Inspectors General: Mandated Studies to Review Costly Bank and Thrift
Failures (Letter Report, 07/31/95, GAO/GGD-95-126).

Pursuant to a legislative requirement, GAO: (1) assessed the
preparations, procedures, and audit guidelines that certain Inspectors
General (IG) have established for material loss reviews (MLR); (2)
verified the information contained in the MLR reports; (3) recommended
improvements in bank supervision based on MLR reports issued between
July 1, 1993 and June 30, 1994; and (4) assessed the economy and
efficiency of the current MLR process.

GAO found that the IG reviewed have satisfied their MLR responsibilities
by: (1) establishing a statement of understanding (SOU) that coordinates
their approaches in performing MLR; (2) initiating and completing
several pilot studies; (3) hiring staff with bank and audit experience;
and (4) developing relevant training programs and comprehensive audit
guidelines. In addition, GAO found that: (1) if these MLR guidelines are
implemented correctly, they will be adequate in determining the causes
of bank failures, as well as the quality of bank supervision; (2) the
costs associated with producing MLR reports can be considerable, and may
include personnel and financial expenditures that cause temporary
operational disruptions to IG offices; and (3) the current MLR
requirements do not always give IG sufficient time to review reports
prepared by other Federal Deposit Insurance Corporation (FDIC) officials
who investigated causes of bank failures.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-95-126
     TITLE:  Inspectors General: Mandated Studies to Review Costly Bank 
             and Thrift Failures
      DATE:  07/31/95
   SUBJECT:  Inspectors General
             Reporting requirements
             Auditing standards
             Bank failures
             Bank management
             Insured commercial banks
             Savings and loan associations
             Losses
             Auditing procedures
             Bank examination
IDENTIFIER:  Bank Insurance Fund
             BIF
             
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Cover
================================================================ COVER


Report to Congressional Committees

July 1995

INSPECTORS GENERAL - MANDATED
STUDIES TO REVIEW COSTLY BANK AND
THRIFT FAILURES

GAO/GGD-95-126

Mandated Studies


Abbreviations
=============================================================== ABBREV

  BIF - Bank Insurance Fund
  C&D - Cease and Desist Order
  CFO - Chief Financial Officer's Act of 1990
  DAS - Federal Deposit Insurance Corporation's Division of Asset
     Services
  DOF - Federal Deposit Insurance Corporation's Division of Finance
  FDIA - Federal Deposit Insurance Act
  FDIC - Federal Deposit Insurance Corporation
  FDICIA - Federal Deposit Insurance Corporation Improvement Act
  IG - Inspector General
  JBT - Jefferson Bank and Trust
  MLR - material loss review
  OCC - Office of the Comptroller of the Currency
  OTS - Office of Thrift Supervision
  PCR - Post Closing Report
  SOU - Statement of Understanding
  TBSD - The Bank of San Diego

Letter
=============================================================== LETTER


B-259972

July 31, 1995

The Honorable Alfonse D'Amato
Chairman
The Honorable Paul Sarbanes
Ranking Minority Member
Committee on Banking, Housing,
 and Urban Affairs
United States Senate

The Honorable James A.  Leach
Chairman
The Honorable Henry B.  Gonzalez
Ranking Minority Member
Committee on Banking and
 Financial Services
House of Representatives

This report presents the results of our review of the compliance of
the Inspectors General (IG) offices for the Board of Governors of the
Federal Reserve System, Federal Deposit Insurance Corporation (FDIC),
and the Department of the Treasury with section 38(k) of the Federal
Deposit Insurance Act (FDIA) as amended in 1991.\1 This section of
FDIA requires the IGs to issue reports on depository
institutions--banks or thrifts--whose failures result in "material
losses" to deposit insurance funds, i.e., basically those that exceed
$25 million.  The section directs the IGs to determine why a bank's
or thrift's problems resulted in a material loss to a deposit
insurance fund and to make recommendations for preventing such losses
in the future.\2 Finally, the section requires us to annually review
reports issued by the IGs, verify the accuracy of one or more of
these reports, and make recommendations as needed to improve the
supervision of depository institutions. 

In carrying out our responsibilities under section 38(k), our
objectives were to (1) assess the adequacy of the preparations,
procedures, and audit guidelines that IGs have established for
performing material loss reviews (MLR) to ensure compliance with
their responsibilities under the section; (2) verify the information
contained in the MLR reports upon which the IGs based their
conclusions; (3) recommend improvements, if necessary, in bank
supervision based on a review of the MLR reports issued between July
1, 1993, and June 30, 1994; and (4) assess the economy and efficiency
of the current MLR process. 


--------------------
\1 12 USC Section 1831o(k). 

\2 The Treasury IG is responsible for auditing failed national banks
supervised by the Office of the Comptroller of the Currency, but did
not become responsible for doing investigations of thrift failures
that cause material losses until July 1, 1995.  On that date, the
Savings Association Insurance Fund became responsible for paying, or
paying off, the insured deposits of failed thrifts, and the Treasury
IG became responsible for reviewing thrift failures whose cost to the
Savings Association Insurance Fund meet the criteria specified by
section 38(k).  Until that date, the Resolution Trust
Corporation--which is not an insurance fund as defined by the
section--was responsible for paying, or paying off, the insured
deposits of failed thrifts. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :1

To satisfy our objectives, we discussed the IGs' plans, policies,
procedures, and MLR audit guidelines with IG officials and bank
regulators.  We assessed the MLR audit guidelines for their
completeness, detail, and relevance to the IGs' audit objectives.  We
compared the MLR audit guidelines to audit guidelines that we
developed and used in our earlier reports on the causes of bank
failures and the adequacy of bank supervision.  In addition, we
verified the information contained in the two MLR reports completed
between July 1, 1993, and June 30, 1994, the first year that section
38(k) was in effect.  A detailed description of our objectives,
scope, and methodology is provided in appendix I.  The IGs for FDIC,
the Federal Reserve, and Treasury provided written comments on a
draft of this report, which are discussed on pages 21 and 22 and are
reprinted in appendixes III, IV, and V. 

We did our work between April and October 1994 in Washington, D.C.;
Irvine, CA; San Francisco; and Denver in accordance with generally
accepted government auditing standards. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

The Federal Reserve, FDIC, and Treasury IGs have effectively
positioned themselves to satisfy their MLR responsibilities as
required by section 38(k) of FDIA, as amended.  The IGs have
established a Statement of Understanding (SOU) to coordinate their
approaches to performing MLRs, initiated and completed several pilot
studies, hired staff with banking and audit experience, and developed
relevant training programs.  Moreover, the IGs have developed
comprehensive and detailed audit guidelines for performing MLRs that
were refined on the basis of the IGs' experiences in completing the
pilot studies.  Although these guidelines differ somewhat among IGs,
we believe that, if effectively implemented, the guidelines are
adequate for determining the causes of bank failures resulting in
material losses and assessing the quality of supervision of those
banks. 

The Federal Reserve and FDIC IGs each issued a MLR report during the
first year that the MLR requirement went into effect.  The Federal
Reserve IG issued a report on Jefferson Bank and Trust (JBT) in
Colorado, and the FDIC IG issued a report on The Bank of San Diego
(TBSD) in California.  We found that the IGs fully described and
supported the reasons for the failures of JBT and TBSD.  The IGs also
assessed the adequacy of the banks' supervision, although the FDIC IG
could have more fully evaluated the effectiveness of FDIC's
supervisory enforcement actions in the TBSD report. 

We believe the JBT and TBSD reports provide important information
about the causes of these banks' failures and the quality of their
supervision.  However, the limited number of reports that have been
issued to date do not provide a sufficient base of evidence to ensure
valid conclusions about the bank regulators' overall performance. 
Therefore, we do not make any recommendations to the bank regulators
to improve supervision in this report. 

Meanwhile, the costs associated with producing MLR reports can be
considerable and include personnel and financial expenditures and
some temporary operational disruptions to the IG offices.  Another
potential limitation of the current MLR requirements is that they do
not always give IGs sufficient time to review reports that are
prepared by other FDIC officials who also investigate the causes of
bank failures.  On the basis of discussions with IG officials, we
identified various options that could improve the efficiency and/or
effectiveness of the current MLR process. 


   BACKGROUND
------------------------------------------------------------ Letter :3

The FDIC, the Federal Reserve, and the Office of the Comptroller of
the Currency (OCC) and the Office of Thrift Supervision (OTS)--which
are part of the Department of the Treasury--share responsibility for
regulating and supervising banks and thrifts in the United States. 
FDIC regulates state-chartered banks that are not members of the
Federal Reserve system while the Federal Reserve regulates
state-chartered banks that are members of the system.  OCC regulates
nationally chartered banks, while OTS regulates thrifts.\3 The
regulators carry out their oversight responsibilities through, among
other things, conducting annual examinations and issuing enforcement
actions for unsafe and unsound banking practices. 

Congress amended FDIA in 1991 after the failures of about 1,000 banks
between 1986 and 1990 had resulted in billions of dollars in losses
to the Bank Insurance Fund (BIF).  The amendments were designed
largely to strengthen bank supervision and to help avoid a taxpayer
bailout of the BIF similar to the nearly $105 billion in taxpayer
funds that Congress provided between 1989 and 1993 to the Resolution
Trust Corporation to protect the depositors of failed thrifts.  The
amendments require the banking regulators to take specified
supervisory actions when they identify unsafe or unsound practices or
conditions.  For example, the regulators can close banks whose
capital levels fall below predetermined levels.  Congress also added
section 38(k) to FDIA to (1) ensure that the regulators learn from
any weaknesses in the supervision of banks whose failures cause
material losses and (2) make improvements as needed in the
supervision of depository institutions. 

The IGs for the Federal Reserve, FDIC, and the Treasury--which is
responsible for auditing OCC and OTS--are officials responsible for
identifying fraud, waste, and abuse and recommending improvements in
agency operations.  Each IG oversees a staff of auditors and
investigators to assist in carrying out its mission.  The staff
engages in a range of activities, including criminal investigations,
financial audits, and audits of the economy and efficiency of agency
programs and operations. 

Section 38(k) of FDIA requires the IGs to review the failures of
depository institutions when the estimated loss to a deposit
insurance fund becomes "material":  i.e., when the loss exceeds $25
million and a specified percentage of the institutions' assets.  (See
table 1.)



                           Table 1
           
             Applicable Percentage of the Bank's
                  Assets on a Sliding Scale

Time period                                       Percentage
------------------------------------------------  ----------
July 1 -June 30
------------------------------------------------------------
1993 -1994                                                7%
1994 -1995                                                 5
1995 -1996                                                 4
1996 -1997                                                 3
After 1997                                                 2
------------------------------------------------------------
Source:  Section 38(k) of the FDIA Act. 

The MLR reports must be completed within 6 months of the date that it
becomes apparent that the loss on a bank or thrift failure will meet
the criteria established by the section.\4

Before July 1, 1993, when the section's requirements went into
effect, the IGs had each done pilot studies of previous bank or
thrift failures to gain experience in this type of audit.  Between
July 1, 1993, and February 28, 1995, four banks that met the
section's requirements failed.  The Federal Reserve IG issued MLR
reports on JBT in Lakewood, CO, and Pioneer Bank in Fullerton, CA;
the FDIC IG issued MLR reports on TBSD and The Bank of San Pedro,
CA.\5 The Treasury IG had not initiated any MLRs as of February 28,
1995, because there had not been any failures of nationally chartered
banks or thrifts that met the section's requirements. 


--------------------
\3 State regulatory authorities share responsibility for regulating
and supervising banks and thrifts that they charter with FDIC, the
Federal Reserve, and OTS. 

\4 The section defines a loss incurred as follows:

 when FDIC is appointed receiver of the institution and it is or
becomes apparent that the present value of a deposit insurance fund's
outlays with respect to the institution will exceed the present value
of the receivership dividends or other payments on claims held by
FDIC, or:

 if FDIC provides assistance to the institution while an ongoing
concern and it is not substantially certain that the assistance will
be repaid within 24 months after the date on which the assistance was
initiated or the institution ceases to repay the assistance in
accordance with its terms. 

\5 In this review, we focused our audit work on reports on Jefferson
Bank and Trust and The Bank of San Diego since they were issued in
the first year that section 38(k) went into effect.  Although we read
the MLR reports on The Bank of San Pedro and Pioneer Bank, we did not
attempt to verify the information contained in these reports. 


   INSPECTORS GENERAL MADE
   SUBSTANTIAL EFFORTS TO PREPARE
   FOR MATERIAL LOSS REVIEWS
------------------------------------------------------------ Letter :4

Our review indicated that all of the IGs made substantial efforts in
preparation for meeting their MLR responsibilities under section
38(k).  In a coordinated effort, the IGs entered into a SOU that
outlined their approach to conducting the MLRs which, among other
things, specified when IGs should initiate a MLR.  The IGs also
initiated pilot studies of depository institution failures before the
effective date of section 38(k) (July 1, 1993) to develop and refine
audit procedures and to familiarize their staffs with this type of
review.  Finally, the Federal Reserve and FDIC IGs hired additional
staff with banking and financial audit expertise to meet anticipated
demands for conducting MLRs.  All three IGs enrolled their staff in
relevant training courses. 


      INSPECTORS GENERAL ENTERED
      INTO A STATEMENT OF
      UNDERSTANDING
---------------------------------------------------------- Letter :4.1

The FDIC, Federal Reserve, and Treasury IGs entered into a SOU in
preparation for conducting MLRs.  The SOU is intended to ensure that
(1) statutory requirements for doing a MLR are met as effectively as
possible, (2) the IGs' work is consistent relative to MLRs, (3)
mutual cooperation and efficient use of resources are maximized, and
(4) privileged and confidential information contained in failed bank
records is protected from unauthorized disclosure.  The SOU was
finalized on August 18, 1994. 

Among other provisions, the SOU details how FDIC's Division of
Finance (DOF) is to notify each IG office that a bank failure is
expected to result in a material loss, thereby documenting that a MLR
must be initiated.  The FDIC IG is to be the primary liaison between
the FDIC DOF and the Federal Reserve and Treasury IGs.  The FDIC DOF
is to notify the FDIC IG by letter when it "books" a material loss to
BIF on a bank failure.  If the bank was regulated by FDIC, the date
of the letter starts the 6-month clock for the FDIC IG to complete
its MLR.  If the bank was regulated by the Federal Reserve or OCC,
the FDIC IG is to notify the responsible IG by letter of the material
loss.  The date of this letter starts the 6-month clock for the
Federal Reserve or Treasury IG office to complete its MLR. 


      INSPECTORS GENERAL OFFICES
      COMPLETED PILOT STUDIES
---------------------------------------------------------- Letter :4.2

Each of the three IG offices we contacted conducted pilot studies on
banks or thrifts that failed before July 1, 1993, the effective date
of section 38(k).  The officials we contacted said they did the pilot
studies to develop policies and procedures to do MLRs after section
38(k) went into effect.  The officials also said that they wanted to
train their new staff in how to do this type of review and to
establish contacts with officials in the bank regulatory agencies. 
The Treasury IG office did pilot studies on two California
institutions, the Mission Viejo National Bank and the County Bank of
Santa Barbara; the FDIC IG office did pilot studies on Coolidge Bank
and Trust, located in Boston, and Union Savings Bank, located in
Patchogue, NY; and the Federal Reserve IG office did a pilot study on
the Independence Bank of Plano, located in Texas. 


      INSPECTORS GENERAL HIRED AND
      TRAINED STAFF TO PERFORM
      MLRS
---------------------------------------------------------- Letter :4.3

The FDIC and Federal Reserve IGs also hired additional staff in 1992
and 1993 to assist in performing MLRs and to fully staff their agency
oversight functions.  The FDIC IG hired 12 additional staff members
for a total of 37 staff members to conduct MLRs and other program
audits.  In addition to persons with auditing experience, the new
staff included four banking specialists.  These more experienced
staff were hired to provide training to junior staff on banking
examination procedures, including loan reviews to assess a bank's
asset quality.  According to FDIC IG officials, all of the staff had
enrolled in the FDIC's examiner training program to learn more about
the bank supervisory process. 

The Federal Reserve IG hired 5 additional staff members in 1993 to
give it a total of 11 staff for completing MLRs and other audit work
on bank supervision.  These five staff persons have expertise in
areas such as bank loan analysis, consumer compliance regulations,
and auditing computer systems.  The Federal Reserve IG had also sent
these individuals to banking classes conducted by the American
Institute of Certified Public Accountants and the Federal Reserve's
examiner classes.  In addition, two IG officials enrolled in the
American Bankers Association banking course at Stonier College in
Delaware. 

At the time that these hirings occurred, numerous costly bank
failures were projected to occur between 1993 and 1995.  A FDIC IG
official said that additional staff were needed to meet the
anticipated workload associated with these potential MLRs.  However,
the number of bank failures declined substantially in 1993 and 1994
as a result of low interest rates and an improving economy.  The
number of bank failures fell from 122 in 1992 to 42 in 1993 and 13 in
1994.  Only four banks failed between July 1, 1993, and February 28,
1995, with losses exceeding the statutory threshold, thereby
prompting the IGs to initiate MLRs.  FDIC and Federal Reserve IG
officials we contacted said that MLRs represent only a part of their
overall efforts to assess bank supervision.  The officials plan to
use the staff hired in 1992 and 1993 to do future MLRs and other
audit work on the economy and efficiency of agency supervisory
operations. 

Treasury IG officials said that the organization did not receive
additional resources to hire more staff for conducting MLRs. 
Although the Treasury IG office plans to divert staff to work on MLRs
as needed, other mandated work could limit their ability to do so. 
For example, the IG is required to do audit work on the Treasury
Department's compliance with the Chief Financial Officers Act of 1990
(CFO).\6 The Treasury IG also has developed a comprehensive training
module on how to conduct MLRs for its current staff.  The module
includes separate student and teacher instructions so Treasury IG
staff with banking experience can train staff with limited banking
experience.  The modules are also designed to be self-taught and can
be used without assistance.  Some of the issues covered in the
training module include an introduction to banking; a section on how
to analyze and evaluate causes of bank failures; and an assessment of
enforcement actions, including the effectiveness and timeliness of
regulator enforcement actions. 


--------------------
\6 Among other things, the CFO Act created chief financial officer
positions in 23 major federal agencies.  These officers must have
substantial financial management experience and are responsible for,
among other things, developing integrated accounting systems,
directing agency financial operations, and approving and managing
agency financial management systems.  The act also specifies that the
Office of Management and Budget establish qualification standards for
the CFOs. 


   INSPECTORS GENERAL DEVELOPED
   COMPREHENSIVE MLR AUDIT
   GUIDELINES
------------------------------------------------------------ Letter :5

We reviewed the MLR guidelines that the IGs had developed for their
completeness and relevance for satisfying the MLR objectives and
compared the guidelines to our audit guidelines for investigating
costly bank failures.  On the basis of this analysis, we believe the
IGs' audit guidelines, if effectively implemented, represent a
comprehensive approach to identifying the causes of bank failures and
assessing the adequacy of their supervision.  Although many
provisions of the guidelines are similar, the Federal Reserve and
FDIC IG audit guidelines differ from the Treasury IG guidelines in
that they generally call for doing extensive loan portfolio reviews
in every case when loan losses are determined to be the primary
causes of failure.  By contrast, the Treasury IG is to perform such
loan reviews on a case-by-case basis. 


      MLR AUDIT GUIDELINES ARE
      ADEQUATE FOR ASSESSING
      CAUSES OF BANK FAILURES
---------------------------------------------------------- Letter :5.1

Our review of the IGs' audit guidelines to do MLRs found that the
guidelines represent a comprehensive approach for assessing the
causes of bank failures.  Under established guidelines, senior IG
officials are to maintain contact with the bank regulators to
identify troubled banks whose failures could cause material losses. 
The guidelines direct the IG staff to obtain and review basic
documents about these troubled banks--such as examination reports
dating back several years; enforcement actions; and historical
financial data, such as asset growth over time.  When a bank fails
and causes a material loss, the IG staff are to interview responsible
bank examiners and other regulatory officials and meet with former
bank officials and FDIC closing personnel.  Through reviewing these
documents and interviewing knowledgeable officials, the IGs are to
identify and document the major reasons for the banks' failures. 
These reasons may include rapid growth; poor loan underwriting and
documentation; loan concentrations, such as in real estate; and
insider abuses. 

The Federal Reserve and FDIC IGs' MLR audit guidelines differ from
the Treasury IG audit guidelines in that they generally call for the
staff to review failed bank loan portfolios when loan losses are
determined to be the primary cause of failure.  FDIC IG officials we
contacted said that they need to review loan portfolios to arrive at
an independent judgment as to why the banks failed.  The officials
said that they do not rely solely on documents generated by the bank
regulators--such as examination reports and supporting workpapers--to
determine the cause of failure.  Although the Federal Reserve IG
follows a similar procedure to the FDIC IG for selecting a sample of
loans to review, Federal Reserve IG officials said that they perform
loan reviews primarily to assess the quality of bank supervision. 
These Federal Reserve IG loan review procedures are discussed later
in this section. 

Under the loan review audit guidelines, FDIC IG staff are to select a
sample of the loans on the books of banks whose failures result in
material losses.  The sample is to include classified (troubled)
loans and nonclassified loans as well as a mixture of commercial,
real-estate, and consumer loans.  Once a bank fails and causes a
material loss, the staff are to visit the bank and review the sampled
loans.  The guidelines direct the staff to comment on, among other
things, the quality of the bank's loan underwriting standards.  The
IG staff are to use lending standards that the regulators have issued
to bank examiners to assist in making these assessments. 

According to an FDIC IG official, the staff review the loan files to
identify the management strategy or lending weaknesses that
ultimately caused the bank to fail.  By reviewing information in the
loan files dating back several years, for example, he said the staff
could determine whether bank management had adopted an aggressive
growth strategy without adequate regard for maintaining credit
standards. 

Unlike the FDIC IG guidelines, the MLR audit guidelines developed by
the Treasury IG do not call for loan reviews even if loan losses were
the primary cause of failure.  As a result of the time and resources
necessary to complete a MLR, the guidelines state that the Treasury
IG staff should generally rely on OCC examination reports and
workpapers and discussions with examiners to assess the causes of a
bank's failure.  However, the guidelines do direct the IG staff to
initiate loan reviews similar to those done by the FDIC and Federal
Reserve IG staff in certain situations.  The Treasury IG staff are to
do a loan review if they determine that OCC's records do not
adequately address or develop the problem(s) that resulted in a
bank's failure.  For example, it may be necessary to do a loan review
or examine the bank's records if it appears that insider abuse caused
the bank to fail and the OCC examiners did not adequately develop the
related issues. 


      MLR AUDIT GUIDELINES CALL
      FOR ASSESSING THE BANK
      REGULATORS' SUPERVISORY
      PERFORMANCE
---------------------------------------------------------- Letter :5.2

Our reviews of the IG MLR guidelines showed that they call for the IG
staff to assess the timeliness and effectiveness of bank supervisory
activities.  Based on reviews of examination reports and supporting
workpapers, as well as discussions with bank examiners, the IG staff
are to assess the adequacy of the supervision of failed banks.  For
example, the IG staff are to determine whether the regulators
complied with their policies and procedures in supervising the banks. 
Among other requirements, the IG staff are directed to determine
whether the bank regulators selected an adequate sample of loans to
evaluate at each bank examination and made determinations about the
bank's financial condition.  The IG staff are also to review the
supporting workpapers for each examination to determine whether the
regulators had adequate support for their findings on the quality of
each bank's loan portfolio. 

The guidelines also direct the IG staff to determine whether the bank
regulators had taken timely and effective enforcement actions--such
as Memorandums of Understanding, Cease and Desist Orders (C&D), and
Civil Money Penalties--against banks that engage in unsafe or unsound
practices.  For example, the Treasury IG guidelines direct the staff
to focus their analysis on problems that the bank regulators
identified during the course of examinations, particularly those that
resulted in the bank's failure.  The IG staff are to determine what
enforcement actions, if any, were taken against the bank by OCC to
get the bank to correct these problems, and the guidelines direct the
IG staff to determine why OCC did not take particular enforcement
actions against a bank.  Moreover, the guidelines call for the IG
staff to evaluate OCC's oversight of banks that are subject to
enforcement actions to ensure that bank managers comply with the
provisions of such actions.  Once this analysis has been completed,
the IG staff are to reach a conclusion about the timeliness and
forcefulness of the OCC's enforcement actions.  The FDIC IG and
Federal Reserve IG MLR guidelines contain similar provisions. 

Federal Reserve IG officials we contacted said they primarily use the
loan review process discussed earlier to assess the adequacy of the
Federal Reserve's examinations of bank lending activities.  In the
recent MLR audit of Pioneer Bank, the officials said they reviewed a
sample of 40 large commercial and commercial real estate loans in the
bank's portfolio.  The staff reviewed these loans in a manner similar
to that done by bank examiners.  For example, the staff determined,
from a review of information in the files, whether they believed each
loan should be classified as "substandard," "doubtful," or "loss."\7
The staff used the regulatory examination standards that were in
place at the time the loans were originated to make these
classifications.\8

Next, the staff compared their loan review findings to the findings
of the Federal Reserve examiners who actually examined the bank in
the years before the bank's failure.  The IG officials said they
tried to determine the reasons that their loan classifications
differed from those of the Federal Reserve examiners and assess
whether the examiners had adequate justification for their
classifications.  The IG staff concluded that the Federal Reserve
examiners overlooked substantial weaknesses in the bank's lending
practices over the years.  Although the Federal Reserve IG officials
said this type of analysis is complicated and time consuming, they
believe it is often necessary for assessing the overall quality of
the bank's supervision. 

However, FDIC IG officials said that when they conduct a loan review
they use it for the purposes of determining the causes of bank
failures rather than determining the adequacy of bank supervision. 
The officials said that they generally do not use loan reviews to
assess bank supervision because it is difficult to replicate the
conditions that existed when FDIC examined banks in the past. 


--------------------
\7 Examiners use classifications to determine the likelihood that a
loan will be repaid.  "Substandard" refers to loans whose repayment
is in question as a result of the weakened financial condition of the
borrower or the decline in value of the collateral pledged to secure
the loan.  "Doubtful" refers to loans that are substandard and whose
repayment is highly questionable.  "Loss" refers to loans that are
generally considered uncollectible. 

\8 The Federal Reserve IG staff said they made separate
classifications of each loan in the sample for several years before
the bank's failure. 


   JBT AND TBSD MLR REPORTS FULLY
   DESCRIBE CAUSES OF BANK
   FAILURES, BUT FDIC IG COULD
   HAVE EXPANDED ITS ANALYSES
------------------------------------------------------------ Letter :6

During the first year that section 38(k) went into effect, the
Federal Reserve and FDIC IGs each used the audit guidelines discussed
above to do a MLR report.  We believe that these reports fully
describe and support the causes of the banks' failures.  The IGs also
assessed the supervisory efforts of the bank regulators and
recommended specific steps the regulators could take to improve their
oversight efforts.  However, the FDIC IG could have more fully
evaluated the effectiveness of FDIC's supervisory enforcement actions
in the TBSD report. 


      MLR REPORTS FULLY DESCRIBE
      CAUSES OF FAILURE
---------------------------------------------------------- Letter :6.1

On December 27, 1993, the Federal Reserve IG issued a report on JBT,
which failed on July 2, 1993.  The report concluded that the bank
failed as a result of a massive securities fraud perpetrated by its
investment adviser; the fraud resulted in a $43 million loss for the
bank.  The IG staff decided not to do a loan review for the JBT
investigation because trading in government securities, rather than
loan losses, caused the bank's failure.  Instead, the IG staff
focused its investigation on reviewing JBT's securities trading
activities and the Federal Reserve's oversight of this trading. 

On April 29, 1994, the FDIC IG issued a report on TBSD, which failed
on October 29, 1993.  The report concluded that the bank failed as a
result of poor loan underwriting, excessive real estate lending, high
expenses, and poor management.  As part of the MLR, FDIC staff
reviewed a sample of 60 of TBSD's loans, including 41 real-estate
loans.  The IG staff identified many of the deficiencies in the
bank's lending practices through the loan analysis. 

We reviewed the workpapers the IGs developed to support the JBT and
TBSD reports to (1) ensure that the IGs complied with the MLR
guidelines and (2) verify the basis for the reports' conclusions
about the causes of the banks' failures.  We also interviewed
officials from the IGs' offices, as well as examination officials
from the Federal Reserve and FDIC, respectively.  On the basis of our
review, we believe that the reports fully describe and support the
causes for each bank's failure.  See appendix II for more information
about each report. 


      FDIC IG COULD HAVE EXPANDED
      ITS ANALYSIS OF ENFORCEMENT
      ACTIONS
---------------------------------------------------------- Letter :6.2

Our review of the JBT and TBSD reports and their supporting
workpapers also found that the Federal Reserve and FDIC IGs generally
complied with their guidelines on assessing the quality of bank
supervision.  As examples, the IGs obtained copies of bank
examination reports dating back several years, collected economic
data about the regions in which the banks were located, and
interviewed bank regulators.  In addition, IG audit teams traveled to
the banks' locations to review bank records and interview bank
officials. 

The IGs also identified certain deficiencies in Federal Reserve and
FDIC supervisory practices.  For example, the Federal Reserve IG, in
the JBT report, identified specific steps that the Federal Reserve
could take to improve its oversight of bank securities trading
activities.  Moreover, the FDIC IG, in the TBSD report, recommended
that FDIC evaluate on a case-by-case basis the need to collect better
data about the quality of bank assets before approving the merger of
weak banks.  The FDIC IG further recommended that FDIC develop
examination guidance to ensure that banks place reasonable limits on
the financing of speculative real-estate projects. 

The IGs also obtained and reviewed copies of enforcement action
documents that were taken against JBT and TBSD and summarized those
actions in the MLR reports.  However, we found that the FDIC IG did
not fully evaluate whether FDIC ensured that TBSD complied with
outstanding enforcement actions as provided in the MLR audit
guidelines.  We did such an analysis of FDIC supervision's follow-up
efforts of its enforcement actions against TBSD.  From our review, we
determined that TBSD continued its aggressive real-estate lending
activities even though FDIC had initiated an enforcement action
intended to limit the bank's exposure.  We also found that FDIC
supervision did not ensure its enforcement actions were effective to
get bank management to better control its real-estate lending.  These
additional insights may have strengthened the FDIC IG's
recommendations to include supervisory follow-up of the effectiveness
of actions taken. 

In 1985, FDIC issued a C&D against TBSD that, among other provisions,
required the bank to improve its lending standards.  On May 9, 1988,
FDIC lifted the C&D, but the bank continued to have problems, such as
high loan losses and high overhead expenses.  According to the TBSD
report workpapers, in September 1988, a FDIC examiner recommended
that FDIC sign a Memorandum of Understanding with TBSD that would
require the bank to correct its lending and operational problems. 
However, in April 1989, FDIC agreed to a resolution by TBSD's Board
of Directors, in lieu of a Memorandum of Understanding, that required
changes in the bank's operations.  For example, the resolution called
on the bank to assess its loan exposure to the commercial real-estate
construction industry and the financial consequences for the bank in
the event of a downturn in that industry.  The resolution further
directed TBSD management to consider capping its commercial
real-estate loans as a percentage of the bank's total loans, assets,
and capital. 

Despite the board resolution, bank management continued to pursue an
aggressive commercial real-estate lending strategy, and FDIC did not
take forceful actions to correct these problems for 2 years.  The
FDIC TBSD report showed that the bank's construction and commercial
real-estate loans increased by nearly 75 percent from about $47
million to $82 million between year-end 1988 and year-end 1991.  Many
of these real-estate loans contributed to the bank's failure in 1993. 
California state banking regulators examined TBSD in 1989 and 1990
and gave its overall operations relatively high ratings:  i.e., an
overall CAMEL\9 rating of "2" in 1990.  FDIC officials did not begin
to discover the extent of TBSD's loan loss problems until their
examinations of the bank in late 1990 and in 1991.  On the basis of
these exam findings, FDIC signed a Memorandum of Understanding with
TBSD in April 1991 that required the bank to improve its operations. 

TBSD also disregarded the board resolution's provisions that it
consider capping total commercial real-estate loans as a percentage
of its assets and capital.  Specifically, commercial real-estate
loans grew from 35 percent of banks total assets to 42 percent
between year-end 1988 and year-end 1991.  In the same period,
commercial real-estate loans increased from 423 percent of TBSD's
total capital plus reserves to 597 percent.  The insights we gained
from this analysis may have been beneficial to the FDIC IG in
assessing FDIC's oversight of TBSD and in making its recommendations
for improving bank supervision. 


--------------------
\9 The results of an onsite examination by banking regulators are
summarized in a report addressed to the bank's board of directors. 
The examination usually results in the examiner assigning a numerical
rating to each of these bank components--capital, assets, management,
earnings, and liquidity (CAMEL).  The examiner is to assign a
composite CAMEL rating to the bank.  CAMEL ratings range from 1, the
best rating and the lowest level of supervisory concern, to 5, the
worst rating and the most serious level of supervisory concern. 


   LIMITED BENEFITS OF CURRENT MLR
   PROCESS ARE ACHIEVED AT CERTAIN
   COSTS
------------------------------------------------------------ Letter :7

For this report, we focused our assessment on the plans, policies,
and audit guidelines that the IGs have developed for complying with
the MLR mandate.  Although the current MLR process produces important
benefits in understanding the circumstances surrounding individual
bank failures, the benefits so far may have had a limited impact in
improving bank supervision overall.  We do not make any
recommendations for improving bank supervision in this report since
only two MLR reports were issued in the first year that the mandate
went into effect and only two more reports had been issued as of
February 1995.  Further, certain costs associated with producing MLR
reports should be considered; these costs include IG financial and
personnel expenditures, some temporary disruptions to IG office
operations, and duplication of effort among investigators.  In
addition, our continued annual reviews of the MLR process may not add
value beyond this initial assessment.  We conclude this section by
providing a discussion of the reasons for and against various options
that could be considered to address the MLR requirement. 


      MLRS PRODUCED IMPORTANT BUT
      LIMITED BENEFITS
---------------------------------------------------------- Letter :7.1

IG officials we contacted said that the JBT and TBSD reports had
produced important benefits.  These IG officials said that MLRs
initiated to date had generated significant information about the
causes of individual bank failures, the quality of these banks'
supervision, and the opportunity to train the IG staff in the bank
supervisory process.  A senior FDIC IG official also said that MLRs
provided important information about other areas of bank management
and supervision that may need to be evaluated.  For example, he told
us that as a result of the MLR investigation of the Bank of San
Pedro, the FDIC IG may review banks' use of "money desks" to fund
their lending operations.\10

In addition, an IG official said that the MLR process provides the
office with a strong justification for assessing other aspects of
bank supervision.  For example, before the MLR requirement, the
office had not yet established an overall program for assessing bank
supervision.  However, the official said that the MLR process
provided the IG with a formal basis for assessing the regulators'
supervisory efforts and allowed the IG to establish working
relationships with supervisory officials. 

Although the JBT and TBSD reports provided valuable information about
the circumstances surrounding these banks' failures, we are not
making any recommendations for improving bank supervision on the
basis of these reports.  We do not believe that the two cases done
during the first year or the total of four cases that had been
completed as of February 1995 represent a sufficient base of evidence
to arrive at conclusions about the overall quality of bank
supervision.  To make recommendations, we would need to review a
larger sample of MLR reports.  This larger sample would allow us to
identify any common problems or trends in bank regulation that need
to be corrected. 

Some IG officials we contacted said that the MLRs completed to date
provide little basis for identifying supervisory trends.  For
example, a FDIC IG official said that there has not been an adequate
number of MLR reports issued to draw overall conclusions about the
adequacy of bank supervision.  In addition, a Federal Reserve IG
official said that it is difficult to convince agency supervisory
officials to accept recommendations contained in a MLR report since
the recommendations would be based on only one bank's failure.  In
its MLR report on the failure of the Pioneer Bank, the Federal
Reserve IG chose not to make any recommendations for improving
overall bank supervision even though the report identified certain
supervisory weaknesses. 

It should be pointed out that MLRs are just one part of the IGs'
overall efforts to evaluate the quality of bank supervision
nationwide.  For example, in September 1994, the FDIC IG issued a
report on FDIC's efforts to implement provisions in the Federal
Deposit Insurance Corporation Improvement Act (FDICIA)\11 that
require the prompt closure of capital-deficient banks.\12 At the time
of our review, the Federal Reserve IG was doing audits of the Federal
Reserve's examinations of commercial real-estate loans and its bank
examination program.  In addition, the Treasury IG was doing studies
on OTS' implementation of various sections of FDICIA and the
effectiveness of OCC's examinations of national banks. 


--------------------
\10 A money desk is a mechanism by which orders are executed for bank
customers, correspondent banks, or a bank's own account.  Banks can
use money desks to attract deposits from outside of their
geographical area.  For example, according to the FDIC IG report, The
Bank of San Pedro attracted $25 million in deposits in the early
1990s by offering above-market interest rates to depositors
nationwide. 

\11 18 USC Section 1811 et seq., as amended by Section 131(a) of the
Federal Deposit Insurance Act of 1991.  Public Law 102-242, Section
131(a), 151 Stat 2236, 2263-64 (1991). 

\12 Federal Deposit Insurance Corporation, Office of Inspector
General, Audit of FDIC's Implementation of the Prompt Corrective
Action Provisions of FDICIA (Sept.  23, 1994). 


      COSTS ASSOCIATED WITH THE
      CURRENT MLR PROCESS
---------------------------------------------------------- Letter :7.2

The benefits of the MLR reports completed to date have been achieved
at certain costs to the IG offices.  IG officials said that a
significant amount of financial and personnel resources are needed to
do MLRs.  In the 4 MLRs initiated as of February 28, 1995, by the
FDIC and Federal Reserve IGs, between 5 to 11 staff visited the
banks' premises within the first several weeks of their failures. 
These staff conducted initial interviews with regulatory and bank
personnel, reviewed bank examination records, and conducted loan
reviews.  For example, in one recent FDIC IG MLR, six staff spent 2
weeks reviewing loan files on the bank's premises.  A FDIC IG
official said that the number of staff needed to perform MLRs should
decline in the future as the organization gains experience in this
type of work. 

IG officials also said that the resources necessary to complete a MLR
report within the 6-month deadline can have temporary but disruptive
effects on their normal operations.  Treasury IG officials said that
approximately 30 percent of their staff are already dedicated to
assessing executive agency financial systems as required by the CFO
Act.  The Treasury IG officials estimate that 50 percent of their
staff resources would be dedicated to CFO work by 1996.  Therefore,
an increasing MLR workload could hinder the Treasury IG's ability to
devote sufficient staff resources to meet its CFO Act and other audit
obligations.  Similarly, Federal Reserve and FDIC IG officials said
that the resources necessary to complete the JBT and TBSD reports
within the 6-month deadline caused certain operational challenges. 
For example, these officials said they had to pull staff from other
ongoing studies to assist in the material loss investigations. 

We believe that these disruptive effects on the IGs' operations could
be magnified should there be a substantial increase in the number of
costly bank failures, particularly in the case of the Treasury IG,
which did not receive additional staffing to do MLRs.  Although the
Federal Reserve and FDIC IGs have increased their staffing in recent
years, they could also face substantial pressures to complete MLR
reports within 6 months should numerous banks fail simultaneously. 
For example, a FDIC IG official estimated that the organization could
handle a maximum of about 14 MLRs per year. 


      MLRS DO NOT ALWAYS ALLOW FOR
      USE OF FDIC INVESTIGATORS'
      REPORTS
---------------------------------------------------------- Letter :7.3

Another potential limitation of the current MLR process is that it
does not always allow time for the IGs to review reports prepared by
FDIC's Division of Asset Services (DAS) investigators who also
investigate the causes of bank failures.  Like MLR reports, these
reports provide information about individual bank failures.  However,
Federal Reserve and FDIC IG officials question whether it would be
beneficial to review these DAS reports and mentioned that these
reports were often not available until months after banks failed. 

DAS is responsible for recovering a portion of FDIC's outlays to
resolve bank failures by selling each failed bank's assets to private
sector bidders.  DAS also sends investigators to failed banks to
determine whether FDIC could pursue civil claims against any bank
officials culpable for the losses to help offset the costs of the
failure.  It is the policy of the DAS investigators to issue a report
within 90 days of a bank failure--although the process can take
longer--that documents their findings.  This report is called a Post
Closing Report (PCR).  DAS has issued PCRs on JBT and TBSD. 

In our discussions, a Treasury IG official said that PCRs provide
information that could be useful in doing MLR reports.  The official
also said it may make sense for the IGs to wait until DAS has issued
PCRs before initiating MLRs.  If the IGs initiated MLRs after PCRs,
this could allow the IGs to avoid duplicating the work of the DAS
investigators and it would allow the IGs to plan the scope of their
MLR audit work on the basis of information contained in the PCRs. 

However, Federal Reserve and FDIC IG officials said that there is no
significant relationship between MLRs and the DAS investigations. 
The officials said that DAS investigations are more narrowly focused
than MLRs and, therefore, have limited use.  For example, Federal
Reserve IG officials pointed out that PCRs, unlike MLR reports, do
not assess the quality of bank supervision.  IG officials also said
that they consult with FDIC DAS investigators during the course of
MLRs to obtain information.  Finally, the FDIC and Federal Reserve
officials said that PCRs were often not available until months after
a bank failure.  For example, the JBT PCR was completed nearly 4
months after the failure, and the TBSD PCR was completed about 7
months after the failure.  As discussed earlier, MLR reports must be
completed within 6 months of a bank's failure. 

Although the PCR's primary purpose is to assess whether FDIC should
pursue civil actions against former bank officials, the reports
contain some information that is similar to that found in MLR
reports.  For example, we reviewed PCRs that were issued for JBT and
TBSD.  Like the MLR reports, these PCRs provide historical
information about each bank and the results of regulator exam
findings.  The PCRs also established the causes of the banks'
failures and documented the provisions in any enforcement actions
taken against the banks. 


      OUR ANNUAL REVIEWS MAY NO
      LONGER BE NECESSARY
---------------------------------------------------------- Letter :7.4

As discussed earlier in this report, the IGs have generally
positioned themselves effectively to meet their responsibilities
under the MLR requirement.  In addition, if bank failures continue at
a relatively low rate as projected over the next several years, MLR
reports will not provide either the IGs or us with an adequate basis
for assessing the overall quality of bank supervision and making
needed recommendations for improvement.  Therefore, our annual
reviews of the MLR process may no longer add value to either the MLR
or supervisory processes. 


      MLR OPTIONS
---------------------------------------------------------- Letter :7.5

Several options are available concerning the current MLR process that
we discussed with IG officials.  Specifically, the current MLR
process could be maintained, repealed, or amended so that the IGs
have more discretion on the number and timing of MLRs to perform each
year.  Table 2 presents several reasons for and against each of these
options. 



                                     Table 2
                     
                         Available Options Concerning the
                           Material Loss Review Process

Option                     Reason for option          Reason against option
-------------------------  -------------------------  --------------------------
1. Maintain the current    May continue to hold the   May provide an inadequate
MLR process.               bank regulators            basis for assessing the
                           accountable for their      overall quality of bank
                           performance in             supervision if relatively
                           supervising individual     few banks fail over the
                           banks.                     next several years.

                           May provide the IG staffs  May continue to involve
                           with detailed knowledge    costs, such as personnel
                           and understanding of what  and travel expenditures.
                           causes bank failures and
                           how bank supervision
                           works.

                           May provide the IGs with   May not permit the IGs to
                           the ability to identify    take advantage of other
                           issues in bank             reviews or investigations
                           supervision warranting     of bank failures, such as
                           further analysis.          PCRs produced by FDIC DAS
                                                      investigators.

                           May allow for broader      May divert the IG staff
                           assessments of the         from doing broader audits
                           overall quality of bank    of bank supervision.
                           supervision if there is a
                           substantial increase in
                           the number of bank
                           failures.

2. Repeal the MLR          Would eliminate the costs  May reduce bank
requirement.               associated with            regulators' accountability
                           performing mandatory       for their supervision of
                           MLRs.                      individual banks.

                           May allow the IGs to use   May reduce the IGs'
                           their resources cost       ability to identify issues
                           effectively by focusing    in bank supervision that
                           their efforts on broader   require further
                           aspects of bank            investigation.
                           supervision and doing
                           individual case studies
                           of bank failures only
                           where determined
                           necessary.


                                                      May decrease the IGs'
                                                      contacts with bank
                                                      supervisory officials and
                                                      current knowledge and
                                                      understanding of the
                                                      supervisory process.


3. Amend section 38(k) so  May allow the IGs to use   May lead to inconsistent
that the IGs have the      their resources cost       approaches and numbers of
discretion to determine    effectively by focusing    MLRs performed by the
the number, timing, and    their efforts on broader   various IGs.
scope of MLRs to initiate  analysis of the overall
each year.                 quality of bank
                           supervision, particularly
                           in years when few banks
                           are projected to fail.

                           May maintain the bank      May extend the period of
                           regulators'                time it takes the IGs to
                           accountability for their   issue reports on costly
                           supervision of individual  bank failures.
                           banks.


                           May allow the IGs to take
                           advantage of other audit
                           and investigative
                           reports.


                           May permit the IGs to do
                           a sample of MLRs in years
                           when there is a
                           substantial increase in
                           the number of bank
                           failures. This could
                           potentially minimize the
                           IGs' resource
                           requirements during such
                           periods.

--------------------------------------------------------------------------------
Source:  GAO. 


   CONCLUSIONS
------------------------------------------------------------ Letter :8

Congress added section 38(k) to FDIA so that the regulators would
learn from any weaknesses in the supervision of costly bank failures
and possibly avoid such weaknesses in the future.  We believe that
MLR reports can provide important information about individual bank
failures and that the IGs have generally positioned themselves
effectively to meet their responsibilities.  However, the current MLR
requirements may not be the most cost-effective means of achieving
improved bank supervision. 

The Federal Reserve, FDIC, and Treasury IGs have made substantial
efforts in preparation for performing MLRs as required by section
38(k).  The IGs have also developed detailed and comprehensive MLR
guidelines that, if effectively implemented, are adequate for meeting
the IGs' responsibilities under section 38(k).  The Federal Reserve
and FDIC IGs have each used the guidelines to prepare MLR reports
that fully described the causes of the JBT and TBSD failures. 
However, the FDIC IG could have gained greater insights on bank
supervision if it had expanded its analysis of the effectiveness of
the enforcement actions that FDIC took against TBSD. 

Although the MLR process can produce important benefits in
understanding the circumstances surrounding individual bank failures,
these benefits have been limited and are achieved at certain costs. 
IG officials we contacted said that the two MLR reports completed
during the first year that section 38(k) went into effect did not
provide an adequate base of evidence to assess the overall quality of
bank supervision. 

The limited benefits may have been outweighed by the costs associated
with producing the MLR reports, which include IG personnel and
financial expenditures; temporary disruptions in IG office
operations; and potential duplication of effort among the IGs and
FDIC DAS.  However, if the IGs had more flexibility to determine the
number and timing of MLRs to perform each year, they could (1) have
more flexibility to utilize their resources, particularly in years
when there are numerous bank failures; (2) potentially take advantage
of PCRs issued by DAS; and (3) do broader analysis of the overall
quality of bank supervision.  A more flexible approach could still
maintain the original intent of section 38(k), which was to hold the
bank regulators accountable for their actions.  Thus, Congress may
wish to consider whether the currently required approach remains the
best available.  Similarly, we believe that requiring us to perform
annual reviews of MLRs may no longer add sufficient value to the MLR
or bank supervisory processes to warrant continuation. 

We do not make any recommendations for improving overall bank
supervision in this report because we agree with the IG officials
that the limited number of reports produced so far does not provide
an adequate base for identifying improvements. 


   RECOMMENDATION
------------------------------------------------------------ Letter :9

We recommend that the Inspector General of FDIC, in future MLR
reports, take steps to more fully assess the effectiveness of FDIC's
enforcement actions. 


   MATTERS FOR CONGRESSIONAL
   CONSIDERATION
----------------------------------------------------------- Letter :10

Congress may wish to consider whether the current MLR requirement,
which requires the IGs to report on bank and thrift failures costing
the deposit insurance funds in excess of $25 million, is a
cost-effective means of achieving the requirement's intended
benefit--to help improve bank supervision.  If it determines that the
requirement is not cost effective, Congress can choose to either
repeal or amend the requirement.  Of these options, amending the
current MLR requirement may be more desirable because it would allow
the IGs to continue their bank supervision work and also provide them
greater flexibility in managing their resources.  Moreover, Congress
should consider repealing our mandate to review MLRs on an annual
basis. 


   AGENCY COMMENTS AND OUR
   EVALUATION
----------------------------------------------------------- Letter :11

The IGs for the Federal Deposit Insurance Corporation, the Board of
Governors of the Federal Reserve System, and the Department of the
Treasury provided written comments on our draft report, which are
reprinted in appendixes III, IV, and V.  The three IGs agreed with
the report's overall conclusions that the IGs have effectively
positioned themselves to carry out their responsibilities and have
developed comprehensive and detailed audit guidelines.  In response
to our recommendation, the FDIC IG agreed to take steps to more fully
evaluate the effectiveness of FDIC's supervisory enforcement actions
in future MLRs, even though he did not necessarily agree that our
analysis of TBSD's compliance with FDIC enforcement actions provided
additional insights into the effectiveness of FDIC's supervision of
TBSD. 

The IGs also agreed that Congress should consider amending section
38(k) of FDIA so that the IGs have more discretion on the number,
timing, and scope of MLRs to initiate each year.  The Federal Reserve
IG stated that, although MLR reports may not be the most
cost-effective means of achieving improved bank supervision, they
allow the staff to focus their analysis on the implementation of bank
supervision policies and procedures over time relative to a
particular bank.  He also said that the Federal Reserve IG office may
be able to make broader recommendations with respect to bank
supervision as additional MLRs are completed and that additional
flexibility with regard to the MLR requirement would allow the
organization to better manage its resources while preserving the
intent of the legislation. 

The IGs also provided comments that were generally technical in
nature and are incorporated in this report where appropriate. 


--------------------------------------------------------- Letter :11.1

We are sending copies of this report to the Inspectors General for
the Federal Deposit Insurance Corporation, the Board of Governors of
the Federal Reserve System, the Department of the Treasury, and other
interested parties.  We will also make copies available to others
upon request. 

This report was prepared under the direction of Mark J.  Gillen,
Assistant Director, Financial Institutions and Markets Issues.  Other
major contributors to this review are listed in appendix VI.  If you
have any questions about this report, please call me on (202)
512-8678. 

James L.  Bothwell
Director, Financial Institutions
 and Markets Issues


OBJECTIVES, SCOPE, AND METHODOLOGY
=========================================================== Appendix I

In accordance with section 38(k) of the Federal Deposit Insurance Act
as amended, our objectives were to (1) assess the adequacy of the
preparations, procedures, and audit guidelines that the Inspectors
General (IG) have established for performing material loss reviews
(MLR) to ensure compliance with their responsibilities under the
section; (2) verify the information contained in the MLR reports upon
which the IGs based their conclusions; (3) recommend improvements, if
necessary, in bank supervision based on a review of the MLR reports
issued between July 1, 1993, and June 30, 1994; and (4) assess the
economy and efficiency of the current MLR process. 

To accomplish these objectives, we interviewed staff from the Federal
Reserve, Federal Deposit Insurance Corporation (FDIC) and Treasury IG
offices on the plans, policies, and procedures they had established
to perform MLRs, including their audit guidelines, staffing, and
training programs for employees assigned to perform MLRs.  We also
conducted a round table discussion session with representatives from
each of the IG offices to share their views on some of the MLR issues
and concerns.  Additionally, we met with bank supervision officials
and bank examiners from the Federal Reserve and FDIC to obtain their
views on the MLR process.  We also reviewed the legislative history
of the Federal Deposit Insurance Corporation Improvement Act of 1991,
pilot studies completed by the IGs, and our previous reports on bank
failures and bank supervision. 

To assess the adequacy of the IGs MLR audit guidelines, we reviewed
them for their completeness and relevance to the MLR objectives.  We
also compared the MLR audit guidelines to audit guidelines that we
had developed for investigating costly bank failures.\1 We developed
these guidelines to (1) understand why so many depository
institutions failed in the late 1980s and early 1990s causing
substantial Bank Insurance Fund (BIF) losses and (2) recommend
improvements in depository institution supervision.  These guidelines
produced report findings that were praised as complete and accurate
even by bank regulators whose examination practices were sometimes
criticized in the reports.  The guidelines involve obtaining and
reviewing copies of

  historical financial data, which is available from the bank
     regulators, showing information such as the growth in the bank's
     loan portfolio over time;

  regulatory examinations and their supporting workpapers that had
     been done on a particular bank 5 to 10 years before its failure;

  enforcement actions that the regulators had taken against the bank
     for unsafe and unsound practices, such as Memorandums of
     Understanding or Cease and Desist Orders;

  correspondence between the bank and the regulator primarily
     responsible for its supervision; and

  the Post Closing Reports that identify both the causes of bank
     failures and determine whether FDIC should pursue civil claims
     against bank officials to help compensate the BIF for any losses
     incurred in resolving the failures. 

Moreover, we reviewed the two MLR reports issued by the Federal
Reserve IG and FDIC IG during the first year that section 38(k) went
into effect:  the reports on Jefferson Bank and Trust in Colorado and
The Bank of San Diego in California, respectively.  We substantiated
the accuracy of the MLR reports' findings and recommendations on the
causes of the banks' failures by generally following our audit
guidelines discussed above.  We reviewed the reports' supporting
workpapers and interviewed Federal Reserve and FDIC examination
officials.  We also reviewed the two MLR reports to identify
potential recommendations that we could make to improve the overall
quality of bank supervision.  Although we reviewed the MLR reports on
The Bank of San Pedro and Pioneer Bank, we did not verify the
information contained in these reports because they were issued in
the second year that section 38(k) went into effect. 

We did our work between April and October 1994 in Washington, D.C.;
Irvine, CA; San Francisco; and Denver in accordance with generally
accepted government auditing standards. 


--------------------
\1 Bank Insider Activities:  Insider Problems and Violations Indicate
Broader Management Deficiencies (GAO/GGD-94-88, Mar.  30, 1994), Bank
and Thrift Regulation:  Improvements Needed in Examination Quality
and Regulatory Structure (GAO/AFMD-93-15, Feb.  16, 1994), Bank
Supervision:  OCC's Supervision of the Bank of New England Was Not
Timely or Forceful (GAO/GGD-91-128, Sept.  16, 1991), Bank
Supervision:  Prompt and Forceful Regulatory Actions Needed
(GAO/GGD-91-69, Apr.  15, 1991), Failed Banks:  Accounting and
Auditing Reforms Urgently Needed (GAO/AFMD-91-43, Apr.  22, 1991),
Deposit Insurance:  A Strategy for Reform (GAO/GGD-91-26, Mar.  4,
1991), Thrift Failures:  Costly Failures Resulted From Regulatory
Violations and Unsafe Practices (GAO/AFMD-89-62, June 16, 1989), and
Bank Failures:  Independent Audits Needed to Strengthen Internal
Control and Bank Management (GAO/AFMD-89-25, May 31, 1989). 


SUMMARY ON THE FAILURES OF THE
JEFFERSON BANK AND TRUST AND THE
BANK OF SAN DIEGO
========================================================== Appendix II

In the first year that section 38(k) went into effect--July 1, 1993,
to June 30, 1994--two banks failed and caused material losses.  The
Federal Reserve Inspector General (IG) issued a material loss review
(MLR) report on the Jefferson Bank and Trust (JBT), and the Federal
Deposit Insurance Corporation (FDIC) IG issued a MLR report on The
Bank of San Diego (TBSD).  We read these reports, reviewed their
supporting workpapers, and interviewed Federal Reserve IG and FDIC IG
officials and agency officials responsible for the supervision of
these banks.  This appendix summarizes the MLR reports' findings and
recommendations. 


   JEFFERSON BANK AND TRUST
-------------------------------------------------------- Appendix II:1

On December 27, 1993, the Federal Reserve IG issued a MLR report on
JBT of Lakewood, CO, which failed on July 2, 1993.  The report
concluded that JBT failed as the result of a massive securities fraud
perpetrated by its investment adviser.  The investment adviser
diverted approximately $43 million worth of JBT's government
securities for his own benefit and provided fictitious records to the
bank so that it was not aware of the securities' diversion.  In
December 1991, JBT liquidated its account with the investment
adviser.  However, JBT was subsequently sued by the Iowa Trust,
another client of the investment adviser, which claimed that a
portion of its securities had been diverted to pay JBT.  A U.S. 
District Court ruled in favor of Iowa Trust, and JBT was forced to
turn over approximately $43 million in government securities. 
Colorado closed JBT on July 2, 1993, because the bank was no longer
solvent.  The investment adviser pled guilty to defrauding the bank,
and other investors, and was sentenced to a federal prison term. 

The Federal Reserve IG's report on JBT also recommended steps that
the Federal Reserve could take to improve its oversight of bank
securities trading.  For example, the report recommended that the
Federal Reserve ensure compliance with a policy the IG contends
limits the percentage of assets, such as government securities, that
a bank can keep with a securities dealer.  This policy, which is one
of the recommendations for a bank's selection of a securities dealer
included in the Board of Governors' Commercial Bank Examination
Manual, sets guidelines for limiting the aggregate value of
securities a bank should keep with a selling dealer.  The IG
concluded that if JBT had followed this recommendation with respect
to the government securities diverted by its investment adviser, the
bank would have sustained a loss of approximately $1.6 million
instead of its loss of approximately $43 million. 

The Board disagreed with the IG's recommendation, contending that the
policy does not apply to pure safekeeping arrangements, but only to
those involving a credit risk arising from transactions between a
bank and a securities dealer.  Specifically, the Board maintained
that the policy is an attempt to "limit banks' exposures to
questionable securities transactions involving credit risks--not
safekeeping risks." Thus, according to the Board, the policy did not
apply to the arrangement between JBT and its broker-dealer because
they had purely a safekeeping relationship, rather than a credit
relationship. 


   THE BANK OF SAN DIEGO
-------------------------------------------------------- Appendix II:2

On April 29, 1994, the FDIC IG issued a MLR report on TBSD, which
failed on October 29, 1993.  In December 1992, TBSD, with the
approval of FDIC, merged with its two affiliates, Coast Bank and
American Valley Bank, to form the consolidated TBSD.  The report
concluded that TBSD failed as a result of weak loan underwriting;
concentrations in high-risk, real-estate loans; high overhead
expenses; and inadequate oversight by bank management.  The report
stated that, in the 1980s, TBSD adopted a strategy of making
high-risk loans to real-estate developers in southern California.  By
1991, high-risk, real-estate loans comprised more than 50 percent of
the consolidated bank's loan portfolio.  The IG concluded that many
developers defaulted on their loans in the early 1990s when the
real-estate market declined in California.  TBSD had inadequate
capital and loan loss reserves to cover these losses, and California
subsequently closed the bank. 

The report concluded that FDIC's supervision of TBSD was in
compliance with applicable laws and regulations and that it properly
identified and addressed the conditions that caused the bank to fail. 
The report recommended that FDIC issue regulations to implement
provisions in FDICIA that are designed to improve bank lending
practices.  The report also concluded that the FDIC's decision in
1992 to approve the merger between TBSD and its affiliates was
reasonable.  FDIC approved the merger so that the banks could reduce
their expenses and so that managers responsible for their condition
could be removed.  However, the IG found that it may have been
appropriate for FDIC to have obtained more current information about
the banks' asset quality problems before it approved the merger. 
These asset quality problems proved to be more substantial than
originally believed in December 1992 and resulted in the bank's
failure the following October.  FDIC generally concurred with the
IGs' conclusions and recommendations. 




(See figure in printed edition.)Appendix III
COMMENTS FROM THE INSPECTOR
GENERAL OF THE FEDERAL DEPOSIT
INSURANCE CORPORATION
========================================================== Appendix II




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE INSPECTOR
GENERAL OF THE FEDERAL RESERVE
SYSTEM
========================================================== Appendix II



(See figure in printed edition.)




(See figure in printed edition.)Appendix V
COMMENTS FROM THE INSPECTOR
GENERAL OF THE DEPARTMENT OF THE
TREASURY
========================================================== Appendix II



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)

and 21. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix VI

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Nolani T.  Courtney, Evaluator-in-Charge
Wesley M.  Phillips, Evaluator
Phoebe A.  Jones, Secretary

OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C. 

Paul G.  Thompson, Attorney

SAN FRANCISCO FIELD OFFICE

Bruce K.  Engle, Evaluator

