the 175 Banks With
Insider Problems
Number Percen Number Percen Number Percen Number Percen
Type of of t of of t of s of t of of t of
enforcement action action action action action action action action
action s s s s s s s s
---------------- ------ ------ ------ ------ ------ ------ ------ ------
Formal 62 64% 8 57% 58 76% 128 68%
Informal 35 36 6 43 18 24 59 32
Total 97 100 14 100 76 100 187 100
--------------------------------------------------------------------------------
Note: The data in this table include those from all examinations
completed in the 3 years before the banks failed.
Source: Federal bank regulator examination report data.
In 79 percent of the banks where insider violations were discovered,
the federal regulators took some type of enforcement action. We
found only a few cases in which the enforcement actions specifically
included provisions that related to insider activities. However,
enforcement actions may contain general provisions requiring the bank
to correct all violations of law or regulations. Such provisions
would include the correction of insider violations.
Regardless of the actions that were taken, regulators may have been
able to take stronger enforcement actions, considering that 126, or
72 percent, of the banks had repeated insider violations. For
example, in a 1991 report,\8 we cited an example of a bank with
repeated Regulation O violations to illustrate the impact insider
violations could have on a bank's financial condition. We also
wanted to illustrate the importance of effective enforcement action
to protect banks against such adverse impacts. We stated that
"according to the regulator's guidelines, civil money penalties would
have been in order, particularly in light of the pattern of repeat
violations."
For the 126 banks in our failed bank analysis that were cited for
repeat insider violations, civil money penalties (CMP) by federal
examiners were brought against officers or directors in only 6 of
these banks. Overall, only 8 CMPs were brought against individuals
in all 175 banks.
--------------------
\7 Overall, federal and state regulators took 235 enforcement
actions; 187 actions were federal enforcement actions, and 48 were
state enforcement actions. We focused on the 187 federal enforcement
actions because we did not have access to complete information on
state enforcement actions.
\8 Bank Supervision: Prompt and Forceful Regulatory Actions Needed
(GAO/GGD-91-69, Apr. 1991).
FEDERAL REGULATORS ALSO TOOK
POST-FAILURE ENFORCEMENT
ACTIONS
---------------------------------------------------------- Chapter 2:5
The three federal bank regulators can also take post-failure
enforcement actions against former bank officers and directors of
failed banks. FDIC, as the federal bank insurer, has the authority
to pursue post-failure enforcement actions against any of those
officers and directors who are found to be negligent in discharging
their fiduciary responsibility, regardless of the failed banks'
primary regulator. Some of these actions against the former officers
and directors have involved the pursuit of financial recoveries.
FDIC has pursued and ultimately received some financial recoveries in
about 25 percent of the banks that failed.
The post-failure enforcement actions available to primary federal
bank regulators include supervisory letters, letters of reprimand,\9
CMPs, and removal and/or prohibition orders banning officers or
directors from the banking industry.
For the 286 banks that failed in 1990 and 1991, we found that primary
federal regulators took 167 post-failure enforcement actions against
167 officers and directors. The most common enforcement action taken
was a letter of reprimand. As shown in table 2.8, there were 68
letters of reprimand, 42 CMPs, and 35 supervisory letters.
Table 2.8
Post-Failure Enforcement Actions Taken
Against Individuals in the 286 Bank
Failures in 1990-91
Federa
l
Type of post-failure enforcement Reserv Tota
action FDIC OCC e\a l
---------------------------------- ---- ---- ------ ----
Supervisory letter \b 35 \b 35
Letter of reprimand \b 68 \b 68
CMPs 8 34 0 42
Removal and/or prohibition 8 3 0 11
CMP and removal and/or prohibition 1 10 0 11
============================================================
Total 17 150 0 167
------------------------------------------------------------
Note 1: The Securities and Exchange Commission, although not a bank
regulator, has initiated post-failure enforcement actions when it has
been determined that bank insiders and other parties violated
antifraud, reporting, internal accounting, and other provisions of
federal securities laws.
Note 2: As of March 31, 1993, federal regulators had proposed, but
had not yet taken, an additional 26 enforcement actions.
\a The Federal Reserve did not take any post-failure enforcement
actions but had actions under consideration at the time of the bank
failures.
\b OCC is the only federal regulator that issues supervisory letters
and letters of reprimand.
Source: Federal bank regulator data.
The number of post-failure enforcement actions that were taken varied
by regulator. OCC took 90 percent of the post-failure enforcement
actions. OCC also was more likely to issue several enforcement
actions against individual former officers and directors. For
example, on the basis of our analysis, we found that OCC issued CMPs
and removals and/or prohibitions simultaneously against 10
individuals.
--------------------
\9 Letters of reprimand and supervisory letters are issued only by
OCC. According to officials in OCC's Enforcement and Compliance
Division, a letter of reprimand is a substitute for a CMP when it has
been determined that the CMP is not cost-effective to pursue. A
supervisory letter is a less formal letter highlighting the need for
corrective action. However, in the case of failed banks, a
supervisory letter informs former officers and directors that certain
banking practices are considered unsafe and unsound and should not be
continued at other financial institutions. The continuance of such
practices can warrant formal enforcement actions, such as CMPs.
SIMILAR INSIDER VIOLATIONS AND
ENFORCEMENT ACTIONS WERE
IDENTIFIED BY FEDERAL EXAMINERS
IN OUR SAMPLE OF OPEN BANKS
---------------------------------------------------------- Chapter 2:6
When we reviewed the case studies of 13 generally financially safe
and sound open banks, we found that federal examiners identified
insider violations and took enforcement actions that were similar to
those identified in our analysis of the failed banks. Although these
problems were not severe enough to have affected the banks' financial
health, such problems--if left uncorrected--could, in time, have
major negative effects on the viability of these banks.
REVIEW OF FEDERAL
EXAMINATIONS FOUND INSIDER
VIOLATIONS IN SAMPLED OPEN
BANKS
-------------------------------------------------------- Chapter 2:6.1
Although we did not find that the examiners identified evidence of
insider fraud, insider abuse, or loan losses to insiders in our
review of open banks, we found 10 of the banks in our sample had
insider violations. The most common insider violation cited was
preferential terms on loans to insiders, which was reported in six of
the open banks. For example, an examination report cited two
insiders as being granted automobile loans at preferential interest
rates of 9 percent and 10.5 percent when regular bank customers were
charged 12 percent and 13.5 percent, respectively, for identical
automobile loans. (See table 2.9.)
Table 2.9
Insider Violations Found in the Open
Banks as Identified by Bank Examiners
Numb
er
of
bank
Insider violations 1 2 3 4 5 6 7 8 9 10 11 12 13 s
---------------------- -- -- -- -- -- -- -- -- -- -- -- -- -- ----
Loans to insiders with XX X XX X XX X 6
preferential terms
Loans to insiders XX X 2
exceeding loan limits
Failure to obtain X XX X 3
prior board approval
for loans
Failure to maintain X XX XX X 4
required records
Overdraft payments X X X XX X X XX 7
exceeding limits
Exceeding restrictions
on transactions to
affiliates\a
--------------------------------------------------------------------------------
Legend:
X = Violation
XX = Repeated violations
Note: Empty cells indicate that no violations were found.
\a As we explained in chapter 1, the provisions that apply to these
transactions are not a part of Regulation O but are located in
Sections 23A and 23B of the Federal Reserve Act.
Source: Federal bank regulator examination report data.
Of the 13 open banks we reviewed, 4 had insider violations repeated
in more than 1 bank examination. The most common repeated insider
violation cited was again preferential terms on loans to insiders.
ENFORCEMENT ACTIONS IN OPEN
BANKS WE REVIEWED
-------------------------------------------------------- Chapter 2:6.2
In the 13 open banks we reviewed, regulators took 6 enforcement
actions and recommended 4 others at 7 banks. Almost all of the
enforcement actions taken or recommended were commitment letters or
MOUs. The remaining six banks we reviewed had no enforcement actions
for the 5-year period before and including the most recent
examination for each bank.
CONCLUSIONS
---------------------------------------------------------- Chapter 2:7
On the basis of our analysis of the 286 banks that failed in 1990 and
1991, we found that FDIC investigators frequently identified banks
with insider problems, such as insider fraud, insider abuse, and loan
losses to insiders. We also found that federal regulators cited many
insider violations and took many enforcement actions before and after
these banks failed. Federal regulators may have been able to act
more forcefully or in a more timely manner to compel bank management
to address safety and soundness problems. However, such actions may
be effective only when bank management is both capable and willing to
address those problems identified by regulators. In chapter 3, we
discuss how insider problems can indicate broader managerial
problems.
INSIDER PROBLEMS ARE INDICATIVE OF
POOR MANAGEMENT PRACTICES
============================================================ Chapter 3
On the basis of our analysis of the 175 failed banks that had insider
problems, we believe that the failure of the banks' management and
boards of directors to effectively address insider violations and
other problems identified by examiners indicate a much larger
problem. We believe the problem is poor administration by bank
management and inadequate oversight by the boards of directors.
Further analysis of the failed banks showed that a bank was more
likely to be cited for a problem of poor management when it was also
cited for an insider violation in the same examination.
In our review of 13 open banks, we found that examiners frequently
identified management problems in those banks that were also cited
for insider violations. We found negligent management and poor bank
oversight to be the most significant problems in our analysis of both
failed and open banks.
BANKS CITED FOR INSIDER
VIOLATIONS WERE MORE LIKELY TO
BE CITED FOR PROBLEMS RELATED
TO POOR MANAGEMENT
---------------------------------------------------------- Chapter 3:1
Of the 175 failed banks that were cited by federal examiners for
insider violations, banks cited for insider violations were also more
likely to be identified by federal regulators for having various
management problems. To assess the underlying causes of insider
problems, we used odds ratios. Odds indicate the tendency for an
outcome to occur, and odds ratios show how much that tendency is
affected by different factors. If there is no difference in the odds
across the factors that are compared, the odds ratio will equal 1.0.
The extent to which odds ratios are greater or less than 1.0
indicates how sizable the difference is across the factors that are
compared. Table 3.1 shows the ratios of the likelihood that a
management problem is cited given that an insider violation is also
cited in the same examination. A ratio greater than 1 means that it
is more likely that a particular management problem is cited when a
particular insider violation is cited than when an insider violation
is not cited. Some of the odds ratios are statistically significant.
For example, in our analyses we looked at the odds of a bank being
cited for a dominant board member and then calculated odds ratios to
determine how much those odds differed for banks that were also cited
for excessive insider loans. One of the more significant findings is
that when examiners cited loans to insiders exceeding the loan
limits, they were four times more likely to cite the management
problems of a dominant board member than when they did not cite loans
to insiders exceeding loan limits.\1 Further, when examiners cited a
bank's failure to maintain records, they were about 2.7 times more
likely to cite it for poor and/or negligent management. They also
were 2.6 times more likely to cite it for passive and/or negligent
boards than when they did not cite the Regulation O violation of
failure to maintain records. Finally, when examiners cited a failure
to obtain prior board approval, they were about 6.8 times more likely
to cite a lack of board expertise than when they did not cite a
failure to obtain prior board approval.
Table 3.1
The Likelihood That a Management Problem
Is Cited Given That an Insider Violation
Is Also Cited
Failure Failure to
Loans to to obtain
insiders Loans to prior Exceeding
insiders maintain approval Exceeding restrictions
Insider exceeding with for overdraft on
violation loan preferenti required extension payment transactions
s limits al terms records of credit limits to affiliates
--------- --------- ---------- -------- ---------- --------- -------------
Managemen
t
problems
Failure 1.69 3.24\a 1.15 \3.31\a \2.66\a 0.87
to
respond
to
regulato
ry
criticis
ms
Poor and/ 2.50\a 1.51 \2.75\a 2.58 2.58 0.76
or
negligen
t
manageme
nt
Passive 2.02 1.43 \2.63\a 2.47 1.98 1.21
and/or
negligen
t board
Lack of 2.75 1.91 0.87 \6.83\a 1.14 0.93
expertise
(board)
Lack of 2.65\a 2.40\a 1.33 \2.70\a 1.51 0.81
expertise
(officer
)
Dominant 4.00\a 3.57\a 0.39 1.91 1.23 1.00
board
member(s
)
Loan 1.09 2.97 1.70 0.98 0.98 0.54
losses
due to
lax
lending
practice
s
Dominant 0.75 1.07 1.31 2.18 0.87 0.39
executive
Lack of 3.04\a 2.24\a 1.54 \6.13\a 1.61 1.24
or
inadequa
te
systems
to
ensure
complian
ce with
laws and
regulati
ons
--------------------------------------------------------------------------------
\a Significant at the 0.05 level.
Although the federal examiners cited these banks for insider
violations and associated management problems, the banks still
failed. On the basis of our analysis, we believe the failure of bank
management to correct insider violations and problems with insiders
indicate much broader problems related to management and inadequate
board oversight.
--------------------
\1 The odds ratios are derived as follows. We calculated the odds of
being cited for dominant board member given that loans to insiders
exceeding loan limits was also cited (16/66 = 0.24 odds). We then
calculated the odds that dominant board member was cited when loans
to insiders exceeding loan limits was not cited (5/88 = 0.06 odds).
The final result is the ratio of the odds or 0.24/0.06 = 4.00. The
other odds ratios were calculated in a similar manner.
NEGLIGENT MANAGEMENT AND
INADEQUATE BOARD OVERSIGHT
WERE THE MOST SIGNIFICANT
MANAGEMENT DEFICIENCIES IN
THE 1990 TO 1991 BANK
FAILURES
-------------------------------------------------------- Chapter 3:1.1
Competent bank management is critical to the successful operation of
a bank and must be performed in a manner that will ensure the bank's
safety and soundness. According to FDIC's Manual of Examination
Policies, the primary responsibility of bank management is to
implement in the bank's day-to-day operations the policies and
objectives established by the board of directors. FDIC defines the
board of directors as the source of all authority and responsibility,
including the formulation of sound policies and objectives of the
bank, the effective supervision of its affairs, and the promotion of
its welfare.
Additional responsibility has been placed on bank directors and
officers through the Financial Institutions Reform, Recovery and
Enforcement Act of 1989 (FIRREA), which gave regulators additional
authority to take enforcement actions against individual bank
officers and directors when the gross negligence of those officers
and directors threatens the financial safety of the bank. Bank
directors and officers can be held personally liable, in certain
instances, for their performance.
Our analysis of failed banks shows that both the FDIC investigators
and the federal examiners cited management and board deficiencies as
the most significant factors in the failure of the banks. As shown
in table 3.2, the most common management problems identified by both
were a passive and/or negligent board, loan losses due to lax lending
practices, poor and/or negligent management.
While it is apparent the examiners cited these management problems
less frequently than the FDIC investigators, some of the discrepancy
may be due to the differences in the timing and focus of their
respective review processes. Investigators clearly are to pursue
management problems for financial recoveries. However, bank
examiners may be somewhat reluctant to be critical of bank management
and boards, particularly of those managers and boards who assure
examiners of their willingness and ability to cooperate in addressing
bank safety and soundness problems. We discuss these issues further
in chapter 5.
Table 3.2
Management and Insider Problems Cited by
FDIC Investigators (Post-Failure) and by
Examiners (When the Banks Were Open)
Percent of Percent of
Management problems Number 175 banks Number 175 banks
---------------------------------------- ------ ---------- ------ ----------
Passive and/or negligent board 160 91% 129 74%
Loan losses due to lax lending practices 152 87 137 78
Poor and/or negligent management 138 79 112 64
Insider abuse 117 67 65 37
Failure to respond to regulatory 105 60 84 48
criticisms
Insider fraud 104 59 28 16
Loan losses to insiders 81 46 36 21
Dominant board member(s) 56 32 11 6
Dominant executive 43 25 8 5
Lack of or inadequate systems to ensure 38 22 28 16
compliance with laws and regulators
Lack of expertise (officer) 30 17 21 12
Lack of expertise (board) 26 15 5 3
--------------------------------------------------------------------------------
\a Data are only for the 175 banks that had evidence of insider
problems.
\b The examination data included in this table include data from
examinations completed 3 years before the failure of the bank.
Source: FDIC PCRs and federal bank regulator examination report
data.
MANAGEMENT PROBLEMS IDENTIFIED
BY FEDERAL EXAMINERS IN OPEN
BANKS WERE SIMILAR TO THOSE
IDENTIFIED IN FAILED BANKS
---------------------------------------------------------- Chapter 3:2
From our review of the 13 open banks, we found that in about half of
the banks, the federal regulators cited problems of poor and/or
negligent management and passive and/or negligent boards of
directors.
Table 3.3
Insider Violations and Management
Problems Found in the Open Banks as
Identified by Bank Examiners
Violations/ Number
problems 1 2 3 4 5 6 7 8 9 10 11 12 13 of banks
------------------ -- -- -- -- -- -- -- -- -- -- -- -- -- --------
Insider violations
Loans to insiders XX X XX X XX X 6
with preferential
terms
Loans to insiders XX X X 3
exceeding loan
limits
Failure to obtain X XX X 3
prior board
approval for loans
Failure to X XX XX X 4
maintain required
records
Overdraft payments X X X XX X X XX 7
exceeding limits
Exceeding
restrictions on
transactions to
affiliates\a
Management
problems
Poor and/or X XX X XX X X X 7
negligent
management
Passive and/or X X X XX X X 6
negligent board
Failure to respond X X 3
to X regulatory
criticisms
Lack of board/ X X X X 4
management
expertise
Dominant board X X X X 4
member/executive
Insider fraud,
insider abuse,
loan losses to
insiders
Excessive X 1
compensation
Excessive
dividends
--------------------------------------------------------------------------------
Legend:
X = Violation
XX = Repeated violations
\a As we explain in chapter 1, the provisions that apply to these
transactions are not a part of Regulation O but are located in
sections 23A and 23B of FRA.
Source: Federal bank regulator examination report data.
For example, an examiner cited a bank for poor management because the
bank's management team did not provide the bank's board of directors
with the necessary management reports about bank operations. Federal
examiners also cited the bank's board of directors for inadequate
oversight because the board failed to request the same reports from
the bank's management.
In another example, the examiners stated in an examination report
that the board of directors lacked an active involvement in the
supervision of the bank. In this case, the federal examiner
identified 17 areas where the board's attention was needed to
evaluate or incorporate existing committees or policies in its
overall supervision of the bank. One of the areas needing the
board's attention was the development of and adherence to an insider
compliance program.
Problems of poor management and inadequate board oversight are not
explicitly violations of banking laws and regulations; however,
safety and soundness problems are and, therefore, federal examiners
can take enforcement actions to compel bank management and directors
to address potential safety and soundness problems. It is critical
that a bank's management and board of directors work together as a
team to ensure the financial viability of the bank.
EXAMINERS EXPRESSED CONCERN
REGARDING POOR
MANAGEMENT-RELATED PRACTICES
IN OPEN BANKS WITH INSIDER
VIOLATIONS
-------------------------------------------------------- Chapter 3:2.1
From our review of examination reports for the 13 open and relatively
healthy banks, we found instances when examiners expressed concern
that poor management practices could lead to certain insider problems
and/or insider violations. We found two banks where the examiners
expressed concern over the banks' insufficient policies relating to
loans to insiders and inadequate monitoring of insider activities.
For example, in one of the banks, examiners found that the bank's
internal controls to ensure the accuracy of the Regulation O
recordkeeping requirements for loans to insiders needed to be
improved. On the basis of his review of the bank's system, the
examiner determined that the system did not account for insider loans
from overdraft protection or installment loans. This bank had been
previously cited for other Regulation O violations.
In another examination report, examiners expressed a concern over the
interaction of a bank's management with two other banks. The
examiner cited these relationships as having the potential for
Regulation O violations and a possible conflict of interest involving
a director and his business interests. However, no Regulation O
violations were cited. In another example, an examiner found one
bank with a tradition of lending money based on borrowers' character.
The examiner determined that insider abuse could easily occur at this
bank because of such lax lending practices. In all of the examples
we have discussed, the examiners identified problems with management
and board oversight and the potential for insider violations.
CONCLUSIONS
---------------------------------------------------------- Chapter 3:3
On the basis of our analysis of the 175 banks that failed in 1990 and
1991 in which insider problems were identified by FDIC investigators,
we found poor bank management and inadequate board oversight were the
predominant reasons for the failures. We also found that a pattern
of repeated insider violations and noncompliance with enforcement
actions are clearly symptomatic of broader management and board
failures.
In 10 of the 13 relatively healthy banks we reviewed, examiners found
insider violations, deficiencies in bank management and boards of
directors, and failures of bank management and boards to respond to
repeated regulatory criticisms. It is critical that violations and
problems are corrected before they jeopardize a bank's financial
viability. The correction of these violations and problems is
particularly critical because the same problems, although more
severe, led to most of the 175 bank failures with insider problems in
1990 and 1991.
THE EXTENT OF INSIDER LENDING AT
FAILED AND OPEN BANKS
============================================================ Chapter 4
In pursuit of one of our objectives, we attempted to determine the
overall extent of insider lending at failed and open banks. We
initially attempted to do this for the 286 banks that failed in 1990
and 1991. We did so by obtaining information on the extent of
insider lending from investigators' PCRs and other materials (e.g.,
loan lists developed by examiners and the minutes from meetings of
boards of directors). Because FDIC's database of the assets of
failed banks did not allow us to estimate the amount of insider
lending at such banks, we attempted to identify manually insider
lending at 10 judgmentally selected failed banks. We were able to
estimate the amount of insider lending at 8 of these 10 banks.
However, because of some uncertainties of the data we do not know if
these estimates are valid.
For open banks, we used bank call report data to estimate insider
lending. These data became available in March 1993. The March data
show the aggregate amount of insider lending at all open banks to be
$24 billion.
FDIC'S PROFESSIONAL LIABILITY
SECTION GENERALLY DOES NOT
CONSIDER INSIDER-SPECIFIC DATA
NECESSARY IN PURSUING A
SUCCESSFUL CLAIM
---------------------------------------------------------- Chapter 4:1
A primary function of FDIC investigators is to determine whether
there are sufficient sources of recovery to warrant the pursuit of a
claim against those responsible after a bank has failed. To fulfill
this function, investigators do not necessarily have to develop or
have a complete accounting of or comprehensive data on the extent of
losses stemming from insider problems. In discussions with senior
DOL and Professional Liability Section (PLS) officials, we were told
that in most cases, investigators do not treat insider loans
differently from loans to others. It is not necessary for
investigators to tie losses sustained by the bank directly to
insiders or their interests. Instead, investigators need only to
establish that it was the management or oversight of the insiders
that either led to or failed to avert the bank's losses for PLS to
establish grounds for a negligence claim.
In pursuing potential claims, DOL works with PLS to establish the
extent of losses stemming from the negligence of those involved with
the management of a bank. In general, FDIC investigators and
attorneys seek to determine at what point those associated with the
bank may reasonably have been expected to recognize the deficiencies
that led to the bank's losses. For example, a claim against a bank's
outside directors may result if the post- failure investigation
discloses that a deficiency that was identified in a regulatory
examination or bank audit report remained uncorrected and resulted in
the bank suffering further losses.
After determining the primary reasons for a bank's failure, DOL
investigators may develop a target loan list consisting of loan
losses that stem from deficiencies identified in the bank's lending
practices. If, for example, a bank was criticized by its primary
regulator for having a loan concentration in commercial real estate
development but took no corrective action and later failed,
investigators would review the bank's loan losses and compile a
target loan list consisting of commercial real estate loans that were
extended or renewed after the bank had been criticized for the
concentration. If losses were substantial enough, a claim against
outside directors may be warranted. The case against the directors
is not changed substantially if some of the losses involved insider
loans. Therefore, DOL investigators generally do not establish the
extent of lending to insiders.
FDIC'S DATABASE PROVED
INADEQUATE IN IDENTIFYING THE
EXTENT OF INSIDER LENDING AT
FAILED BANKS
---------------------------------------------------------- Chapter 4:2
After determining that investigators do not often develop complete
information on the extent of lending to insiders, we turned to DOL's
LAMIS database, which tracks loans from failed banks, to see whether
it could provide data on the extent of insider lending at the 286
banks that failed in 1990 and 1991. To determine whether it was
feasible to identify insider-related loans through LAMIS, we provided
FDIC with an extensive list of insiders and their related interests
from bank failures associated with the James Madison Limited holding
company. This list had been developed for one of our previous
reports on the failures of the Bank of New England and Madison.\1 In
preparing that report, we reviewed data developed by OCC, which
indicated that loans to Madison insiders totaled $83 million, or 17
percent of all loans. We then attempted to match the names of the
Madison's insiders and their related interests to the names on the
LAMIS database for Madison. If the match program produced results
that were generally in agreement with the OCC data, we felt we could
be reasonably confident that the match had been effective.
After numerous attempts by DOL and our staff, we were unable to
complete an automated match that accounted for a reasonable
percentage of the loans to insiders we had previously identified by
manual means. Through additional manual manipulations, we were able
to use the LAMIS database to approximate the total amount of loans we
had identified in our prior work. From our manual manipulations, we
identified 127 insider-related loans involving amounts of $10,000 or
more. Our analysis of these insider-related loans showed the
aggregate loan amount to be $71 million dollars. This amount
represented approximately 18 percent of the Madison loans of $10,000
or more listed on LAMIS. As this amount was in line with the level
of insider lending activity identified by OCC shortly before
Madison's failure, we believe our approach resulted in a reasonable
estimate of the insider lending activity at this bank.
However, the manual manipulations required to come up with this
estimate of insider lending were extremely labor-intensive and
time-consuming and, therefore, impractical for application to each of
the 286 failed banks we reviewed. We present the details of our
attempts to identify the extent of insider lending using LAMIS data
in appendix IV.
--------------------
\1 Bank Supervision: OCC's Supervision of the Bank of New England
Was Not Timely or Forceful (GAO/GGD-91-128, Sept. 1991).
IDENTIFYING INSIDER LENDING AT
OPEN BANKS
---------------------------------------------------------- Chapter 4:3
Until recently, only very limited data on lending to insiders were
available. The Securities and Exchange Commission (SEC), for
example, requires all companies with publicly traded securities to
report all transactions of more than $60,000 in which certain
insiders are involved.\2 SEC also requires all such companies to
report the names and specified related interests of directors or
nominees for directors. However, SEC does not require companies to
report the names of officers and principal shareholders. Under
Section 12 of the Securities Exchange Act of 1934, banks are subject
to substantially similar requirements under regulations made by
federal banking agencies.
We believed examination reports might also provide data on the extent
of insider lending at open banks. In our review of open bank
examinations, however, we found examiners generally did not document
the extent of lending to insiders. In their review of loans to
insiders, examiners typically attempt to identify violations of
Regulation O, such as loans with preferential terms. However, unless
the amount of lending to insiders is considered a problem, examiners
are unlikely to document the extent of insider loans in the
examination report.
In addition, we attempted to use call report data to estimate the
overall level of insider lending. Before March 1993, call reports
required banks to report insider lending only for officers and
principal shareholders and their related interests but not for
directors. As of the March 1993 call report, the requirements were
changed so that banks would also report aggregate insider lending to
directors. As of March 1993, the aggregate amount of insider lending
was reported as $24 billion, with an average aggregate amount per
bank of $2 million within a range of no insider lending to $623
million. Historically, it often takes several reporting cycles for
new data to be reliably reported by banks. As banks become more
familiar with new call report requirements, future reports should
more accurately reflect aggregate insider lending activity.
--------------------
\2 SEC's definitions for insiders and related interests differs
somewhat from those in Regulation O. For example, SEC includes
family relationships in its definition of related interests.
THE NEW REQUIREMENT MAY
PROVIDE COMPREHENSIVE DATA
-------------------------------------------------------- Chapter 4:3.1
Because of the lack of data on loans to directors in prior call
reports, we contacted the organization responsible for requiring
changes in the call reports, the Federal Financial Institutions
Examination Council, to determine the impetus behind this change. We
were told the addition of data on loans to directors was advocated by
the Federal Reserve to address changes to Regulation O required under
FDICIA. FDICIA established an aggregate lending limit on loans to
insiders. It also required directors to adhere to the same
individual limit on loans to individuals and their related interests
that had previously applied only to executive officers and principal
shareholders.
The addition of this requirement will make available to regulators
and the public the total amount of insider lending at banks if banks
accurately report the amounts of loans to officers, directors, and
major shareholders. To respond to the new requirement, banks must
have or develop systems to collect and maintain this information.
Accuracy in call report data is required under provisions 12 U.S.C.
1817 and 12 U.S.C. 161, and banks are instructed to maintain the
records needed to generate the figures they provided in the call
reports. We further discuss reporting requirements in chapter 5.
CONCLUSIONS
---------------------------------------------------------- Chapter 4:4
Until recently there was no comprehensive source of data for
identifying the total amount of lending to bank insiders. Therefore,
we were not able to determine the extent of insider lending for our
failed bank analysis. As of March 1993, the aggregate amount of
insider lending at open banks was reported as $24 billion. The new
requirement for additional reporting of insider lending on call
reports has the potential to provide an accounting of all insider
loans. However, as a solution, it is dependent on the accuracy of
the information reported by banks and the diligence of examiners to
ensure accurate bank reporting.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 4:5
In its comments on a draft of this report (see app. IX), the Federal
Reserve said that our inability to quantify the specific amount of
insider lending and losses calls into question our conclusion in
chapter 2 that insider problems are a significant contributing factor
to bank failures. As discussed in this chapter, we do not believe it
is necessary to demonstrate exact dollar losses to conclude that
insider problems were a significant factor; according to FDIC
investigators, 26 percent of the banks we reviewed failed because
insider fraud, insider abuse, or loan losses to insiders was a major
factor contributing to the failures.
EXAMINERS OFTEN DID NOT IDENTIFY
INSIDER PROBLEMS
============================================================ Chapter 5
In our review of the examination reports of 175 failed banks from
1990 and 1991, we found that when the banks were open examiners were
less likely to identify insider problems than were investigators
after the banks failed. There are a number of reasons for this.
Overall, examiners face many more obstacles than investigators in
identifying insider fraud, insider abuse, or loan losses to insiders.
Nonetheless, we believe there are some tools examiners could consider
using to improve their abilities to detect these insider problems.
EXAMINERS ARE LESS LIKELY THAN
FDIC INVESTIGATORS TO IDENTIFY
INSIDER PROBLEMS
---------------------------------------------------------- Chapter 5:1
We reviewed the examination reports of the 175 failed banks for the 3
years before they failed. On the basis of our review, we believe
examiners may often fail to identify insider fraud, insider abuse,
and loan losses to insiders. In many cases, both the FDIC
investigator and the examiner identified insider problems in the
bank. (See fig. 5.1.) However, in general, investigators were
better able to identify these activities after the banks failed than
the examiners were when the banks were open.
Figure 5.1: Identification of
Insider Problems by
Investigators and Examiners
(See figure in printed
edition.)
Note 1: We counted the number of failed banks that were cited for
insider fraud, insider abuse, or loan losses to insiders in those
examination reports completed in the 3 years before the banks failed.
Note 2: We counted the number of banks in which the investigator
stated in the PCR that insider fraud, insider abuse, or loan losses
to insiders was a contributing factor in the failures of the banks.
Source: Federal examination report and PCR data.
Examiners were less likely to identify instances of insider problems
in banks than were investigators. Investigators were substantially
more likely to identify instances of insider fraud and abuse than
were examiners. However, examiners were closer to investigators in
identifying instances of loan losses to insiders. This makes sense
in that one of the primary focuses of the safety and soundness
examinations is the loan portfolio. Examiners concentrate much of
their resources on the loan portfolio review. Because the loan
portfolio typically represents the majority of a bank's assets and
the greatest potential risk to its health, such scrutiny is
necessary.
DIFFERING CIRCUMSTANCES AND
FOCUS AFFECT THE OUTCOME OF
EXAMINER AND INVESTIGATOR
REVIEWS
---------------------------------------------------------- Chapter 5:2
Two factors appear to largely account for the varying rates with
which investigators and examiners identify various problems. These
factors are (1) the different circumstances under which investigators
and examiners conduct their reviews and (2) the disparate focus of
examiners and investigators.
Concerning the first factor, several investigators told us that after
a bank has failed, interviews with bank personnel often aided their
investigation of insider problems. Investigators also told us that
bank employees are generally more willing to discuss a bank's
problems after it has failed. Bank employees are more willing to do
so because they are no longer restrained by concern over their
positions at the bank and are, therefore, more willing to speak
freely about the bank's management and board. Unfortunately,
examiners find that bank employees, who rely on the bank for their
livelihood, are less likely to discuss the bank's management and
board.
Investigators also have greater access to bank documents than do
examiners. Although examiners may request all documents necessary to
conduct their examinations, they are unlikely to receive documents
from bank officials involved in abusive or fraudulent acts in which
the officials are self-incriminated. After a bank fails, however,
investigators have full access to all records (both manual and
automated) on the bank's premises. To ensure that all pertinent
documents are obtained, investigators will use desk audits, in which
they examine the contents of desks and files belonging to key bank
personnel. Through this effort, investigators may produce documents
that were unavailable to examiners. However, this approach is of
little use to examiners, as such an intrusion would probably be
viewed as inappropriate without due cause.
Examiners are primarily concerned with the safety and soundness of an
institution, while investigators are primarily concerned with
determining the culpability of those associated with the bank.
Because examiners and investigators have different concerns, the way
they perform their duties and the outcome of their efforts differ.
Although examiners strive to maintain or improve the condition of
open banks and investigators to identify potential recoveries from
failed banks, it is important to note that both examiners and
investigators ultimately serve a similar purpose--to minimize losses
to the BIF. Given the high incidence of management and insider
problems at failed banks we discussed in chapters 2 and 3, we believe
examiners may prove better able to minimize such losses by increasing
their scrutiny of insider activities.
DEFICIENCIES CAN SOMETIMES
BE DIFFICULT FOR EXAMINERS
TO IDENTIFY
-------------------------------------------------------- Chapter 5:2.1
Some deficiencies--insider problems and violations--may be difficult
for examiners to identify. For example, if a bank's system for
ensuring that the bank complies with Regulation O fails to identify
certain related interests of an insider, examiners may have little
opportunity to detect the omission. To identify such an omission the
examiner would need evidence of the existence of the unreported
related interests. If the omission was inadvertent, the examiner may
identify the related interests through the insider's financial
statement. This scenario assumes the insider is a borrower and the
bank has obtained a complete financial statement. Here again,
problems can arise because the bank's system may lack data that
identifies the insider as a borrower. Therefore, the examiner may be
unaware that a financial statement is available. If a financial
statement is not available or its accuracy is questionable, the
examiner may interview bank staff to help identify unreported related
interests. However, interviewing would require the examiner to ask
the right questions and the staff to be aware of and be willing to
disclose the insider's related interests.
By itself, the omission of an insider's related interests may have
little effect on the bank's overall condition. However, it also may
mask other potentially abusive problems, such as the failure of a
director to abstain from voting on loans to his or her interests or
approving loans that exceed the bank's aggregate insider lending
limit. Regardless of whether such management deficiencies have a
direct detrimental effect or demonstrable financial impact on the
bank, they may indicate broader internal control weaknesses in need
of corrective action.
REGULATORS COULD IMPROVE THEIR
ABILITIES TO IDENTIFY INSIDER
PROBLEMS
---------------------------------------------------------- Chapter 5:3
We believe our data show that the relationship between insider
problems and the overall health of a bank warrants greater attention
by examiners in terms of identifying and countering such
deficiencies. We also recognize that identifying such activities is
often more difficult than identifying poor lending or credit
administration practices. Several tools or approaches may aid
examiners in improving their abilities to identify these activities.
EXISTING DATA SYSTEMS AND
RECORDKEEPING REQUIREMENTS
COULD HELP EXAMINERS TO
OVERSEE INSIDER ACTIVITIES
-------------------------------------------------------- Chapter 5:3.1
Examiners rely largely on bank records to identify insider problems.
In our review of examination files for 13 open banks, we found that
examiners generally accepted the information provided by the banks as
truthful when they assessed insider activities. In other areas of
bank operations, examiners can readily determine whether a bank is
operating within the confines of regulations. For example, an
examiner can identify a bank's failure to maintain current appraisals
by pulling a sample of the bank's credit files and reviewing the
appraisals they contain. For an examiner to identify a bank's
failure to report all of its insiders and their related interests is
more complex.
If an examiner requests and is provided with a bank's records
required under Regulation O, he or she cannot be certain that the
information is complete. For example, in the case of the James
Madison National Banks, there were approximately 500 insiders and
their related interests involved. Our review of documents from
Madison revealed that its directors and officers had submitted
information on their related interests. However, we found the
information was not always complete. We believe that if an insider
does not report a related interest, whether intentionally or not, an
examiner may have little opportunity to identify the omission. If
credit is extended to an unreported interest or if such credit
extension is not reported, again an examiner has little chance of
identifying such omissions. This is because examiners must rely
largely on their manual reviews of a bank's loan portfolio and other
bank documents to identify unreported loans or related interests.
If, as in the case of Madison, the bank has a large loan portfolio
and its insiders have a number of related interests, this task is
extremely burdensome.
We found the guidance in regulators' examination manuals vague
concerning how examiners are to determine the extent to which a
bank's compliance systems for Regulation O are complete. For
example, OCC's manual states only that "examiners should be alert for
any relationship with insiders which are not included on the list."
While it appears to be largely true that examiners must rely
primarily on the veracity of data provided by a bank, we believe this
only underscores the need for examiners to place greater emphasis on
ensuring the bank has appropriate reporting systems in place. We
believe that aggressive enforcement of existing reporting
requirements will place examiners in a better position to identify
insider problems. Conversely, failure to enforce those few
safeguards that currently exist creates an environment that allows
abuse.
FULL COMPLIANCE WITH
REGULATION O RECORDKEEPING
REQUIREMENTS WOULD AID
IDENTIFICATION OF INSIDER
PROBLEMS
-------------------------------------------------------- Chapter 5:3.2
Regulation O has several recordkeeping requirements. If banks
adhered to these requirements, examiners would have sufficient
information to allow them to determine the bank's compliance with the
regulation's lending provisions. Doing so would help examiners
identify potential insider problems.
Regulation O's basic reporting requirements are contained in section
215.8,\1 which requires each bank to maintain records that
identify all executive officers, directors, and principal
shareholders and their related interests; and
specify the amount and terms of each loan to these entities.
In addition, section 215.8 requires each bank to request, at least
annually, that each officer, director, or principal shareholder
identify his or her related interests.
If banks fully complied with the provisions of section 215.8,
examiners would be able to readily determine whether other key
provisions of the regulation, such as the limits on insider lending
and the prohibition against preferential terms, were being followed.
In addition, the recordkeeping requirements can aid examiners in
their review of other potential insider problems, such as insider
abuse.
For example, if a bank director has a financial interest in a real
estate management corporation that leases office space to the bank,
an examiner may be unaware of the relationship. However, if the
director complies with the section 215.8 reporting requirement, the
examiner can readily identify the management corporation as a related
interest and review the lease agreement for potential self-dealing.
If the management corporation is receiving excessive fees for the
space being leased to the bank, the examiner can identify the
possibility of insider abuse.
Using data we reviewed from the examination histories of the 175
failed banks, we found examiners had identified violations of the
Regulation O recordkeeping requirements in only 81 (or about 12
percent) of the 656 examinations done at these banks at any time
during the 3 years before the banks failed. We believe that this may
underreport the true extent of such violations. In our discussions
with DOL officials and our review of the PCRs for the 1990 and 1991
bank failures, we found investigators often do not find adequate
records on hand at the time of failure to permit the ready
identification of loans to insiders. Our finding appears to conflict
with data from the examinations of these banks. The examination data
suggest that the banks generally maintained adequate records before
they failed and therefore were not cited for failing to maintain such
records.
In addition to our failed bank analysis, our review of examination
findings for our sample of 13 open bank case studies also indicated a
potential underreporting of these violations. In the examinations of
the open banks, examiners reported a violation of section 215.8
provisions in only 1 of the 13 banks we reviewed. However, our
review of these examinations and our discussions with the examiners
in charge revealed that violations existed in at least three other
institutions; examiners either failed to recognize these violations
as such or judged them not severe enough to warrant citing them in
the examination report. In addition, recordkeeping problems appeared
in the case studies of two other banks, although the information
available was insufficient for us to say with certainty that a
violation of Regulation O recordkeeping requirements had occurred.
One of the case studies was particularly illustrative of violations
existing. The most recent examination for that bank focused on
insider lending because of violations of the preferential terms
provisions of Regulation O that had been cited in the bank's previous
examination.\2 The most current examination report noted that the
bank had complied with Regulation O. However, the examiner suggested
the bank develop an insider loan list that included information on
the terms of the insider loans. Because Regulation O requires such a
list, the bank is, in fact, in violation of the regulation. Yet,
even though such a list is intended to guard against the very
violations for which the bank had been cited previously, the
examination report fails to cite the lack of such a list as a
violation.
The failure of examiners to aggressively pursue compliance with
Regulation O's recordkeeping requirements was also mentioned by
investigators. Many investigators told us that examiners do not
commonly criticize banks for having poor systems in place to track
insider activities, or if the examiners do, they treat such
violations lightly.
Without complete records, examiners may encounter substantial
difficulty in trying to identify banks' insider problems and their
violations of Regulation O's lending provisions. To improve their
abilities to identify these insider activities, we believe examiners
need to place greater emphasis on ensuring that a bank is maintaining
the appropriate records. Examiners could do this by periodically
cross-checking insider reports produced by the bank with other
information, such as known lists of major shareholders, officers, and
directors that appear in annual reports and SEC filings. In
addition, examiners could periodically check bank systems for
producing insider information for reasonableness and the existence of
good internal controls in connection with other reviews of major bank
information systems when warranted.
--------------------
\1 While other provisions of Regulation O also contain certain
recordkeeping requirements, Section 215.8 includes those requirements
most directly related to the issues addressed in this report.
\2 Section 215.4(a).
THE NEW REPORTING
REQUIREMENT MAY IMPROVE
OVERSIGHT OF INSIDER LENDING
-------------------------------------------------------- Chapter 5:3.3
As we discussed in chapter 4, as of the March 1993 call report, banks
were required to report loans to directors in addition to loans to
officers and principal shareholders. The new requirement now
requires data on all loans made to bank insiders as defined by
Regulation O.
The addition of this requirement should assist examiners in their
effort to ensure that all insider loans are identified. To respond
to the new requirement, banks must have or develop systems to collect
and maintain this information. Accuracy in call report data is
required,\3 and banks are instructed to maintain the records needed
to generate the numbers they provide in the call reports. If banks
properly report their information on insider lending, examiners will
now be able to cross-check the totals of insider lending that are
reported on call reports with the totals produced by banks' systems
for examination purposes. The addition of data on loans to directors
should make it easier for examiners to detect incomplete or sloppy
recordkeeping. However, willful misrepresentation would still be a
problem because examiners would largely rely on the information
reported by the bank to be truthful. Nonetheless, the new
requirement should provide examiners with a substantial new tool to
use in their assessment of insider lending activities.
--------------------
\3 Under provisions including 12 U.S.C. 1817 and 12 U.S.C. 161.
BOND AND DIRECTORS AND
OFFICERS LIABILITY INSURANCE
LAPSES CAN ALSO INDICATE
INSIDER PROBLEMS
-------------------------------------------------------- Chapter 5:3.4
Bank officers and directors can be held personally liable for
negligence in meeting their fiduciary responsibilities. In doing our
work, we reviewed FDIC investigator files. Our review showed that of
the 286 banks that failed in 1990 and 1991, 201, or 70 percent of the
banks, had no directors and officers (D&O) liability insurance at the
time of failure. D&O liability insurance protects bank directors and
officers. Of the 201 banks without D&O insurance, 84 percent had no
known coverage for more than a year before the banks failed. The
remaining 16 percent of the 201 banks allowed their D&O insurance to
lapse within 1 year of the banks' failure. Within the same 201
banks, 60 percent had bond insurance coverage at the time the banks
failed, 17 percent had let their bond insurance lapse in the year
before the banks failed, and 23 percent had no known coverage for
more than a year before the banks failed.
In many of these banks, management may have allowed the banks'
insurance to lapse because it could not afford the high cost of D&O
liability or bond insurance given the financial condition of the
bank. However, in some cases, insurance companies that issued the
D&O liability insurance policies may have refused to renew coverage
because of problems they identified at the banks. Officials of such
companies told us that before issuing or renewing a policy they
carefully review the bank's soundness and look for any indicators
that there are problems, including insider problems. Thus, a lack of
insurance or exclusions under a bank's policy could be an indicator
to federal examiners that the bank is experiencing financial,
management, or insider problems.
For example, FDIC investigators wanted to file a bond insurance claim
because of the abusive insider activities of three executive officers
of a bank. The abuses directly contributed to the failure of the
bank. However, a review of the bond insurance policy by the
investigator found the same three executive officers were excluded
from coverage because of their classified loans. Although we found
no evidence in our review of the examinations and workpapers of that
bank that the examiners had made themselves aware of this exclusion
by examining the bond policy, we cannot say with certainty that they
had not done so.
Nonetheless, in our review of the failed bank examination reports for
the 175 failed banks, we did not find any evidence that examiners
determined the existence of, or exclusions from, a bank's bond or D&O
liability insurance policy. Given the apparent carefulness with
which insurance companies make decisions on whether and under what
conditions to offer insurance, such a review of a bank's policies--or
the circumstances under which coverage was declined--may be useful
for examiners in helping them identify insider problems.
CONCLUSIONS
---------------------------------------------------------- Chapter 5:4
Examiners were less likely to identify insider problems when banks
were open than were investigators after banks failed. Examiners face
numerous impediments to determining the full extent of insider
problems at banks. Records that would assist examiners' efforts are
sometimes missing or incomplete. One reason for this is that
insiders involved in abusive or fraudulent activity will often
attempt to conceal their activities. Another reason is that bank
personnel may be disinclined to provide information on those to whom
they report. Still, we believe improvements can be made in the
examination of insider activities.
An examiner's greatest resource in the effort to identify and deter
insider problems is information. We recognize that examiners can do
little to get beyond their reliance on the truthfulness of bank
documents. However, we believe this reliance only increases the need
for examiners to insist that banks comply with the Regulation O
recordkeeping requirements. If banks comply, they would provide
examiners with, among other things, the names of all insiders and
their related interests. If complete, this information would allow
examiners to review a bank's loan portfolio and other transaction
records (e.g., office leases or appraisal contracts) to determine
whether potential abuses exist. Without this information, examiners
may be kept from identifying potential insider problems. If such
problems go undetected, they create an environment that could
encourage insider abuse. One way examiners could increase their
confidence in the reliability of a bank's data on insiders would be
to compare call report data, which now includes loans to directors as
well as other insiders, with bank records. In addition, a review of
a bank's insurance policies--or the circumstances under which
coverage lapsed or was declined--may be useful to examiners in
identifying insider problems.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 5:5
We recommend that the Board of Governors of the Federal Reserve, the
Comptroller of the Currency, and the Chairman of the FDIC direct
examiners to include, as part of their next full-scope examination of
each bank under their authority, a review of the insider lending
information as reported by each bank in their call reports. This
review should include a study of the accompanying documentation to
ensure the numbers reported are supportable. Further, we recommend
that Regulation O recordkeeping requirements be given higher priority
by examiners to ensure that bank boards and management understand the
importance of proper reporting and to improve examiners' abilities to
identify potential insider problems.
We also recommend that the Board of Governors of the Federal Reserve,
the Comptroller of the Currency, and the Chairman of the FDIC direct
examiners to include in their examinations a brief review of a bank's
insurance policies. Such a review could determine whether insurers
have identified any reasons--such as insider problems--to deny
coverage or write exclusions into the policies.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 5:6
In written comments on a draft of this report, OCC officials agreed
with our recommendations, saying they plan to improve the related
examination process. This includes revising the section of their
Comptroller's Handbook for National Bank Examiners for reviewing
insider activities and including a discussion of call report
requirements and a reemphasis of the importance of recordkeeping and
reporting requirements. (See app. VII.)
The Federal Reserve agreed with our findings and conclusions but
stated that it already has policies in place to address our
recommendations. On the basis of our review of the Federal Reserve's
examination files for failed and open banks, we agree that in almost
all cases we found these policies were adhered to. However, we
believe that an increased emphasis by the Federal Reserve on
Regulation O recordkeeping requirements and an analysis of directors
and officers liability insurance policies may provide additional
opportunities for identifying insider problems. (See app. IX.)
FDIC officials agreed with the substance of our recommendations, but
officials stated they already have policies in place to address these
recommendations. On the basis of our review of FDIC's examination
files for failed and open banks, we found these policies are not
consistently adhered to. In a subsequent letter, FDIC agreed to
reemphasize to its field staff the importance of a thorough analysis
of insider activities, effective communication with boards of
directors, and adherence to established policies and procedures.
(See app. VIII.)
IMPROVED COMMUNICATIONS BETWEEN
BANK REGULATORS AND BOARDS OF
DIRECTORS ARE ESSENTIAL
============================================================ Chapter 6
As we discussed in chapter 2, some examination findings went
uncorrected between bank examinations. These findings went
uncorrected in both the failed and open banks we reviewed. While the
problems identified by examiners in the open banks were clearly not
as severe as those identified by investigators in the failed banks,
the failure of both the federal bank examiners and bank boards to
ensure that problems were corrected is troubling. In some instances,
bank boards may have failed to understand the potential seriousness
of repeated insider violations and management and insider problems.
Effective communication between bank regulators and bank officers and
directors is essential. We believe bank examiners need to place
greater emphasis on helping, to the extent possible, bank management
and boards of directors to understand the seriousness of deficiencies
identified by examiners. Examiners also need to help directors
understand their responsibilities to correct these deficiencies.
Also, bank boards need to listen to examiners and ensure that
management takes the necessary steps to correct problems.
We identified several steps that both examiners and bank boards can
take to better ensure that problems are effectively communicated and
promptly corrected.
FOCUS GROUP PARTICIPANTS
BELIEVE EXAMINERS INEFFECTIVELY
COMMUNICATE EXAMINATION
FINDINGS
---------------------------------------------------------- Chapter 6:1
As we discuss in chapter 1 and appendix I, we conducted six focus
groups with outside bank directors (directors who are not employees
of their banks) of small and large banks.\1 Many of the focus group
participants described their interactions with regulators in
generally favorable terms. However, the focus group participants
also expressed frustration concerning their interactions with their
banks' primary federal regulator. Most often their frustrations
centered on their need for examiners to prioritize examination
findings and work more closely with the boards of directors to ensure
that the boards understand the findings.
The participants of the focus groups implied that directors view
dealing with the examiners as challenging and confusing. The
participants expressed frustrations with both the consistency of
examination findings and the way in which the examiners communicated
these findings to bank management and the boards. Several of the
participants believed that examiners often take an adversarial
approach in communicating examination findings. For example, one
participant said that instead of helping the bank's management and
directors to understand a new policy, examiners are quick to
criticize the bank's management and place the bank under an
enforcement action because the management and directors fail to
understand a new policy. In another example, a participant said that
examiners appear to have a "chip on their shoulders--almost a little
hostility." In addition, another participant said examiners were
vague in communicating the deficiencies identified, and therefore
boards were sometimes unconvinced that corrective action was needed.
Many of the participants of the focus groups expressed concern over
the lack of consistency among examiners and the lack of communication
with their federal regulator. In one focus group, a participant said
that before her bank opened, its loan policy was reviewed by an
examiner. The bank made the requested changes and the regulator
approved the revised loan policy. At the bank's first examination,
the examiners reviewed the loan policy and found it to be inadequate.
The bank consulted with the regulator and fixed these problems. Six
months later a different examination team came in and found a
completely new set of problems with the bank's loan policy.
Participants said examiners sometimes meet with a bank's board but
more often they meet only with bank management. In such cases, the
board, particularly its outside directors, is likely to get
management's version of the examination findings. For example, one
participant said his board members have "no interface" with
examiners. Instead, an audit committee reviews the examination
report and presents the findings to the board. In another example, a
participant said that he was concerned because in his bank examiners
give oral briefings only to bank management. Another participant
said the directors at his bank do not have an on-going relationship
with their bank examiner, but instead hear from the bank's president,
who deals with the examiners during their examination review.
However, another participant reported that sometimes examiners would
meet with the board and sometimes they would not. This participant
felt that the regulator should have a uniform policy of having the
examiners meet with the board after all examinations. We believe
that these situations may prevent bank boards from tasking management
to implement satisfactory corrective actions.
We believe the regulators could consider several steps for improving
the effectiveness of their communication with bank boards and
management. These steps would more explicitly connect insider and
broader management problems. Examiners should recognize that
repeated insider violations can indicate broader management problems.
In addition, examiners should clearly communicate their findings to
the boards of directors. They also should prioritize any
deficiencies they found in their examinations. Finally, examiners
should ensure the directors understand their roles and
responsibilities to correct the identified deficiencies.
--------------------
\1 Small banks are banks with less than $100 million in assets.
Large banks are banks with more than $100 million in assets.
REPEATED VIOLATIONS SHOULD
SIGNAL TO EXAMINERS PROBLEMS
WITH BANK MANAGEMENT AND
OVERSIGHT FUNCTION
-------------------------------------------------------- Chapter 6:1.1
As we discussed in chapter 3, continuing or repeated deficiencies
such as insider violations can indicate broader management problems.
In our review of the failed banks, we found that 141 of the 175
failed banks that were cited for insider violations were also cited
for various management problems. Combined, these problems
jeopardized the financial health of the banks, and the banks
eventually failed.
On the basis of our review of examination reports for both the failed
and open banks, we found that violations, such as those involving
insiders and examiners' assessments of management, were listed in two
separate places in the reports. Examiners often communicated
violations to the boards as separate issues requiring the board's
attention. On the basis of our interviews with directors and our
review of the examination reports, we cannot say with certainty that
examiners were connecting repeated insider violations and possible
problems related to the effectiveness of the bank management and
overall supervision by the boards of directors. Even repeated
insider violations were generally treated by examiners as instances
of noncompliance with regulations, but not as significant as unsafe
or unsound banking practices. As a result, we believe the boards of
directors may not usually have perceived the insider violations as
potentially serious and therefore may not always have taken prompt
and necessary corrective action.
EXAMINATION FINDINGS SHOULD
BE PRIORITIZED WHEN
COMMUNICATED TO BOARDS OF
DIRECTORS
-------------------------------------------------------- Chapter 6:1.2
In our review of examination reports for failed and open banks, we
noted that examiners frequently cited several problems without
distinguishing the relative importance of these problems. Although
we believe banks should correct all identified deficiencies, the
participants in our focus groups expressed frustration because
examiners often failed to prioritize their findings. Some
participants pointed out that some identified deficiencies appeared
to be "nit picky," while others appeared to be more serious. We
believe that when examiners feel that the correction of specific
problems is crucial for the continued financial soundness of a bank,
it would be appropriate for the examiners to prioritize the
deficiencies needing correction. Such prioritization would also
serve to reduce some of the frustrations bank directors feel in
dealing with examiners.
EXAMINERS SHOULD BETTER
ENSURE DIRECTORS UNDERSTAND
THEIR ROLES AND
RESPONSIBILITIES
-------------------------------------------------------- Chapter 6:1.3
In our review of examination reports from the failed banks, we found
examiners generally failed to hold boards responsible for identified
deficiencies until the bank was in poor condition. We also found
many instances in which examiners took an "impersonal" approach to
communicating their findings. By impersonal we mean that generally
examiners do not specifically hold bank boards and management
directly responsible for the problems identified, until the problems
become quite severe. For example, in a 1987 examination report of a
1990 failed bank, an examiner cited repeated deficiencies in the
bank's lending practices and asset growth. In the report, the
examiner cited that "the bank is especially vulnerable to conditions
in the market..." However, by 1989, conditions at the bank had
substantially worsened. In the 1989 examination report, the examiner
directly blamed the bank's supervision and administration by the
board of directors for failing to correct the identified
deficiencies.
We discussed this impersonal approach with FDIC and OCC officials who
generally agreed that their examiners are prone to use such an
approach in examination reports unless a bank's problems go
uncorrected, are repeated, or become severe. Officials also told us
that examiners do not need to personally direct their findings toward
a board in the examination report of banks with limited problems.
Officials also told us that boards are responsible for seeing that
corrective actions are implemented.
Although we recognize that examiners address reports to banks' boards
of directors, we believe examiners should make all of their implicit
examination findings explicit in all written and oral communications.
Examiners should clearly state in their findings--for banks that
warrant corrective action--that a bank's board is responsible for
ensuring that such action is taken.
The Federal Reserve's bank examination manual outlines that by
communicating problems to bank boards examiners can
"ensure that each director of a [bank] considered to be a
`problem' organization or identified as having a significant
weakness, will clearly understand the nature and dimension of
their organization's problems and the responsibilities of its
board of directors to correct them."
In our interviews with Federal Reserve officials and in documents we
reviewed, we found the Federal Reserve requires that examiners send a
separate summary of their examination findings to each director of a
bank with a composite CAMEL rating of 3 or worse.\2
These summary reports focus on key issues needing the board's
attention. To acknowledge the contents of the summary examination
report, each director is to sign his or her copy of the summary and
return it to the bank.
We believe all examiners should better communicate with boards and
directors. Such communication would help to ensure that directors
understand the nature of problems and their responsibilities to
correct such problems.
--------------------
\2 The summary examination report is also sent to directors of banks
that receive a CAMEL rating of 1 or 2 and show a significant
deterioration in condition or violations of law.
BANK BOARDS OF DIRECTORS HAVE A
RESPONSIBILITY TO CORRECT
IDENTIFIED PROBLEMS
---------------------------------------------------------- Chapter 6:2
In our review of failed banks, we found directors were often not
actively involved in the supervision of their banks' operations and
management. In addition, in our review of open banks, we found
instances where directors appeared passive in their oversight
function and nonresponsive to deficiencies found by federal
examiners. In several instances, directors failed to understand the
seriousness of examination findings.
From our review of the examination reports for the open banks and on
the basis of our conversations with the participants in our focus
groups, we found three possible reasons boards of directors can be
passive in their oversight of banks. These reasons are as follows:
(1) a lack of understanding regarding examination findings, (2) a
lack of assistance from the regulators, and (3) limited training
opportunities available specifically for bank directors.
SOME DIRECTORS FAILED TO
UNDERSTAND THE SERIOUSNESS
OF EXAMINATION FINDINGS
-------------------------------------------------------- Chapter 6:2.1
In our review of the banks that failed in 1990 and 1991, we found
that investigators cited that about 90 percent of the banks had
passive or negligent directors. In addition, in an OCC report on
national banks that failed from 1979 to 1987, OCC noted that 60
percent of these failed banks had uninformed or passive boards of
directors.\3 Both OCC and we found directors' negligence contributed
to the failure of the banks. The directors of the banks seem not to
have understood their roles and responsibilities or how to
effectively maintain or return the banks to a financially sound
position.
In our review of federal examination reports of 13 open banks, we
found instances of passive or uninformed directors. In these
instances, federal examiners noted that some boards of directors and
individual directors failed to understand the seriousness of the
examination findings; in some instances, they also failed to take
corrective actions on the identified deficiencies.
--------------------
\3 Bank Failure: An Evaluation of The Factors Contributing to The
Failure of National Banks Office of the Comptroller of the Currency
Report (Washington, D.C.:June 1988).
BETTER ASSISTANCE FROM
REGULATORS CAN AID DIRECTORS
-------------------------------------------------------- Chapter 6:2.2
The participants in our focus groups expressed a need for better
assistance from regulators to aid them in their responsibilities as
bank directors. According to their comments, they believe better
assistance from the regulators could consist of providing thorough
explanations of examination findings, offering suggestive corrective
actions to alleviate the identified deficiencies, and providing
clarifications on the constantly changing and complex banking laws.
However, assistance from the regulators would only be most effective
when boards of directors are willing to work with the examiners.
LIMITED TRAINING
OPPORTUNITIES AVAILABLE
SPECIFICALLY FOR OUTSIDE
BANK DIRECTORS
-------------------------------------------------------- Chapter 6:2.3
We found the directors in our focus groups and those in the meetings
we held with the boards of directors appeared knowledgeable of their
responsibilities as directors and the banking laws and regulations,
such as Regulation O and FDICIA.
However, we believe additional training opportunities could increase
directors' knowledge and effectiveness in their supervision of banks,
particularly in today's banking regulatory environment. For example,
since 1986 new federal banking laws have been enacted, such as FIRREA
and FDICIA, which have resulted in a number of new regulations, set
additional supervisory guidelines, and required additional regulatory
reports from banks. Participants of our focus groups expressed a
need for training--such as banking seminars and conferences--to keep
them informed of these changes in the banking industry. In addition,
officials from the Office of Thrift Supervision (OTS) told us that
many directors of thrifts refuse to make insider loans because of the
complexity of federal regulations governing insider activity. Also,
OTS' General Counsel receives a number of requests daily from
directors for interpretations of banking laws and regulations,
particularly Regulation O.
FEDERAL REGULATORS COULD
RECOMMEND TRAINING AS
CORRECTIVE MEASURE
-------------------------------------------------------- Chapter 6:2.4
In our review of the examination reports of both the failed and open
banks, we found no instances where federal examiners recommended
training or educational courses as a corrective measure when
examination findings suggested bank management and directors lacked
knowledge or skills to effectively supervise their banks. However,
in some of these reports it was clear that some form of training
could have enhanced the overall performance of the board of
directors. We believe that in instances where examiners determine
that directors do not understand banking operations or what actions
are needed to correct identified deficiencies, training may be a
helpful resource.
Federal regulators told us they do not recommend training for
directors as a corrective measure. Each of the federal regulators
believes it is ultimately the responsibility of a bank director to
obtain the skills and knowledge of banking needed to effectively
supervise banks. Officials from the federal bank regulators told us
the agencies' main function is to evaluate the financial safety of
banks. They also said that although federal bank regulators have
recognized the importance of knowledgeable and responsible bank
directors, federal regulators do not have a formal or structured
training program for the directors. We found that some training
opportunities exist for bank directors. We discuss these training
opportunities in appendix VI.
CONCLUSIONS
---------------------------------------------------------- Chapter 6:3
In our analysis of failed banks, we found that repeated insider
violations and management and insider problems caused the banks to
deteriorate and ultimately to fail. We believe the failure to
correct repeated violations may result, in part, because examiners do
not always effectively communicate the seriousness of examination
findings and the role the board is to play in correcting
deficiencies.
We believe directors, individually, need not possess all of the
skills and abilities necessary to understand the specific activities
of the bank. However, each board, collectively, has a responsibility
to have sufficient expertise to effectively oversee bank management's
activities. Directors also have to understand their responsibilities
when presented with examination findings. In instances where the
board appears to not understand the identified deficiencies or
possible corrective actions, training may be useful, especially with
the frequent changes in federal banking laws.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 6:4
To improve the communication between examiners and bank boards and
increase the likelihood that boards will initiate appropriate
corrective actions we have a recommendation. We recommend that the
Board of Governors of the Federal Reserve System, the Comptroller of
the Currency, and the Chairman of the FDIC direct examiners to better
ensure--through examination reports, exit conferences, and any other
appropriate means--that all directors understand (1) the primary
issues in need of the board's attention, (2) that the problems facing
a bank are most often a consequence of deficiencies in the overall
management and oversight by the boards of directors, and (3) that the
board must see that effective corrective action is taken. In
addition, when directors do not understand the problems examiners
identify or potential corrective measures, federal regulators should,
when appropriate, recommend training to improve the directors'
abilities to oversee the management of banks.
AGENCY COMMENTS AND OUR
EVALUATION
---------------------------------------------------------- Chapter 6:5
OCC officials agreed with our recommendation and said that it will
reinforce its guidance for examiners to better ensure that bank
boards understand the issues they must address. OCC is also
considering additional changes to its guidance to draw examiner
attention to the possible need for them to recommend training for
directors. (See app. VII.)
The Federal Reserve officials agreed with our findings and
conclusions but stated it already has policies in place to address
our recommendations. We believe the Federal Reserve could take
additional steps to communicate the need for corrective actions and
provide more assistance to bank directors and management in
accomplishing the corrections. The Federal Reserve's written
examination summary, which is provided to each director, is a good
step in this direction. However, we believe the steps we outline in
this chapter would provide additional assurances that identified
deficiencies are understood and corrected before they negatively
affect a bank's financial health. (See app. IX.)
FDIC officials agreed with our findings and conclusions, but stated
FDIC already has policies in place to address these recommendations.
On the basis of our review and our discussions with bank directors,
we found that these policies are not consistently adhered to. In
addition, we believe there are additional opportunities for improving
communication between FDIC and bank boards and management. In a
subsequent letter, FDIC agreed to reemphasize the importance of
effective communication with boards of directors and adherence to
established policies and procedures. (See app. VIII.)
OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I
As discussed in chapter 1, we had the following five objectives for
this review:
Determine the frequency of various insider activities at selected
failed and open banks and the potential impact of insider
activities on the safety and soundness of bank operations.
Evaluate the effectiveness of the regulators of federal financial
institutions to identify and supervise insider activities at
banks.
Determine the underlying causes of insider problems, specifically
whether there is an association between insider problems and
broader managerial or operational problems in failed and open
banks.
Determine the overall extent of loans to insiders at failed and
open banks.
Compare state banking laws and regulations with federal Regulation
O and analyze state examination policies and procedures
governing insider activities.
More detailed information on our scope and the methodologies we used
to address the first, third, fourth, and fifth objectives follows.
For our first objective, we collected the information on the 286
banks that failed in calendar years 1990 and 1991 on a two-part form,
or data collection instrument (DCI), that we designed and pretested.
To address the requesters' question about the frequency of insider
activities, we completed part I of the DCI for 286 bank
investigations. Part I focused on the reasons for a bank's failure.
These reasons include an assessment by the investigator as to whether
insider problems played a major role in the bank's failure; the types
and nature of the insider problems, as identified by the
investigator; and the extent to which recoveries from directors,
officers, and others are likely. We then completed part II only for
those cases where investigators identified insider problems as being
a factor in the failure of the bank.
We collected specific information on the types of insider activities
identified by the investigator and the other management and economic
problems that led to the failure of the banks.\1 We also collected
the same information from the examination reports and accompanying
workpapers of the 175 banks for the 3 years before the banks failed.
To design part I of the DCI, we reviewed examination reports from
prior studies to develop a comprehensive list of insider activities
and management problems. We field tested this DCI at two FDIC field
offices. FDIC officials at these offices reviewed our list of
insider activities and management problems. On the basis of their
comments, we refined our list as necessary. Our explanations of
insider activities are generally consistent with those discussed in
the Office of the Comptroller of the Currency's (OCC) study of bank
failures.\2 Explanations of the major insider activities and
management problems we focused on are as follows.
Operating Losses. Operating losses refer to losses associated with
the pricing of products, the processing of bank transactions, or
unusually high personnel costs. For example, a bank that has an
antiquated computer system may experience delays in processing
transactions, which increases costs to the bank when cash cannot be
deposited immediately.
Excessive Growth. For a bank, growth generally refers to its loan
portfolio, either through increased lending or through acquisitions
of other banks' assets (i.e., loans). A bank may grow rapidly
without experiencing excessive growth if the bank's systems and
staffing also grow to keep pace with the growth of the loan
portfolio.
Excessive Dividends. Dividends paid to shareholders are excessive
when the bank has insufficient profits to pay them.
High-Risk Exposure. High-risk exposure occurs when a bank's loan
portfolio is concentrated in high-risk loans, such as those in
commercial real estate made on land alone.
Poor and/or Negligent Management. This is failure of management to
exercise due care in the management of the bank.
Passive and/or Negligent Board. This is caused by failure of the
board to properly oversee management's operation of the bank.
Failure to Respond to Regulatory Criticism. This condition is
present when the regulator repeatedly has cited the same problems at
a bank and the bank's directors took only partial, little, or no
action to correct the problems.
Lack of Expertise of the Board or Management. Although individual
board directors need not have a thorough knowledge of the intricacies
of banking, the board as a whole should have sufficient expertise to
oversee management's operations. Management should have the
expertise to manage the lines of business of the bank. For example,
if the management of a small bank decided to enter the derivative
products market but the bank had no staff experienced in this complex
product line, the bank could have problems because of the staff's
lack of expertise.
Dominant Board Member/Dominant Executive. This term refers to a
director, officer, or small group who unduly influences the
decisionmaking process within the bank to the extent that dissenting
voices were either not allowed or not heard.
Insider Abuse/Insider Fraud. There are clear distinctions between
insider abuse and insider fraud. Insider abuse is abuse that falls
short of being a criminal act. It occurs when an insider (as defined
by Regulation O) benefits personally from some abusive action he/she
takes as part of his/her position at the bank. Not all insider
violations are necessarily abusive; the violation must be accompanied
by personal gain to the insider to be considered abusive. Insider
fraud is a criminal act. Such action includes embezzlement,
falsifying documents, and check kiting. The actions must have been
perpetrated by an insider, as defined in Regulation O. However,
unlike insider abuse, insider fraud does not have to benefit the
individual perpetrating the crime. For example, if a bank president
falsifies loan documents to improve the apparent creditworthiness of
a borrower, this is fraud--even if no personal gain by the president
can be identified.
Lack of or Inadequate Systems to Ensure Compliance With Laws and
Regulations. This is present when the bank is criticized for lacking
a system or program to identify and avert potential violations of law
or regulation. Also, this may indicate a failure of the board or
management to properly assign responsibility for correcting
deficiencies cited by examiners.
Lack of or Inadequate Lending Policies, Lax Lending Practices, and
Inadequate Credit Administration. There are clear distinctions among
these terms. A bank should have in place specific lending policies
to cover the various types of lending it does. The policies serve as
instructions for the lending officers. Lax lending practices deal
with the issuance of loans, whether they are made on a sound basis,
and whether the bank obtained adequate credit information on the
borrower before deciding to lend. The composition of a bank's loan
portfolio can also indicate lax lending practices. For example, if a
bank's loan portfolio is highly concentrated in a specific type of
loans (e.g., commercial real estate) or if there are a lot of loans
to uncreditworthy borrowers, it indicates that the bank has lax
lending practices. Inadequate credit administration refers to how
the bank manages its loans after they have been made. Such
criticisms as failure to maintain current appraisals, failure to
obtain periodic credit information on borrowers, and inadequate
documentation in the loan files all point to inadequate credit
administration.
Loans to Insiders. Loans to insiders refer to loan losses to
individuals defined as insiders by Regulation O. Tellers and loan
officers generally do not meet the definition of insider for
Regulation O purposes.
Excessive Compensation. This refers to compensation to officers or
board members that an investigator or examiner has identified as
beyond what is typical for the bank, considering its financial
situation and comparing it to other similarly sized and located
banks.
Improper Affiliate Transactions. These are violations of section 23A
and 23B of the Federal Reserve Act.
As part of our review of the examination histories of the 175 banks
with insider problems, we also reviewed any enforcement actions taken
by the regulators against the banks. So that we could have complete
information, we also obtained from FDIC, OCC, the Federal Reserve,
and the Securities and Exchange Commission (SEC) information on the
enforcement actions they had taken against the former officers and
directors after the failures of all 286 banks.\3
To better understand the issues related to potential recoveries from
negligent officers and directors, we also talked with representatives
of insurance companies that offer directors and officers (D&O)
liability insurance policies.
After we had completed our data collection efforts on the failed
banks, we contacted the DOL investigators in charge for 18 randomly
selected banks to verify that as their investigations continued, the
conclusions they presented in the post-closing reports as to the
reasons for the banks' failures had not changed.
We did our work on the failed banks in Washington, D.C., and the 14
FDIC-DOL consolidated field offices located in Irvine and San Jose,
California; Denver, Colorado; East Hartford, Connecticut; Orlando,
Florida; Atlanta, Georgia; O'Hare (Rosemont), Illinois; Bossier City,
Louisiana; Franklin, Massachusetts; South Brunswick, New Jersey;
Oklahoma City, Oklahoma; and Addison, Houston, and San Antonio,
Texas.
We also reviewed a judgmentally selected sample of 13 open banks.
Our objectives were to determine whether the same types of insider
and management problems we found in the failed banks were also
present in open banks. The 13 banks included banks supervised by all
3 federal bank regulators and were located in various geographic
parts of the country. We selected only banks with a composite CAMEL
rating of 3 or better because we did not want to purposely select
banks with a higher likelihood of having problems. In addition, we
did not want to select banks where the level of regulatory activity
might be higher and our presence at the regulatory agency might
impede the supervisory process. All of the 13 banks we selected had
recent federal bank examinations. We used this criterion because we
wanted to interview the current examiner in charge about the history
and most current conditions at the banks.
For each bank, we prepared a case study in which we focused on the
efforts of the federal regulators to review insider and management
problems. We collected information on insider activities as defined
by Regulation O, affiliate transactions, and the efforts of
management and the bank's board to operate and manage the bank with
due care. We also collected general financial information and some
bank history for each bank. We used examination reports for the 5
years prior to our review, available financial information, and bank
publications obtained by the examiners. Finally, we conducted
in-depth interviews with the examiner in charge of the most recent
federal bank examination.
We did our work on open banks at FDIC, OCC, and the Federal Reserve
headquarters in Washington, D.C., and at the FDIC field offices in
New York and Syracuse, New York; Rolling Meadows and Burr Ridge,
Illinois; and San Francisco, California; at the OCC field offices in
Great Neck and New York, New York; Bensalem, Pennsylvania; Rockford
and Chicago, Illinois; and Evansville, Indiana; and at the Federal
Reserve banks in Philadelphia, Pennsylvania, and San Francisco,
California. We discuss the overall results of our work on insider
and management problems in failed and open banks in chapters 2 and 3.
To determine the underlying causes of insider problems, we conducted
focus groups and interviews with bank directors. We also collected
information on training opportunities for bank directors. Additional
information on our interviews and focus groups with bank directors
and training for bank directors follows.
The analysis of our results from the failed and open bank work led us
to consider further the key role played by the board of directors in
ensuring that a bank is managed properly, that problems requiring
correction receive attention, and that insider problems do not occur.
As a result, we decided to obtain additional information directly
from bank directors. We used two approaches to do this. First, we
met with four boards of directors of the open banks we reviewed who
were willing to meet with us. Second, we conducted six focus groups
with randomly selected bank board members from a variety of large and
small banks in the Washington, D.C., New York, and Chicago
metropolitan areas. With both the full bank boards and the focus
groups we discussed the following general issues:
the roles and responsibilities of bank directors;
how directors actually discharge their duties;
how the regulators work with board members and management to ensure
the safe and sound operation of a bank;
the effects of recent legislative and regulatory changes (most
notably the Federal Deposit Insurance Corporation Improvement
Act) on the environment in which they operate; and
information, guidance, and training available to directors.
We present the results of this work in chapters 5 and 6.
We did our work for this segment of the evaluation in Washington,
D.C., New York, and Chicago, and at four selected open banks around
the country.
Evidence from our failed bank work indicated that in some cases bank
directors had little knowledge about their duties and
responsibilities or had received little training regarding their
corporate governance responsibilities. In our meetings with the
directors of the open banks and our focus groups bank directors also
said they had received little training when they accepted invitations
to become board members, and some of them expressed concerns about
their ability to keep up with rapidly changing banking laws,
regulations, and regulatory directives. As a result of the
directors' comments, we decided to obtain information on the nature
and types of educational programs available for directors.
To do the work for this objective, we interviewed officials of
federal and state bank regulatory agencies, insurance companies that
supply banks with D&O insurance coverage, bank trade associations,
and private sector firms involved in the banking industry. We
interviewed these officials to collect information on how they inform
or educate bank directors on corporate governance responsibilities or
other aspects of banking. When available, we reviewed the
educational materials, such as pamphlets and handbooks, supplied to
directors. We also reviewed the educational materials used in
various conferences, seminars, and workshops held for bank directors.
We discuss the results of this work in chapter 6.
We did this work in Washington, D.C. We also obtained information to
satisfy this objective at various state banking agencies we visited
(see objective 4 for specific locations).
Our fourth objective was to determine the overall extent of loans to
insiders at failed and open banks. One section of part II of the DCI
required the GAO evaluator to develop an extensive list of
insiders--officers, board members, major shareholders, and their
related interests--using all of the available documents at the DOL
office. These documents include examination reports and enforcement
actions, investigative files, and asset searches ordered by
investigators. In some cases, investigators had developed lists that
we supplemented with other available information; in others, we had
to do much more extensive research to develop these lists. We
developed these lists to match the names on them against those on the
loans of DOL's Liquidation Asset Management Information System
(LAMIS) database. Using these matches along with additional matches
with other databases --principally pools of loans being managed by
servicers for FDIC --we expected to be able to estimate the amount,
at a minimum, of loans to insiders; the amounts charged off, or lost;
and the amounts that could be lost (i.e., loans to insiders that were
classified as substandard or doubtful). We tried to compile a list
of loans to insiders and their related interests that may have
resulted in losses to Bank Insurance Fund. Because of difficulties
we encountered in using the LAMIS database for these purposes, we
alternatively decided to attempt to match our loan lists to LAMIS
data for 10 selected failed banks. We selected these banks on the
basis of the availability of insider-related data, asset size, and
geographical location. We discuss the results of our work in chapter
4 and appendix IV.
For open banks, we relied on data available in call reports to
determine the total amount of insider lending in open banks. We used
the most recently reported call report data, dated March 1993.
In his request letter, Chairman Gonzalez specified 10 states whose
banking laws and regulations he wanted us to review. These states
were California, Florida, Illinois, Massachusetts, New Jersey, New
York, North Carolina, Ohio, Pennsylvania, and Texas. For our fifth
objective, to compare state banking laws with Regulation O, we
requested information on the state laws and regulations regarding
insider activities, state examination procedures for reviewing these
activities, and any special programs for review of insider activities
at banks or programs related to educational outreach for boards of
directors. We then visited the state banking agencies of 6 of these
10 states. We also conducted telephone interviews with knowledgeable
officials in three other of these states. We were unable to visit or
conduct a telephone interview with officials of the New Jersey
Department of Banking.
To ensure that we were capturing information on any state laws that
might be more stringent than federal law and regulations, we surveyed
the banking agencies of the remaining 40 states, the District of
Columbia, the Commonwealth of Puerto Rico, and two territories (Guam
and the U.S. Virgin Islands) about their state laws and regulations
that related to 5 key provisions of Regulation O. Those provisions
were the definition of insiders, preferential terms, lending limits,
prior board approval, and overdrafts. (See ch. 1 for information on
these provisions in Regulation O.) We conducted our survey with the
assistance of the State Conference of State Bank Supervisors, who
received and forwarded to us 40 responses out of 44 surveys sent out
under its cover letter. On the basis of our analysis of the survey
results, we also visited and collected information from state banking
agencies in Montana, Iowa, Minnesota, and Virginia.
We discuss the results of our review of state laws and regulations
and state examination policies and procedures in appendix V. We
discuss the results of our work on state banking agency educational
efforts in appendix VI.
We did this work in Washington, D.C., and at the state banking agency
headquarters in San Francisco, California; Springfield, Illinois; Des
Moines, Iowa; Boston, Massachusetts; St. Paul, Minnesota; Helena,
Montana; New York, New York; Harrisburg, Pennsylvania; Austin, Texas;
and Richmond, Virginia.
--------------------
\1 In addition to wanting to capture all of the reasons a bank may
have failed, we focused on other problems. We also focused on
specific problems of insider abuse, insider fraud, loan losses to
insiders, and insider violations because field testing of our DCI
indicated they were important.
\2 Bank Failure: An Evaluation of the Factors Contributing to the
Failure of National Banks Office of the Comptroller of the Currency,
(Washington, DC: 1988).
\3 SEC, although not a bank regulator, can propose post-failure
enforcement actions when it determines that such parties violated the
antifraud, reporting, and internal accounting provision of federal
securities laws.
INSIDER ACTIVITIES AT THRIFTS AND
CREDIT UNIONS
========================================================== Appendix II
INSIDER ACTIVITIES AT THRIFTS
-------------------------------------------------------- Appendix II:1
The Office of Thrift Supervision (OTS) is responsible for supervising
the 1,954 active, federally insured thrifts. OTS conducts both
safety and soundness and compliance examinations as part of this
supervision process. During 1991, OTS adopted a policy of annual
examinations for all thrifts. Before 1991, OTS conducted biannual
examinations. In 1991, OTS conducted an on-site, risk-focused
examination of every institution it regulates. In addition, OTS
conducted 793 compliance examinations that included assessments of
how well thrifts complied with consumer laws, such as the Community
Reinvestment Act.
Affiliate transactions and insider loans at thrifts generally are
subject to FRA 23A and 23B and FRA 22(g) and 22(h) to the same extent
as if they were banks. Transactions between savings associations and
their affiliates are subject to restrictions set forth in 12 C.F.R.
563.41 and 563.42. Loans to insiders or their related interests are
governed under 12 C.F.R. 563.43, which generally incorporates
Regulation O by reference. This regulation became effective on
November 5, 1992.
The following are examples of general insider lending restrictions
under Regulation O, incorporated by 12 C.F.R. 563.43, as they apply
to thrifts:
General loan requirements: Loans must be approved in advance by a
majority of the entire board of directors, not be on
preferential terms, and not exceed aggregate individual and
overall lending limits.
Lending limits: The aggregate amount of all transactions with
insiders and their related interests generally may not exceed
100 percent of an institution's unimpaired capital and
unimpaired surplus. Individual lending limits for loans that
are not fully secured are limited to 15 percent of unimpaired
capital and unimpaired surplus, with an additional limit of 10
percent of unimpaired capital and unimpaired surplus for loans
that are fully secured.
OTS uses the same enforcement powers as bank regulators to get
thrifts to correct identified problems. The Financial Institutions
Reform, Recovery and Enforcement Act of 1991 expanded OTS' authority
to issue civil money penalties to make it identical to that of the
bank regulatory agencies. OTS has issued numerous (1) cease and
desist orders requiring restitution and other affirmative relief, (2)
supervisory agreements, (3) orders of removal and prohibition, (4)
civil money penalties, (5) debarments of professionals from agency
practice, and (6) capital directives and other remedial measures.
OTS has also imposed restitution orders on individuals who abused
thrifts. For example, in 1991, OTS obtained restitution of $43
million.
OTS reported that while the total number of initiated or completed
enforcement actions decreased in 1992 compared to 1991, the overall
level of enforcement activity remained high. In addition, OTS
reported that the decrease in the number of actions reflected the
continuing improvement in the quality of management in the industry
and the decrease in the number of problem institutions.
Historically, insider abuses have been relatively common in the
thrift industry. In the 1980s, several particularly egregious and
well-publicized insider abuse cases were discovered. For example,
the Lincoln Savings and Loan Association case involved prohibited
affiliate transactions. Although OTS has reported that the thrift
industry is steadily recovering from past abuses, a 1993 OTS report
documents one of the largest fraudulent "daisy chain" networks ever
discovered by OTS. This case uncovered more than a dozen
transactions involving self-dealing and improper insider loans to a
group of officers and directors.
INSIDER ACTIVITIES AT CREDIT
UNIONS
-------------------------------------------------------- Appendix II:2
Laws and regulations governing insider activities at credit unions
are similar to those applicable to banks. For example, the Federal
Credit Union Act provides for board approval for loans of more than
specified dollar amounts to directors or members of the supervisory
or credit committees. Regulations also prohibit specific conflicts
of interest and insider self-dealing. Article XIX, section 4, of the
Federal Credit Union bylaws provides that no official shall
"participate in the deliberation upon or the determination of
any question affecting his pecuniary interest or the pecuniary
interest of any corporation, partnership or association in which
he is directly or indirectly interested."
The National Credit Union Administration (NCUA) is responsible for
supervising the 7,916 active,\1 federally insured credit unions. As
part of this supervision, NCUA conducts examinations of credit
unions, and each credit union receives a CAMEL rating. As of
December 31, 1992, 4,582 credit unions had a rating of 1 or 2, 2,945
had a rating of 3, and 389 had a rating of 4 or 5. NCUA examination
policy states that examiners need to be alert for any potential
insider dealings or conflict-of-interest problems. The NCUA
Examiner's Guide discusses types of insider problems, including loans
to insiders at preferential terms and the ownership of fixed assets
by officials who borrow from a credit union to purchase an asset,
lease it back to the credit union, and receive commissions or a fee
from the credit union or its members. Because insider lending is the
most common area for insider problems, the guide includes specific
directives for evaluating lending to insiders. NCUA has available to
it enforcement powers similar to those used by bank regulators.
FIRREA broadened NCUA's authority to issue civil money penalties.
An NCUA official told us that NCUA has improved training for
examiners in this area. For example, senior examiners are required
to take a 5-day course on fraud and abuse. In addition, NCUA has a
fraud hotline that anyone can use to report suspected fraud at credit
unions to the General Counsel's office. The official told us that
all calls are investigated. About 10 percent turn out to be fraud or
abuse. An NCUA official told us that NCUA receives an average of
three calls per month on the hotline.
In our comprehensive review of credit unions,\2 we studied insider
activities. In general, we found that insider problems were not a
major cause of credit union failures. NCUA officials told us that in
the last half of the 1980s, insider abuse was more prevalent than it
is now. The officials emphasized that during the late 1980s, the
instances of insider problems were few but when they occurred, they
were usually very costly. For example, the failure of the Franklin
Community Credit Union in 1989, which was caused by massive fraud,
cost the Share Insurance Fund about $40 million. NCUA officials told
us that in the past few years the proportion of losses due to insider
problems has decreased substantially compared to losses due to other
factors. However, the largest single loss to the Share Insurance
Fund in recent years, $19 million, was due to the 1991 failure of the
Barnstable Community Federal Credit Union, which occurred because of
massive fraud. NCUA officials told us that this was the only major
case of insider fraud they had uncovered in recent years.
(See figure in printed edition.)Appendix III
--------------------
\1 As of December 31, 1992.
\2 Credit Unions: Reforms for Ensuring Future Soundness
(GAO/GGD-91-85, July 10, 1991).
FEDERAL RESERVE REGULATION O
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
GAO'S ATTEMPT TO USE LAMIS
DATABASE TO IDENTIFY THE EXTENT OF
INSIDER LENDING AT FAILED BANKS
========================================================== Appendix IV
When a bank fails, FDIC receives and services all of the bank's loans
that are not sold to an acquirer or transferred to an outside loan
servicer. Of the 286 banks that failed in 1990 or 1991, FDIC
contracted out loans from 8 of the largest banks to 7 outside loan
servicers. FDIC officials told us that they do not maintain
automated data on individual loans that they are not servicing.
However, for those loans that FDIC does retain, DOL maintains
individual loan data on its LAMIS database. Thus, we could access
only varying portions of each bank's loan portfolio. LAMIS was the
only automated source available through which we could access
significant portions of the loan portfolios of failed banks.
In preliminary meetings with senior DOL officials, we were told that
LAMIS could provide us with data on the extent of lending to insiders
for all loans maintained on LAMIS (i.e., all loans that were not sold
or transferred to an outside servicer). Although LAMIS contains a
broad range of data on the assets retained by FDIC, it does not
contain a data field that identifies insider loans. However, DOL
officials told us such data could be derived from LAMIS if we could
provide DOL staff with a list of names and related interests for the
insiders at a given bank. To do so, DOL would need to develop a
computer program that would match borrowers listed on LAMIS with our
list of insiders and their related interests.
To determine whether it was feasible to identify insider-related
loans through LAMIS, we provided FDIC with an extensive list of
insiders and their related interests from bank failures associated
with the James Madison Limited holding company. This list had been
developed for one of our prior reports on the Bank of New England and
Madison failures.\1 To prepare for that report, we reviewed data
developed by the Office of the Comptroller of the Currency (OCC),
which indicated that loans to Madison insiders totaled $83 million
(or 17 percent of all loans). We then attempted to match the names
of the Madison's insiders and their related interests to the names on
the LAMIS database for Madison. If the match program produced
results that were generally in agreement with the OCC data, we felt
we could be reasonably confident that the match had been effective.
--------------------
\1 Bank Supervision: OCC's Supervision of the Bank of New England
Was Not Timely or Forceful (GAO/GGD-91-128, Sept. 16, 1991).
TEST CASE OF LAMIS MATCH PROVES
PROBLEMATIC BUT YIELDS SOME
ENCOURAGING RESULTS
-------------------------------------------------------- Appendix IV:1
LAMIS contained the names of more than 8,000 Madison borrowers,\2
and our list contained the names of more than 500 insiders and their
related interests. Given the extensive lending to Madison insiders
described in our prior report, we anticipated the match would
identify a significant number of insider-related loans.
Unfortunately, the computer matching program developed by DOL staff
did not identify any insider-related loans.
DOL staff told us that one of the principal difficulties they
encountered was the inability of DOL's program to compensate for
various derivations of names. For example, if LAMIS listed a
borrower as Smith & Co. and our list identified the same
organization as Smith and Company, the computer would not recognize
this as a match and the loan would not be identified as
insider-related. Still, given the extensive amount of lending to
insiders that occurred and the large number of borrowers and known
insiders, we believed it highly implausible that no two names were
identical.
We requested and DOL agreed to provide computer tapes of the LAMIS
data for Madison. We developed a computer program that identified a
small number of loans to insiders in which the name on LAMIS and the
name on our list were identical. Later, we realized this effort was
inadequate given the extent of insider lending at Madison banks.
We next devised a computer program that matched names using only the
first four characters of the borrower's name with the first four
characters of the insider's name. Using the same example presented
earlier, the name on our list (Smith and Company) would now match the
name as it appears on LAMIS (Smith & Co.). However, the name would
also match with every other "Smith" listed on LAMIS. The result of
this program was a listing of nearly 1,200 potential matches, each
needing manual review to determine whether it was, in fact, an
insider-related loan.
To reduce the amount of manual review needed to identify loans that
were insider-related, we eliminated all loans of less than $10,000
and ran the program again. Using this approach, we reduced the
number of potential matches to 695. From these, we manually
identified 153 matches. These matches were further reviewed to
eliminate double counting of loans for which more than one insider
had been listed as a borrower. In our final count, we identified 127
insider related loans involving amounts of $10,000 or more.
Our analysis of these insider-related loans showed the aggregate loan
amount to be $71 million dollars. This amount represented
approximately 18 percent of the Madison loans of $10,000 or more
listed on LAMIS. Because this percentage was in line with the level
of insider lending activity identified by OCC shortly before
Madison's failure, we believe our approach resulted in a reasonable
estimate of the insider lending activity at Madison.
Finally, we ran an analysis of the insider-related loans to determine
the extent to which these loans were nonperforming.\3
We found that 85 percent of insider loans and 83 percent of Madison's
entire loan portfolio were nonperforming loans. Because we had not
anticipated such a high percentage of nonperforming loans,\4 we asked
DOL staff to review our approach and results to determine whether
they found them reasonable. DOL staff had no concerns with our
approach and said they reached a similar percentage of nonperforming
loans when they tested data from Madison on LAMIS.
--------------------
\2 This number represents the number of entries listed on the LAMIS
"Borrower Query File" for Madison. It overstates the number of
borrowers (i.e., borrowers, co-signers, and guarantors) because those
involved with a number of loans are listed repeatedly.
\3 In general, these were loans that were more than 90 days past due
or for which the terms of the original loan agreement were
renegotiated.
\4 Although we had not developed data specifically on nonperforming
loans at Madison before it failed, we found that 43 percent (i.e.,
about half of what is now nonperforming) of Madison's loans were
criticized by OCC as having a less than satisfactory likelihood of
repayment.
APPLYING THE MATCH PROGRAM TO A
LARGE NUMBER OF BANKS IS
IMPRACTICAL
-------------------------------------------------------- Appendix IV:2
Although we were generally satisfied that the results from the test
match were a fair approximation of the extent of insider lending at
Madison, we recognized that there were several impediments to
applying this approach to a large number of failed banks. For
example, developing a comprehensive list of insiders and their
related interests involved a significant amount of work. Even when a
bank maintained records on insiders and their related interests, it
was difficult to determine whether the records were comprehensive.
Often, we found numerous documents had to be reviewed to develop
lists of insiders.
In addition, to effect the match, the names of all insiders and their
identified related interests must be entered into an automated
system. There is also programming time involved to generate the
match for each bank, and more significantly, time is needed to
manually review the potential matches from each bank to determine the
actual number of loans made to bank insiders. Although we believe
few banks would approach the extensive number of insiders and related
interests found at Madison, the resources needed to develop insider
databases for the nearly 300 failures in our universe of matches was
prohibitive.
In addition to the resources involved, we were concerned about the
accuracy and completeness of the data produced by the matches.
Unlike Madison, where we had data on the extent of insider lending
identified before the bank failed, we had no measure by which to
gauge the success of these matches. Further, as we noted earlier in
this section, the percentage of a bank's loan portfolio that is
captured on LAMIS varies from bank to bank. This variation makes it
impossible to obtain complete data on the extent of insider lending
for all failed banks.
Given all these impediments and our concern about the accuracy of the
results, we decided to expand the match to only nine other failed
banks. These banks were selected on the basis of (1) an assessment
by our regional office staff on the extent to which documents held by
FDIC provided complete information on a bank's insiders and their
related interests, (2) the number of borrowers listed on LAMIS for
each bank, and (3) geographic distribution. The results from the
matches for all 10 banks are provided in table IV.1.
Table IV.1
Insider Lending at 10 Failed Banks
(Dollars in thousands)
Insider
Percentage loans as a
of bank's percentage
loans on of all
Bank LAMIS Loan category All Insiders loans
----------------- ---------- ------------------- ------ -------- ----------
Everman National 30% Performing $ $ 0 0%
Bank of Forth 1,005
Worth
Nonperforming 11,628 0 0%
Subtotal (active 12,633 0 0%
loans)
Nonperforming as a 92% 0
percentage of
active loans
Charge-offs 1,788 0 0%
Total (all loans) 14,421 0 0%
Charge-offs as a 12% 0
percentage of all
loans
First National 65% Performing 667 204 31%
Bank of Desoto
Nonperforming 10,372 65 1%
Subtotal (active 11,039 269 2%
loans)
Nonperforming as a 94% 24%
percentage of
active loans
Charge-offs 1,617 0 0%
Total (all loans) 12,656 269 2%
Charge-offs as a 13% 0%
percentage of all
loans
First National 37% Performing 612 48 8%
Bank of Kendale
Nonperforming 6,900 560 8%
Subtotal (active 7,512 608 8%
loans)
Nonperforming as a 92% 92%
percentage of
active loans
Charge-offs 1,031 47 5%
Total (all loans) 8,543 655 8%
Charge-offs as a 12% 7%
percentage of all
loans
Pontchartrain 59% Performing 6,117 0 0%
State Bank
Nonperforming 46,835 1,271 3%
Subtotal (active 52,952 1,271 2%
loans)
Nonperforming as a 88% 100%
percentage of
active loans
Charge-offs 4,262 0 0%
Total (all loans) 57,214 1,271 2%
Charge-offs as a 7% 0%
percentage of all
loans
Southcoast Bank 77% Performing 1,601 0 0%
Corporation
Nonperforming 12,960 1,007 8%
Subtotal (active 14,561 1,007 7%
loans)
Nonperforming as a 89% 100%
percentage of
active loans
Charge-offs 2,465 330 13%
Total (all loans) 17,025 1,337 8%
Charge-offs as a 14% 25%
percentage of all
loans
Madison National 76% Performing 63,437 10,101 16%
Banks
Nonperforming 318,17 56,897 18%
7
Subtotal (active 381,61 66,998 18%
loans) 4
Nonperforming as a 83% 85%
percentage of
active loans
Charge-offs 22,956 4,013 17%
Total (all loans) 404,57 71,011 18%
0
Charge-offs as a 6% 6%
percentage of all
loans
The Landmark Bank 89% Performing 18,417 242 1%
Nonperforming 147,62 14,523 10%
9
Subtotal (active 166,04 14,765 9%
loans) 6
Nonperforming as a 89% 98%
percentage of
active loans
Charge-offs 23,284 2,618 11%
Total (all loans) 189,33 17,383 9%
0
Charge-offs as a 12% 15%
percentage of all
loans
Enfield National 87% Performing 688 0 0%
Bank
Nonperforming 14,464 250 2%
Subtotal (active 15,152 250 2%
loans)
Nonperforming as a 95% 100%
percentage of
active loans
Charge-offs 726 34 5%
Total (all loans) 5,878 284 2%
Charge-offs as a 5% 12%
percentage of all
loans
First Pacific 83% Performing 4,142 0 0%
Bank
Nonperforming 53,054 632 1%
Subtotal (active 57,196 632 1%
loans)
Nonperforming as a 93% 100%
percentage of
active loans
Charge-offs 6,925 0 0%
Total (all loans) 64,121 632 1%
Charge-offs as a 11% 0%
percentage of all
loans
Citizens National 43% Performing 138 0 0%
Bank of Limon
Nonperforming 2,124 0 0%
Subtotal (active 2,262 0 0%
loans)
Nonperforming as a 94% 0
percentage of
active loans
Charge-offs 683 0 0%
Total (all loans) 2,945 0 0%
Charge-offs as a 23% 0
percentage of all
loans
--------------------------------------------------------------------------------
Note 1: These 10 banks were selected on the basis of (1) our
assessment of the completeness of FDIC's records concerning insiders
and their related interests for each bank, (2) the number of each
bank's borrowers listed on LAMIS, and (3) geographic distribution.
Note 2: Performing loans are loans that are 97 days or less past due
(a 7-day grace period has been added to the usual threshold of 90
days to allow for data entry lag time in the LAMIS system) and have
not been renegotiated or charged-off.
Note 3: Nonperforming loans are loans that are more than 97 days
past due or have been renegotiated.
Note 4: Charge-offs are loans that have been written off as
uncollectible.
Source: GAO analysis of FDIC data.
STATE LAWS AND REGULATIONS THAT
GOVERN INSIDER ACTIVITIES
=========================================================== Appendix V
In addition to Federal Reserve Regulation O, state laws and
regulations govern insider activities for state-chartered banks. By
surveying state banking laws and regulations governing insider
activity, we found that the majority of states have banking laws
comparable to Regulation O. However, some states have laws that are
more stringent than Regulation O concerning the definition of
insiders, preferential terms, lending limits, prior board of
directors approval, and overdrafts.
We obtained information on state banking laws and regulations from
almost all of the states through a survey we made with the
cooperation of the Conference of State Bank Supervisors. We also
conducted in-depth interviews with officials from state banking
departments in 10 states to obtain information on the examination
policies and procedures they used to detect insider activity. From
these interviews, we found that a few state banking agencies
consistently included a review for insider activity in their
examinations of state-chartered banks. Two state banking agency
officials told us they incorporate a review of insider activity on a
periodic, or as-needed, basis. One state, Texas, has developed,
implemented, and incorporated examination modules to specifically
evaluate the effectiveness of bank management.
SOME STATE BANKING LAWS ARE
MORE STRINGENT THAN REGULATION
O
--------------------------------------------------------- Appendix V:1
Regulation O places certain restrictions on loans to insiders that
are applicable to all federally insured state banks. In addition, on
the basis of responses we received from our survey of state banking
agencies regarding the comparison of their banking laws and
regulations to Regulation O, we found that 12 of the 50 states and
territories that responded to our survey have state banking laws and
regulations about insiders with some provisions that are more
stringent than Regulation O. Prior board of directors approval and
the overall lending limits were the two provisions that we most often
found to be more stringent than the corresponding provisions outlined
in Regulation O.
For example, Kansas banking law requires that any insider loans to
bank officers resulting in total liability of the officer to the bank
of over $10,000 receive prior approval from a bank's board of
directors. Regulation O stipulates that any insider loans which when
aggregated with all other extensions of credit to an insider exceed 5
percent of a bank's unimpaired capital and unimpaired surplus or
$25,000, whichever is greater, must be approved in advance by the
board of directors. In addition, Kansas appears to have more
stringent provisions on lending limits to insiders with a 5-percent
lending limit on loans to bank officers and employees.\1 In
comparison, Regulation O sets the lending at 15 percent of a bank's
capital on loans that are not fully secured and an additional 10
percent of loans that are fully secured. Hawaii's definition of
insiders is more stringent than Regulation O because it also includes
bank employees; agents; and any company, firm, partnership, or
association in which the officers or directors have an indirect or
direct interest. We found that other states also include various
bank employees in their definition of insiders. For example, West
Virginia considers a bank's assistant treasurer, assistant secretary,
assistant cashier, and assistant comptroller to be bank officers
subject to insider-related restrictions.
In one state that responded to our survey, various provisions of its
banking laws are written broadly, but the implementation of the
banking laws is stringent. On the basis of our survey and interview
with the Virginia Banking Commissioner, we found that most of the
state's banking laws about insiders are written to allow for the
judgment and interpretation of the banking commissioner. For
example, the Virginia banking provision on the aggregate lending on
insider loans allows the commissioner to set the aggregate lending
rate at an amount that is "not . . . excessive." In many cases,
the commissioner has set the limit more stringently than that set by
Regulation O.
--------------------
\1 Percentages are of the bank's unimpaired capital and unimpaired
surplus funds.
STATE BANK EXAMINATIONS INCLUDE
A REVIEW OF INSIDER ACTIVITY
--------------------------------------------------------- Appendix V:2
Similar to federal examinations of banks, state examinations of
state-chartered banks also evaluate the financial safety and
soundness of banks. According to state banking officials in several
states where we conducted our interviews, the majority of the state
examinations include a review to determine the extent of insider
activity and how well that activity complied with federal and state
banking laws. From our discussions with the officials, we noted that
state bank examination procedures for insider activity focus mainly
on loans to insiders. These provisions include reviews of loans for
preferential terms; prior approval by boards of directors; and other
insider-related activities, such as overdraft violations.
Some state banking agencies include a very detailed review for
insider activity in every examination. According to officials in the
Florida, Massachusetts, and North Carolina state banking agencies, a
review for insider activity is included in every examination. Their
examination procedures consist of the examination of the banks' loan
portfolios for insider lending and the compliance of insider lending
with applicable state and federal banking laws.
According to banking officials in two states, the scope of their
examinations includes a review for directors and officers (D&O)
liability insurance. Officials said that the review for D&O
liability insurance includes a determination of whether banks have
the insurance and how adequate the insurance coverage is. As we
discussed in chapter 5, we also believe a review to determine the
presence of D&O insurance could be very beneficial. As we found in
our analysis of failed banks, 70 percent of the banks had either let
their D&O insurance lapse before they failed or never had D&O
insurance coverage.
A FEW STATE EXAMINATION
PROGRAMS REVIEW THE
EFFECTIVENESS OF BANK
MANAGEMENT
--------------------------------------------------------- Appendix V:3
Our review of failed and open banks revealed that insider problems
are indicative of management problems in banks. According to
officials in state banking departments, the effectiveness of bank
management is important and plays a vital role in the overall
financial health of banks. A few states have included in their bank
examinations an additional module to independently evaluate bank
management. Many officials we spoke with in the state banking
departments believe an independent evaluation of bank management is
important because it often provides information on aspects of banks'
overall operation, financial performance, and condition. For
example, officials in Minnesota's banking department evaluate bank
management because they believe weak and ineffective management tends
to be the single most significant reason for bank failures.
Because of their belief in the fundamental importance of management,
officials in the Texas banking department implemented and
incorporated into their bank examinations a management evaluation
program that assesses the management of state-chartered banks. The
Texas management evaluation program evaluates management's
performance in five functional areas of bank operations: (1) lending
and credit administration, (2) investments, (3) asset-liability and
funds management, (4) audit and operations, and (5) planning and
budgeting. Each area is reviewed and evaluated on the following five
components: policies, procedures, internal controls, performance,
and prospects. A numeric rating of 1 to 5, with 1 being excellent
and 5 being totally unacceptable, is given to each functional area
based on the review of the five components. An overall management
rating is then derived on the basis of the relative rankings given
each of the five functional areas. On the basis of the overall
management rating, appropriate comments are provided on the
strengths, weaknesses, future plans, and recommendations for each of
the five areas.
Texas officials told us they feel strongly that this program has
reduced the number of bank failures due to managerial incompetence,
director neglect, and insider abuse.
TRAINING OPPORTUNITIES FOR BANK
DIRECTORS
========================================================== Appendix VI
We interviewed federal and state regulatory agencies and some bank
trade associations to determine the various kinds of training
available for bank directors. We found that some training
opportunities are available for bank directors; however, much of the
training available is geared more to bank managers than directors.
Federal regulators have implemented some training for bank directors.
FEDERAL AND STATE REGULATORS
SPONSOR SOME TRAINING
-------------------------------------------------------- Appendix VI:1
Federal bank regulators do not have extensive training programs for
bank directors. However, they do sponsor training programs on a
periodic basis, participate in conferences, seminars, and other
forums sponsored by other groups, including bank trade associations.
For example, each of OCC's district offices is responsible for
developing seminars and workshops for directors of banks in their
vicinity. In another example, the Federal Reserve Bank of
Philadelphia sponsors a seminar on regulatory compliance and holds
annual meetings with all bankers in its district. Officials told us
that many outside directors attend these training sessions.
FDIC, the Federal Reserve, and OCC provide to bank directors a
handbook entitled the Pocket Guide for Directors: Guidelines for
Financial Institution Directors. This publication was developed by
FDIC and endorsed by the Federal Reserve, OCC, and the Federal Home
Loan Bank Board. In addition, each federal regulator distributes its
own publications to directors. OCC distributes The Director's Book:
The Role of A National Bank Director. The Federal Reserve also
distributes publications. For example, the Federal Reserve Bank of
Atlanta has published guidance for directors called The New Bank
Director's Primer: A Guide to Management Oversight and Bank
Regulation for directors of newly chartered financial institutions.
Each of these publications outlines the responsibilities of the
board, highlights areas of concerns, and addresses in broad terms the
duties and liabilities of individual directors.
STATE REGULATORY AGENCY
EFFORTS
------------------------------------------------------ Appendix VI:1.1
Some state bank regulatory agencies we reviewed also sponsor training
programs. Three of the 13 state banking departments we reviewed
offer seminars, workshops, and discussion forums for bank directors.
For example, the North Carolina and Ohio state banking departments
have sponsored annual banking conferences for directors. The
conferences sponsored by North Carolina included such topics as
directors' duties and responsibilities, effective bank management,
and proper board oversight.
BANKING TRADE ASSOCIATIONS
SPONSOR TRAINING PROGRAMS
-------------------------------------------------------- Appendix VI:2
The banking trade associations and other industry groups, such as the
providers of directors and officers liability insurance and law
firms, have provided training opportunities designed mainly for bank
managers. More recently, however, those in the banking industry have
provided some training specifically for bank directors. In addition,
the trade associations also provide journals, informational
pamphlets, and other written materials to directors to keep them
informed and knowledgeable about various banking subjects.
DIRECTOR CERTIFICATE PROGRAM
-------------------------------------------------------- Appendix VI:3
In October 1992, the American Association of Bank Directors (AABD)
established an educational foundation to promote the professional
development of bank and thrift directors. The foundation offers a
director certificate training program through the completion of
continuing education requirements. Directors who complete a 6-hour
core education program and participate in an annual 6-hour
supplemental educational program receive certificates from the
foundation. AABD officials believe the certificate program will
enhance directors' ability to fulfill their oversight
responsibilities.
(See figure in printed edition.)Appendix VII
COMMENTS FROM THE OFFICE OF THE
COMPTROLLER OF THE CURRENCY
========================================================== Appendix VI
(See figure in printed edition.)
(See figure in printed edition.)
The following is GAO's comment on the Comptroller of the Currency's
letter dated February 2, 1994.
GAO COMMENT
-------------------------------------------------------- Appendix VI:4
1. After receiving OCC's comments we reviewed the new report of
examination format. The format includes a page entitled Matters
Requiring Board Attention, which describes the most significant
problems identified during an examination. We agree that the
addition of this information should help board members identify the
most serious problems requiring correction. We believe, and OCC
agrees, that the additional steps we have recommended are also
necessary to improve communications between examiners and boards of
directors.
(See figure in printed edition.)Appendix VIII
COMMENTS FROM THE FEDERAL DEPOSIT
INSURANCE CORPORATION
========================================================== Appendix VI
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on FDIC's letters dated December 9,
1993, and December 23, 1993.
GAO COMMENTS
-------------------------------------------------------- Appendix VI:5
We address FDIC's substantive comments on the following pages. FDIC
also included technical comments in their response letter. We have
made suggested changes where appropriate. We have also responded to
selected technical comments where appropriate.
1. We agree that an insider transaction, conducted in accordance
with applicable laws and regulations, is a perfectly reasonable
banking practice. We acknowledge this in chapter 1. (See p. 14.)
2. We agree that Part 363 of the FDIC Rules and Regulations, 12
C.F.R. 363, "Annual Independent Audits and Reporting Requirements,"
which implements section 112 of the FDIC Improvement Act, may result
in increased scrutiny of insider transactions by federal regulators.
This provision requires management of banks to prepare an annual
assessment of the degree of compliance with safety and soundness
regulations, including those related to insider activities. We agree
that this assessment may be useful to examiners in reviewing such
activities. However, this assessment will not fundamentally change
the way in which examiners do their work. The effectiveness of this
regulation depends on the accuracy of management's assessment. It
also depends on the examiners' increased scrutiny of insider
transactions and their effectiveness in getting management and bank
boards to make necessary changes to correct identified deficiencies
in this area. Our recommendations were designed to accomplish these
objectives.
3. While FDIC's examination policies call for a thorough review of
insider transactions and the identification of "red flags" signaling
potential fraud and abuse, on the basis of our review of open bank
examinations we noted instances in which a separate review of insider
transactions was not part of the scope of an examination. In some of
these cases, selected insider loans were only reviewed as part of the
overall review of the loan portfolio. Though FDIC states that a
review of Regulation O recordkeeping requirements is standard
procedure for FDIC examinations, as we discuss in chapter 5, we found
instances where examiners did not cite banks for recordkeeping
violations even though violations were apparent. FDIC also states
that a review of a bank's directors and officers liability insurance
policy is also standard practice. However, we found only a few
instances where FDIC verified the presence of a bank's directors and
officers liability insurance policy and no evidence that any analysis
of the policy had been done.
4. In our analysis of failed banks we did not find it to be a common
practice for FDIC to send individual letters to directors of banks
highlighting the need for corrective action. In addition, from our
review of open banks and from our interviews with the
examiners-in-charge of these banks, we found that FDIC examination
procedures conclude with the FDIC examiners meeting with bank
management and the board of directors. Examination findings are
presented and discussed at this meeting. However, the directors of
our focus groups told us that the examiners' presentation of
examination findings was not informative, leaving the board with the
sense, in some instances, that corrective actions were not warranted.
(See ch. 6.)
5. We agree, as outlined in our report, that post-closing reports
frequently uncover potential insider problems at closed banks, more
so than routine bank examinations. We also agree that investigators
have the benefit of information developed by examination teams as
well as the availability of information from other sources. While
there may be a tendency for investigators to include instances of
insider problems more frequently in their post-closing reports, the
basic finding that insider problems contributed to a bank's failure
seldom change. While conducting our audit, we reviewed a
statistically valid sample of FDIC status reports, which are
completed quarterly to update the investigators' findings. We did
this in anticipation of some potential concerns of agency officials
about the accuracy of investigator findings in post-closing reports.
We found that the initial findings of insider abuse, insider fraud,
and loan losses to insiders as identified by the investigators had
not changed and were still considered to be contributing factors
toward the failure of the banks.
6. As we noted in chapter 2, regardless of the actions that were
taken, regulators may have been able to take stronger enforcement
actions, considering that 72 percent of the banks had repeated
insider violations. By taking stronger enforcement actions sooner,
regulators may have been able to reduce the number of banks in which
repeated insider problems led to failure.
7. We acknowledge that the insider credits being serviced by FDIC on
its LAMIS database do not represent the universe of insider debt at
any given bank. Because of the limitations of the LAMIS database, we
attempted to use it to identify some minimum amount of insider
lending. However, as explained in chapter 4, we were unable to do
so. In our work on this report and our other work in bank
supervision, we found that the information available on the level of
insider debt varied from bank to bank depending on the quality of the
bank's recordkeeping system for insider transactions.
8. We did not find in our review of federal regulators' examination
reports that examiners "almost always" reviewed insider activities.
On the basis of our analysis, we believe a review of insider
activities was done most often when it was brought to the attention
of the examiner by other sources.
9. On the basis of our analysis of failed bank enforcement actions
(see ch. 2) and our prior work on bank supervision,\1 we believe
bank examiners have, at times, been reluctant to be critical of bank
management, particularly in cases where bank management assures
examiners that deficiencies would be corrected.
10. On the basis of our review of post-closing reports and
conversations with FDIC and DOL staff, we believe the language in the
report accurately portrays that FDIC does not usually establish the
extent of insider lending when pursuing a liability claim.
11. While examiners may be on the alert for insider problems, we
believe they could take additional steps that would help them
identify these problems. (See ch. 5.)
12. We are not suggesting that the absence of directors and officers
liability insurance is a leading indicator of problems at banks.
Nonetheless, we believe a review for the presence of such insurance
and an analysis of any exclusions under the policy may be a useful
additional tool for examiners in some situations. We found only a
few instances where FDIC examiners had determined the presence of
directors and officers liability insurance and the adequacy of
coverage. In addition, we found no evidence that any analysis of the
policy had been done.
13. We agree that it may be a natural human tendency for some
directors to rely upon bank management for information concerning
their banks. However, this only reinforces the need for examiners to
emphasize to directors their responsibilities in ensuring that
identified deficiencies are corrected.
(See figure in printed edition.)Appendix IX
--------------------
\1 See for example, Bank Supervision: Prompt and Forceful Regulatory
Actions Needed (GAO/GGD-91-69, Apr. 15, 1991).
COMMENTS FROM THE FEDERAL RESERVE
SYSTEM
========================================================== Appendix VI
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Federal Reserve System's
letter dated December 28, 1993.
GAO COMMENTS
-------------------------------------------------------- Appendix VI:6
1. The Federal Reserve believes that our inability to quantify the
specific amount of insider lending and losses calls into question our
conclusion that insider problems are a significant contributing
factor to bank failures. As discussed in chapter 4, it is not
possible and we do not believe it is necessary to demonstrate exact
dollar losses due to insider problems to say that insider problems
were significant. Twenty-six percent of the banks we reviewed failed
because insider fraud, insider abuse, or loan losses to insiders was
a major factor contributing to the failures. In some cases, it was
the only factor that caused failure. The banks in this 26 percent
cost the BIF an estimated $1.8 billion. We do not believe losses of
this magnitude are insignificant.
2. Throughout the report we used the term insider problems to refer
specifically to insider fraud, insider abuse, and loan losses to
insiders. We characterized other problems, such as poor and/or
negligent management, as management problems. Our finding that
insider problems were a major contributing factor to 26 percent of
the banks that failed in 1990 and 1991 is independent of the fact
that these banks may also have had management problems. The Federal
Reserve is incorrectly asserting that we are using the term insider
problems to include all of the problems we identified in failed
banks. The specific definitions we used for insider problems and
management problems were consistent with those used by FDIC in its
investigation of failed banks and with OCC's report on bank failures
(see fn. 2 in report, p. 85).
3. As we discuss in chapter 4, we believe some banks may be
underreporting insider transactions. We identified many
recordkeeping violations and many instances in which it was not
possible to identify insider transactions. Even so, while $28
billion as a percentage of all bank assets may be small, this amount
is not insignificant.
4. We acknowledge (see p. 14) that insider transactions conducted
in accordance with applicable laws and regulations, are a perfectly
reasonable banking practice. We also agree that the intent of
monitoring insider transactions is to help ensure safe and sound
banking practices. We believe our finding that insider problems were
a major contributing factor in 26 percent of the banks that failed in
1990 and 1991 clearly demonstrates that insider problems pose a major
safety and soundness issue for the banking industry.
5. We believe it is very important to maintain Regulation O rules on
insider lending limits. Violation of individual lending limits was
the single most common Regulation O violation in our review of failed
banks. The argument that small banks have difficulty attracting
directors because of insider lending limits does not appear to be
consistent with our information. As we point out on page 19, only 54
banks had notified the Federal Reserve that they were taking
advantage of the small bank exception to the aggregate lending
limits. This exception is available to the 8,484 banks with deposits
of $100 million or less (as of September 30, 1993). In addition,
directors of small banks (those with assets of $100 million or less)
we talked to generally did not believe that access to credit at their
banks was a primary reason for becoming a director. In fact, many
suggested they would be less likely to seek a loan from their banks
than from a bank on whose board they did not serve.
As we have discussed with Federal Reserve officials, we are more
concerned about changes to Regulation O that may relax a bank's
recordkeeping requirements related to identifying extensions of
credit to insiders, including related interests. A sound system of
records is critical for accurate quarterly reporting of insider
activity and for examiners to be able to assess the bank's internal
controls over those activities. For these reasons, we believe
examiners need to be diligent in ensuring that banks' related
recordkeeping produces complete and accurate information.
6. In general, we agree that the Federal Reserve's full-scope
examinations include a review of insider activities. However, we
noted instances in which a separate review of insider transactions
was not part of the scope of an examination. In some of these cases,
selected insider loans were only reviewed as part of the overall
review of the loan portfolio. In addition, we noted instances in
which information on insiders and their transactions was accepted by
the examiner with minimal or no attempt at verification. We agree
that Federal Reserve examination policies call for a thorough review
of insider activities. The purpose of our recommendation is to
highlight the need for the scrutiny of insider transactions in
practice consistent with the examination policy.
7. The focus group participants and bank boards in our open bank
sample included individuals from banks supervised by all three
federal bank regulators. In general, as we discuss in chapter 6,
bank boards and focus group participants felt frustrated in their
interactions with examiners and regulators. As we acknowledge, bank
directors have a responsibility to ensure that bank management makes
changes to correct identified deficiencies. However, we believe
federal bank regulators could take additional steps to communicate
the need for corrective actions and provide more assistance to bank
directors and management in accomplishing the corrections. The
Federal Reserve's written examination summary, which is provided to
each director, is a good step in this direction. However, we believe
the steps we outline in chapter 6 would provide additional assurances
that identified deficiencies are understood and corrected before they
negatively affect a bank's financial health.
MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix X
GENERAL GOVERNMENT DIVISION,
WASHINGTON D.C.
--------------------------------------------------------- Appendix X:1
Charles G. Kilian, Evaluator-in-Charge
Nolani T. Courtney, Senior Evaluator
Richard A. Sherman, Senior Evaluator
Joan M. Conway, Evaluator
Barry L. Reed, Senior Social Science Analyst
Susan S. Westin, Senior Economist
Kiki Theodoropoulos, Reports Analyst
OFFICE OF GENERAL COUNSEL,
WASHINGTON, D.C.
--------------------------------------------------------- Appendix X:2
Maureen A. Murphy, Senior Attorney
CHICAGO REGIONAL OFFICE
--------------------------------------------------------- Appendix X:3
Gwenetta Blackwell, Senior Evaluator
Lenny Moore, Evaluator
DALLAS REGIONAL OFFICE
--------------------------------------------------------- Appendix X:4
Jeanne Barger, Senior Evaluator
Ruth Joseph, Evaluator
Mike Harmond, Evaluator
NEW YORK REGIONAL OFFICE
--------------------------------------------------------- Appendix X:5
John Ripper, Senior Evaluator
Bonny Derby, Evaluator
Me'Shae Brooks-Rolling, Evaluator
SAN FRANCISCO REGIONAL OFFICE
--------------------------------------------------------- Appendix X:6
Bruce Engle, Evaluator