Bank and Thrift Regulation: Implementation of FDICIA's Prompt Regulatory
Action Provisions (Chapter Report, 11/21/96, GAO/GGD-97-18).

GAO reviewed the Federal Reserve System's (FRS) and the Office of the
Comptroller of the Currency's (OCC) efforts to implement the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) prompt
regulatory action provisions and the impact of those provisions on
federal oversight of depository institutions.

GAO found that: (1) regulators have taken the required steps to
implement FDICIA prompt regulatory action provisions, but have had to
use the additional enforcement powers granted by the provisions against
a relatively small number of depository institutions; (2) the improved
financial condition of banks and thrifts has allowed them to build their
capital levels to the point where only a few institutions were
considered undercapitalized according to section 38 standards; (3) OCC
and FRS generally took prescribed regulatory actions against the 61
undercapitalized banks reviewed; (4) as of September 1996, regulators
had not used their section 39 authority; (5) the final two safety and
soundness standards, asset quality and earnings, required to fully
implement section 39 became effective on October 1, 1996; (6) the
guidelines and regulations issued to date by regulators to implement
section 39 do not establish clear, objective criteria for what would be
considered unsafe and unsound practices or conditions or link the
identification of such conditions to specific mandatory enforcement
actions; (7) other FDICIA provisions and initiatives recently announced
by regulators should help in the early identification of depository
institutions with safety and soundness problems; and (8) the success of
these provisions and initiatives will be determined by the regulators'
willingness to use their enforcement powers early enough to prevent or
minimize losses to the deposit insurance funds.

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

 REPORTNUM:  GGD-97-18
     TITLE:  Bank and Thrift Regulation: Implementation of FDICIA's 
             Prompt Regulatory Action Provisions
      DATE:  11/21/96
   SUBJECT:  Losses
             Bank failures
             Bank examination
             Regulatory agencies
             Bank management
             Insured commercial banks
             Law enforcement
             Capital
             Internal controls
             Banking regulation
IDENTIFIER:  Savings Association Insurance Fund
             SAIF
             Bank Insurance Fund
             BIF
             
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Cover
================================================================ COVER


Report to Congressional Committees

November 1996

BANK AND THRIFT REGULATION -
IMPLEMENTATION OF FDICIA'S PROMPT
REGULATORY ACTION PROVISIONS

GAO/GGD-97-18

Prompt Regulatory Action Provisions

(233448)


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

  CDRI - Reigle Community Development and Regulatory Improvement Act
     of 1994
  CRP - capital restoration plan
  FDIC - Federal Deposit Insurance Corporation
  FDICIA - Federal Deposit Insurance Corporation Improvement Act of
     1991
  FFIEC - Federal Financial Institutions Examination Council
  FIRREA - Financial Institutions Reform, Recovery, and Enforcement
     Act of 1989
  FSLIC - Federal Savings and Loan Insurance Corporation
  FRS - Federal Reserve System
  OCC - Office of the Comptroller of the Currency
  OIG - Office of Inspector General
  OTS - Office of Thrift Supervision
  SAIF - Savings Association Insurance Fund

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


B-260107

November 21, 1996

The Honorable Alfonse M.  D'Amato
Chairman
The Honorable Paul S.  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 summarizes the results of our self-initiated review of
the implementation of the Federal Deposit Insurance Corporation
Improvement Act of 1991's (FDICIA) Prompt Regulatory Action
provisions, as amended.  Our review focused on the Federal Reserve
System's and the Office of the Comptroller of the Currency's efforts
to implement the provisions and the impact of the provisions on
federal oversight of depository institutions. 

This report also discusses other initiatives, contained in FDICIA or
self-initiated by the regulators, that are intended to improve the
supervision and early identification of institutions with
safety-and-soundness problems.  No recommendations or matters for
congressional consideration are presented in this report because it
is too early to assess many of the more recent initiatives that the
regulators are still implementing or testing to improve federal
oversight of depository institutions. 

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, the Chairman of the Federal Deposit Insurance Corporation,
the Acting Director of the Office of Thrift Supervision, and the
Secretary of the Treasury.  We will also make copies available to
others on request. 

This report was prepared under the direction of Kane Wong, Assistant
Director, Financial Institutions and Markets Issues.  Other major
contributors are listed in appendix VII.  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

The thrift and banking crisis of the 1980s caused deposit insurance
fund losses estimated at over $125 billion.\1 One of the many factors
contributing to the size of the federal losses was weakness in
federal regulatory oversight.  Federal regulators were criticized for
not taking prompt and forceful action to minimize or prevent losses
to the insurance funds due to bank and thrift failures.  The Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was
enacted to make fundamental changes in federal oversight of
depository institutions.  FDICIA's Prompt Regulatory Action
provisions created two new sections in the Federal Deposit Insurance
Act--sections 38 and 39--which mandate that regulators establish a
two-part regulatory framework to improve safeguards for the deposit
insurance funds.  The first part focuses on capital levels of
depository institutions, and the second part focuses on other
measures of an institution's safety and soundness. 

Since the passage of FDICIA, the financial condition of banks and
thrifts has improved, and Congress has taken some actions and
considered other actions to expand bank powers and activities.  To
keep Congress informed about changes in the safeguards of federal
deposit insurance funds, this report assesses the progress and
results of the federal regulators' implementation of FDICIA's Prompt
Regulatory Action provisions, as amended.  Specifically, this report
assesses (1) the regulators' implementation of sections 38 and 39 of
the Federal Deposit Insurance Act as of September 1996 and (2) the
impact of the two sections on federal oversight of the banking
industry. 


--------------------
\1 The $125 billion represents the estimated direct cost to the
federal deposit insurance funds for closing or assisting in the
merger of thrifts and banks that failed from 1980 to 1990.  For
additional information on the estimated cost of resolving the savings
and loan crisis, see Financial Audit:  Resolution Trust Corporation's
1995 and 1994 Financial Statements (GAO/AIMD-96-123, July 2, 1996). 


   BACKGROUND
---------------------------------------------------------- Chapter 0:2

Section 38 of the Federal Deposit Insurance Act requires regulators
to categorize depository institutions into five categories on the
basis of their capital levels and to take increasingly severe
supervisory actions as an institution's capital level deteriorates. 
The section requires regulators to define criteria for four of the
five categories, which are identified as well-capitalized, adequately
capitalized, undercapitalized, and significantly undercapitalized. 
It also requires the regulators to set the threshold for the fifth
category, which is identified as critically undercapitalized, at no
less than 2 percent of tangible equity capital.  The section also
establishes a system of mandatory supervisory actions that are to be
triggered by an institution's capital levels.  For example,
regulators are required to obtain capital restoration plans from
undercapitalized institutions, and the regulators are required to
close critically undercapitalized institutions within a 90-day
period.\2 In addition, section 38 restricts depository institutions
in the three lowest capital categories from engaging in certain
activities that could increase the risk of losses to the federal
deposit insurance funds. 

Section 39 directs regulatory attention to the noncapital areas of an
institution's activities as they pertain to safety and soundness. 
The section requires regulators to develop and implement
safety-and-soundness standards in three areas:  (1) operations and
management; (2) asset quality, earnings, and stock valuation; and (3)
compensation.  Initially, the standards for asset quality and
earnings were to be quantitative.  Section 39 also initially required
regulators to take specific regulatory actions against institutions
not meeting prescribed safety-and-soundness standards, such as
imposing growth restrictions or requiring the institution to increase
its capital position.  The Riegle Community Development and
Regulatory Improvement Act of 1994 amended section 39 by eliminating
the requirement for quantitative standards and allowing regulators
greater discretion in setting standards as well as in determining
whether to take action against institutions that fail to meet the
standards.  The amendments were enacted in response to concerns about
the potential regulatory burden on banks and thrifts associated with
section 39. 

Four federal regulators oversee federally insured banks and thrifts. 
The Federal Reserve System (FRS) regulates state-chartered banks that
are members of FRS (member banks) and all bank-holding companies; the
Federal Deposit Insurance Corporation (FDIC) regulates
state-chartered, nonmember banks; the Department of the Treasury's
Office of the Comptroller of the Currency (OCC) regulates nationally
chartered banks; and Treasury's Office of Thrift Supervision (OTS)
regulates all federally insured thrifts, regardless of charter type. 

GAO's review of the implementation and use of section 38 was confined
to OCC and FRS.  As part of this review, GAO analyzed the supervisory
actions taken on a sample of 61 banks that were undercapitalized for
section 38 purposes.  This sample provided coverage of 68 percent of
the OCC-regulated banks and 56 percent of the FRS-regulated banks
that were undercapitalized during the period December 1992 through
December 1994, according to financial data obtained from FDIC.  GAO
relied on similar reviews of OTS and FDIC, which were performed by
the regulators' respective Offices of Inspector General (OIG), to
assess their implementation of section 38.  The two OIGs did not
assess the implementation of section 39 or the impact of sections 38
and 39 on federal oversight of the thrift and bank industries.  In
its review of section 39 implementation, GAO did not sample cases
because, at the time of its review, the regulators had not exercised
their section 39 powers. 


--------------------
\2 FDICIA allows an exception to the 90-day closure rule if both the
primary regulator and the Federal Deposit Insurance Corporation
concur and document why taking some other action would better achieve
section 38's purpose, which is to resolve the problems of insured
depository institutions at the least possible long-term loss to the
deposit insurance funds. 


   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

Regulators have taken the required steps to implement FDICIA's Prompt
Regulatory Action provisions but have had to use the additional
enforcement powers granted by the provisions against a relatively
small number of depository institutions.  The improved financial
condition of banks and thrifts has allowed them to build their
capital levels to the point where only a few institutions were
considered undercapitalized according to section 38 standards.  On
average, less than 1 percent of all banks and thrifts were classified
as undercapitalized between December 1992 and December 1995.  For the
61 undercapitalized banks in GAO's sample, OCC and FRS generally took
prescribed regulatory actions.  For example, the two regulators
closed or merged all but 2 of the 25 critically undercapitalized
banks in GAO's sample within the required 90-day time frame.  As of
September 1996, regulators had not used their section 39 enforcement
authority.  The final two safety-and-soundness standards--asset
quality and earnings--required to fully implement section 39 became
effective on October 1, 1996.  Regulators issued the other required
safety-and-soundness standards (dealing with operations and
management and compensation) in July 1995, and those standards became
effective in August 1995. 

As amended and implemented to date, the Prompt Regulatory Action
provisions strengthen federal oversight to a degree.  But the
provisions may not fully address one significant weakness that
existed in the 1980s as noted by GAO and others--i.e., the failure of
regulators to take strong, forceful enforcement actions early enough
to prevent or minimize losses to the deposit insurance funds.\3

Effective regulatory use of section 38 standards and enforcement
actions should help prevent capital-deficient depository institutions
from engaging in certain risky practices and conditions that
contributed to the losses suffered by the insurance funds in the
1980s.  Nonetheless, most troubled institutions experienced problems
in other areas, such as asset quality and management, long before
their capital became adversely affected.  Section 39 was intended to
increase the likelihood that regulators would take action to address
safety-and-soundness problems before they result in the deterioration
of capital.  However, the guidelines and regulations issued to date
by the regulators to implement section 39 do not (1) establish clear,
objective criteria for what would be considered to be unsafe and
unsound practices or conditions or (2) link the identification of
such conditions to specific mandatory enforcement actions.  Other
provisions in FDICIA and initiatives recently announced by regulators
should help in the early identification of depository institutions
with safety-and-soundness problems.  Ultimately, the success of these
provisions and initiatives will be determined by the regulators'
willingness to use their enforcement powers, including sections 38
and 39, early enough to prevent or minimize losses to the deposit
insurance funds. 


--------------------
\3 Deposit Insurance:  A Strategy for Reform (GAO/GGD-91-26, Mar.  4,
1991) and Bank Supervision:  Prompt and Forceful Regulatory Actions
Needed (GAO/GGD-91-69, Apr.  15, 1991). 


   PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4


      FEW INSTITUTIONS HAVE BEEN
      SUBJECT TO ENFORCEMENT
      ACTIONS UNDER SECTION 38
-------------------------------------------------------- Chapter 0:4.1

The overall financial condition of banks and thrifts has improved
since the 1991 passage of FDICIA.  Banks and thrifts reported record
profit and capital levels from 1992 to 1995.  As a result, the number
of institutions considered undercapitalized according to section 38
capital standards has steadily declined since 1991.  As of December
1995, a total of 29 federally insured banks and thrifts, or
one-quarter of 1 percent of the total number (11,970), were
considered undercapitalized according to section 38 capital
standards. 

OCC and FRS generally took the prescribed enforcement actions on the
61 undercapitalized banks in GAO's sample.  The two regulators
notified the banks of their undercapitalized status and corresponding
restrictions.  In addition, OCC and FRS typically obtained capital
restoration plans from the banks, reviewed them within the prescribed
60-day time frame, and required modifications for some plans before
granting approval.  Moreover, the regulators generally closed those
institutions that were rated critically undercapitalized within the
90-day time frame specified by section 38.  The FDIC OIG reported
similar conclusions regarding FDIC's compliance with section 38
provisions.  As of September 1996, the Treasury OIG was in the
process of finalizing its report on OTS' compliance with section 38
time frames for the receipt and review of capital restoration plans. 

Neither FRS nor OCC has used the additional enforcement tools
provided by section 38 to any great extent.  These enforcement tools
are the reclassification of a bank's capital category due to
safety-and-soundness reasons and actions, known as directives, which
are used to require banks to take specified corrective actions. 

According to the regulators GAO interviewed, section 39 was not fully
implemented by FDICIA's deadline of December 1, 1993, due to the (1)
difficulty of developing standards acceptable to all four regulators,
(2) concerns of regulators and depository institutions that the
safety-and-soundness standards could increase regulatory burden--the
cost of complying with federal regulations--on thrifts and banks, and
(3) knowledge that Congress was considering amending the section 39
requirements to increase regulatory discretion in implementing and
enforcing noncapital safety-and-soundness standards.  The regulators
obtained public comments on three separate occasions in their efforts
to develop and issue the required safety-and-soundness standards.  On
August 27, 1996, the regulators issued the safety-and-soundness
standards for asset quality and earnings, thereby allowing the full
implementation of section 39 as of October 1, 1996. 


      EFFECTIVENESS OF SECTIONS 38
      AND 39 IS YET TO BE
      DETERMINED
-------------------------------------------------------- Chapter 0:4.2

The capital standards implemented under section 38 have provided some
additional protection against losses to the insurance funds.  Section
38 gave depository institutions a strong incentive to increase
capital levels to avoid the mandatory restrictions and supervisory
actions associated with being undercapitalized.  Section 38 also
allows regulators to promptly close institutions when their tangible
equity capital drops to 2 percent of their total assets, thereby
preventing seriously troubled institutions from compounding their
losses.\4 In addition, capital-based enforcement authority also
serves as a useful supplement to regulators' traditional enforcement
authority. 

However, capital-based safeguards of insurance funds are inherently
limited because capital does not typically show a decline until an
institution has experienced substantial deterioration in other
components of its operations and finances.  Deterioration in an
institution's internal controls, asset quality, and earnings can
occur years before capital is adversely affected.  For example, of
the 193 banks and thrifts designated by regulators as being problem
institutions as of December 31, 1995, only 29 (or about 15 percent)
were classified as undercapitalized for section 38 purposes. 
Consequently, by the time seriously troubled institutions become
subject to section 38's mandatory restrictions and enforcement
actions, there may be few options available to prevent or minimize
losses to the deposit insurance funds. 

Section 39, as amended, does not appear to significantly change the
wide discretion that regulators have regarding the timing and
severity of enforcement actions taken against troubled institutions. 
In 1991, GAO recommended that Congress and the regulators develop a
"trip wire" system that would be based on clear, objective criteria
as to what would constitute unsafe and unsound conditions or
practices and what regulatory actions would result if institutions
violated the specified criteria.  In contrast, the guidelines and
regulations developed to implement the amended section 39 consist of
general statements of sound banking principles rather than specific
measures of safety and soundness.  Furthermore, the guidelines and
regulations do not require regulators to take any specific action
against institutions that fail to comply with the standards. 

Nevertheless, FDICIA contains a number of accounting, corporate
governance, and supervisory reforms that may result in greater
management accountability from depository institutions and could help
prevent safety-and-soundness problems from arising or, at least,
allow their earlier identification.  For example, FDICIA requires the
management of large depository institutions to report annually on (1)
the effectiveness of the institution's internal controls and (2) the
institution's compliance with designated laws and regulations.  Thus,
regulators can use the results of these assessments to enhance their
ability to identify institutions that have emerging or existing
safety-and-soundness deficiencies.  Regulators have also acted to
improve their oversight by revising risk-based capital standards and
their on-site examination procedures to better monitor and control
excessive bank risk-taking (see apps.  I and II).  The success of
these initiatives, coupled with the regulators' willingness to use
their various enforcement authorities, including sections 38 and 39,
will be instrumental in determining whether losses to the deposit
insurance funds are prevented or minimized in any subsequent economic
downturn. 


--------------------
\4 Section 133 of FDICIA amended the Federal Deposit Insurance Act to
establish 12 factors that regulators can use to close seriously
troubled institutions to facilitate prompt regulatory action.  One
factor allows regulators to close critically undercapitalized
institutions, which the regulators have defined as institutions with
tangible equity capital ratios of 2 percent or less.  Another factor
allows regulators to close undercapitalized institutions that have no
reasonable prospect of becoming adequately capitalized or that fail
to (1) become adequately capitalized, (2) submit an acceptable
capital restoration plan, or (3) implement a capital restoration plan
submitted and accepted under section 38. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

GAO is not making any recommendations in this report. 


   AGENCY COMMENTS AND GAO'S
   EVALUATION
---------------------------------------------------------- Chapter 0:6

GAO requested comments on a draft of this report from the Office of
the Comptroller of the Currency, the Federal Reserve Board of
Governors, the Federal Deposit Insurance Corporation, and the Office
of Thrift Supervision.  Their comments and GAO's responses are
discussed at the end of chapter 3.  The staffs of the Office of the
Comptroller of the Currency and Federal Deposit Insurance Corporation
also provided technical comments that were incorporated in this
report where appropriate. 

The Federal Reserve Board of Governors stated that it had no formal
comments but that the report appeared to accurately describe the FRS'
policies, procedures, and practices with respect to the
implementation of FDICIA's Prompt Regulatory Action provisions, as
amended. 

Both the Office of the Comptroller of the Currency and the Office of
Thrift Supervision agreed with GAO's conclusion that the
implementation of section 38 has produced positive benefits to the
regulatory oversight of depository institutions.  In response to
GAO's concern that the section 39 safety-and-soundness standards
adopted by the regulators may not always result in early regulatory
action, the Office of the Comptroller of the Currency, Federal
Deposit Insurance Corporation, and Office of Thrift Supervision
reiterated their endorsements of the regulatory discretion and
flexibility provided by section 39. 

GAO does not disagree that there is a need for some degree of
regulatory discretion.  Rather, GAO sees the issue as one of striking
a proper balance between the need for sufficient regulatory
discretion to deal with particular facts and circumstances and the
need for certainty for the banking industry about what constitutes
unsafe or unsound conditions and the supervisory actions that would
result from those conditions.  GAO notes that the implementation of
FDICIA along with recent regulatory initiatives may help in the
earlier detection of problems in federally insured institutions. 
These initiatives along with regulators' willingness to use their
enforcement authorities--including sections 38 and 39--will be
instrumental in preventing or minimizing potential losses to the
deposit insurance funds and in determining whether the proper balance
between discretion and certainty has been attained. 


INTRODUCTION
============================================================ Chapter 1

In the 1980s and early 1990s, the solvency of the federal depository
insurance funds was threatened when hundreds of thrifts\1 and banks
failed.  Taxpayers were forced to bailout the insurance fund for
thrifts, and the insurance fund for banks had a negative balance for
the first time in its history.  This situation prompted concern and
considerable debate about the need to reform federal deposit
insurance and regulatory oversight.  In response, Congress passed the
Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA)\2 to, among other things, improve the supervision and
examination of depository institutions and to protect the federal
deposit insurance funds from further losses.  Among its various
provisions, FDICIA added two new sections to the Federal Deposit
Insurance Act of 1950\3 --sections 38 and 39--referred to as the
Prompt Regulatory Action provisions.  The Prompt Regulatory Action
provisions required federal regulators to institute a two-part system
of regulatory actions that would be triggered when an institution
fails to meet minimum capital levels or safety-and-soundness
standards.  Enactment of this two-part system was intended to
increase the likelihood that regulators would respond promptly and
forcefully to prevent or minimize losses to the deposit insurance
funds from failures. 


--------------------
\1 The term "thrifts" refers to savings and loan associations and
savings banks. 

\2 FDICIA, Public Law 102-242, was passed on December 19, 1991. 

\3 The Federal Deposit Insurance Act of 1950 (P.L.  81-797) revised
and consolidated earlier Federal Deposit Insurance Corporation (FDIC)
legislation into one act and embodies the basic authority for the
operation of FDIC. 


   BACKGROUND
---------------------------------------------------------- Chapter 1:1

The Federal Deposit Insurance Corporation (FDIC), Federal Reserve
System (FRS), and two agencies within the Department of the
Treasury--the Office of the Comptroller of the Currency (OCC) and the
Office of Thrift Supervision (OTS)--share responsibility for
regulating and supervising federally insured banks and thrifts in the
United States.\4 FDIC regulates state-chartered banks that are not
members of FRS; FRS regulates state-chartered, member banks; OCC
regulates nationally chartered banks; and OTS regulates all federally
insured thrifts, regardless of charter type.  The regulators carry
out their oversight responsibilities primarily through monitoring
data filed by institutions, conducting periodic on-site examinations,
and taking actions to enforce federal safety-and-soundness laws and
regulations. 


--------------------
\4 State regulatory agencies share responsibility with federal
agencies for regulating federally insured banks and thrifts that are
state chartered. 


      PROBLEMS OF THRIFTS AND
      BANKS FROM 1980 TO 1990
-------------------------------------------------------- Chapter 1:1.1

From 1980 to 1990, record losses absorbed by the federal deposit
insurance funds highlighted the need for a new approach in federal
regulatory oversight.  Sharply mounting thrift losses over the decade
bankrupted the Federal Savings and Loan Insurance Corporation
(FSLIC), which was the agency responsible for insuring thrifts until
1989, despite a doubling of premiums and a special $10.8 billion
recapitalization program.  During this period, a record 1,020 thrifts
failed at a cost of about $100 billion to the deposit insurance funds
for thrifts.  Banks also failed at record rates.  From 1980 to 1990,
a total of 1,256 federally insured banks were closed or received FDIC
financial assistance.  Estimated losses to the bank insurance fund
for resolving these banks was about $25 billion.  These losses
resulted in the bank insurance fund's incurring annual net losses in
1988, 1989, and 1990 that jeopardized the fund's solvency for the
first time since FDIC's inception. 

Industry analysts have recognized many factors as contributing to the
high level of thrift failures from 1980 to 1990.  For example,
thrifts faced increased competition from nondepository institutions,
such as money-market funds and mortgage banks, as well as periods of
inflation, recession, and fluctuating interest rates during that
period.  High interest rates and increased competition for deposits
during the decade also created a mismatch between interest revenues
from the fixed rate mortgages that constituted the bulk of the thrift
industry's assets and the cost of borrowing funds in the marketplace. 
Increased powers granted to thrifts in a period during which
supervision did not keep pace has also been cited by some analysts,
including us, as contributing to the problems of the industry. 

Regulators and industry analysts have associated a number of factors
with the problems of banks during the 1980s.  First, banks suffered
losses resulting from credit risk--risk of default on loans--in an
environment of prolonged economic expansion and increasingly volatile
interest rates.  The decade began with crises in agricultural loans
and loans to developing nations.  Next, unrepaid energy loans took a
toll and led to the downfall of several major banks, including
Continental Illinois in Chicago and First RepublicBank in Texas.  As
the decade came to a close, highly leveraged transactions and the
collapse of commercial real estate markets, in which banks had been
heavy lenders, depleted the capital structures of some major East
Coast and West Coast banks and led to their failures. 

One factor we and others cited as contributing to the problems of
both thrifts and banks during this period was excessive forbearance
by federal regulators.  Regulators had wide discretion in choosing
the severity and timing of enforcement actions that they took against
depository institutions with unsafe and unsound practices.  In
addition, regulators had a common philosophy of trying to work
informally and cooperatively with troubled institutions.  In a 1991
report,\5 we found that this approach, in combination with
regulators' wide discretion in the oversight of financial
institutions, had resulted in enforcement actions that were neither
timely nor forceful enough to (1) correct unsafe and unsound banking
practices or (2) prevent or minimize losses to the insurance funds. 
Regulators themselves recognized that their supervisory practices in
the 1980s failed to adequately control risky practices that led to
the numerous thrift and bank failures. 


--------------------
\5 Bank Supervision:  Prompt and Forceful Regulatory Actions Needed
(GAO/GGD-91-69, Apr.  15, 1991). 


      LEGISLATIVE RESPONSE TO THE
      THRIFT AND BANK CRISIS OF
      THE 1980S
-------------------------------------------------------- Chapter 1:1.2

Congress passed two major laws to address the thrift and bank crisis
of the 1980s.  The first, the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 (FIRREA),\6 was enacted
primarily in response to the immediate problems surrounding FSLIC's
bankruptcy and troubles in the thrift industry.  FIRREA created a new
regulator for the thrift industry, OTS, and a new insurance fund, the
Savings Association Insurance Fund (SAIF), to replace the bankrupt
FSLIC.  In addition, FIRREA increased the enforcement authority of
both bank and thrift regulators.  For example, FIRREA expanded the
circumstances under which regulators could assess civil money
penalties and increased the maximum penalty to $1 million per day.\7
FIRREA also authorized FDIC to terminate a bank's or thrift's deposit
insurance on the basis of unsafe and unsound conditions. 

The second major piece of legislation, FDICIA, contains several
provisions that were intended to collectively improve the supervision
of federally insured depository institutions.  Specifically, FDICIA
requires a number of corporate governance and accounting reforms to
(1) strengthen the corporate governance of depository institutions,
(2) improve the financial reporting of depository institutions, and
(3) help in the early identification of emerging safety-and-soundness
problems in depository institutions.  In addition, FDICIA contains
provisions that were intended to improve how regulators supervise
depository institutions. 

Among the corporate governance and accounting reforms, FDICIA
establishes generally accepted accounting principles as the standard
for all reports and statements filed with the regulators.  FDICIA
also requires the management and auditors of depository institutions
to annually report on their financial condition and management.\8 The
report is to include management's assessment of (1) the effectiveness
of the institution's internal controls and (2) the institution's
compliance with designated laws and regulations.  In addition, FDICIA
requires the institution's external auditors to report separately on
management's assertions.\9 Furthermore, FDICIA requires the
institutions to have an independent audit committee composed of
outside independent directors. 

Among the supervision provisions, FDICIA requires regulators to
perform annual on-site examinations of insured banks and thrifts (an
18-month cycle was allowed for qualified smaller institutions with
assets of less than $100 million).\10 FDICIA's sections 131 and 132
added two new sections to the Federal Deposit Insurance Act (sections
38 and 39) that require the implementation of a "trip wire" approach
to increase the likelihood that regulators will address the problems
of troubled institutions at an early stage to prevent or minimize
loss to the insurance funds. 


--------------------
\6 FIRREA, Public Law 101-73, was effective on August 9, 1989. 

\7 The $1 million per day civil money penalty established by FIRREA
can be assessed against an insured institution or
institution-affiliated party under the following conditions.  The
institution or party must "knowingly" (1) engage in unlawful conduct
or unsafe and unsound practices or (2) breach a fiduciary duty. 
Furthermore, the institution or party must "knowingly or recklessly
cause a substantial loss to the institution or a substantial
pecuniary gain or other benefit" to the party. 

\8 FDICIA contains an exemption from the annual reporting requirement
for small depository institutions, which it defined as those
institutions with less than $150 million in total assets or a greater
amount if established by FDIC in regulations.  FDIC issued
regulations on June 2, 1993, that exempt institutions with less than
$500 million in total assets from the annual reporting requirement
(see 58 Fed.  Reg.  31335). 

\9 Section 2301(a) of the Economic Growth and Regulatory Paperwork
Reduction Act of 1996 contained in Title II, Subtitle C, of the
Omnibus Consolidated Appropriations Act for Fiscal Year 1997 (P.L. 
104-208, Sept.  30, 1996) repealed the requirement that an
institution's external auditors report on the institution's
compliance with designated laws and regulations. 

\10 Section 2221 of the Economic Growth and Regulatory Paperwork
Reduction Act of 1996 allows regulators to increase the maximum size
of institutions allowed to be examined on an 18-month cycle to a
level of $250 million in total assets if regulators determine that
the greater amount would be consistent with the principles of safety
and soundness. 


         SECTION 38 PROVISIONS
------------------------------------------------------ Chapter 1:1.2.1

Section 38 creates a capital-based framework for bank and thrift
oversight that is based on the placement of financial institutions
into one of five capital categories.  Capital was made the
centerpiece of the framework because it represents funds invested by
an institution's owners, such as common and preferred stock, that can
be used to absorb unexpected losses before the institution becomes
insolvent.  Thus, capital was seen as serving a vital role as a
buffer between bank losses and the deposit insurance system. 
Although section 38 does not in any way limit regulators' ability to
take additional supervisory action, it requires federal regulators to
take specific actions against banks and thrifts that have capital
levels below minimum standards.  The specified regulatory actions are
made increasingly severe as an institution's capital drops to lower
levels. 

Section 38 requires regulators to establish criteria for classifying
depository institutions into the following five capital categories: 
well-capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized, and critically undercapitalized.  The
section does not place restrictions on institutions that meet or
exceed the minimum capital standards--that is, those that are well-
or adequately capitalized--other than prohibiting the institutions
from paying dividends or management fees that would drop them into
the undercapitalized category.\11

A depository institution that fails to meet minimum capital levels
faces several mandatory restrictions or actions under section 38. 
The mandatory actions are intended to ensure a swift regulatory
response that would prevent further erosion of an institution's
capital.  Specifically, section 38 requires an undercapitalized
institution to

  -- submit a capital restoration plan detailing, among other things,
     how the institution is going to become adequately capitalized;

  -- restrict its asset growth during any quarter so that its average
     total assets for the quarter do not exceed the preceding
     quarter's average total assets, unless certain conditions are
     met; and

  -- receive prior regulatory approval for acquisitions, branching,
     and new lines of business. 

Section 38 allows regulators to take additional actions against an
undercapitalized institution, if deemed necessary.  It also requires
regulators to closely monitor the institution's condition and its
compliance with section 38's requirements. 

Section 38 requires regulators to take more forceful corrective
measures when institutions become significantly undercapitalized.\12
Regulators must take 1 or more of 10 specified actions, including (1)
requiring the sale of equity or debt or, under certain circumstances,
requiring institutions to be acquired by or merged with another
institution; (2) restricting otherwise allowable transactions with
affiliates; and (3) restricting the interest rates paid on deposits
by the institution.  Each of these three steps is to be mandatory
unless the regulator determines that taking such steps would not
further the purpose of section 38, which is to resolve the problems
of insured depository institutions at the least possible long-term
loss to the insurance fund.  Other specific actions available to the
regulators include

  -- imposing more stringent asset growth limitations than required
     for undercapitalized institutions or requiring the institution
     to reduce its total assets;

  -- requiring the institution, or its subsidiaries, to alter,
     reduce, or terminate an activity that the regulator determines
     poses excessive risk to the institution;

  -- improving management by (1) ordering a new election for the
     institution's board of directors, (2) dismissing directors or
     senior executive officers, and/or (3) requiring an institution
     to employ qualified senior executive officers;

  -- prohibiting the acceptance, including renewal and rollover, of
     deposits from correspondent banks;

  -- requiring prior approval for capital distributions from holding
     companies having control of the institution; and

  -- requiring divestiture by (1) the institution of any subsidiary
     that the regulator determines poses a significant risk to the
     institution, (2) the parent company of any nondepository
     affiliate that regulators determine poses a significant risk to
     the institution, and/or (3) any controlling company of the
     institution if the regulator determines that divestiture would
     improve the institution's financial condition and future
     prospects. 

Regulators can also require any other action that they determine
would better resolve the problems of the institution with the least
possible long-term loss to the insurance funds.  Finally, section 38
prohibits significantly undercapitalized institutions from paying
bonuses to or increasing the compensation of senior executive
officers without prior regulatory approval. 

Section 38 requires more stringent action to be taken against
critically undercapitalized institutions.  After an institution
becomes critically undercapitalized, regulators have a 90-day period
in which they must either place the institution into receivership or
conservatorship or take other action that would better prevent or
minimize long-term losses to the insurance fund.\13 In either case,
regulators must obtain FDIC concurrence with their actions.  Section
38 also prohibits critically undercapitalized depository institutions
from doing any of the following without FDIC's prior written
approval: 

  -- entering into any material transaction (such as investments,
     expansions, acquisitions, and asset sales), other than in the
     usual course of business;

  -- extending credit for any highly leveraged transaction;

  -- amending the institution's charter or bylaws, except to the
     extent necessary to carry out any other requirement of any law,
     regulation, or order;

  -- making any material change in accounting methods;

  -- engaging in any covered transaction;\14

  -- paying excessive compensation or bonuses; or

  -- paying interest on new or renewed liabilities at a rate that
     would increase the institution's weighted average cost of funds
     to a level significantly exceeding the prevailing rates of
     interest on insured deposits in the institution's normal market
     area. 

In addition, section 38 prohibits a critically undercapitalized
institution from making any payment of principal or interest on the
institution's subordinated debt beginning 60 days after becoming
critically undercapitalized.\15

Finally, section 38 permits regulators to, in effect, downgrade an
institution by one capital level if regulators determine that the
institution is in an unsafe and unsound condition or that it is
engaging in an unsafe and unsound practice.  For example, regulators
can treat an adequately capitalized institution as undercapitalized
if the institution received a less than satisfactory rating in its
most recent examination report for asset quality, management,
earnings, or liquidity.  This downgrading would then allow regulators
to require the institution's compliance with those restrictions
applicable to undercapitalized institutions, such as limits on the
institution's growth.  Thus, section 38 allows regulators to take
enforcement actions against an institution that presents a danger to
the insurance fund by virtue of a factor other than its capital
level.  In addition to the specific provisions of section 38, another
section of FDICIA provides FDIC with the authority to appoint a
conservator or receiver for undercapitalized institutions that meet
certain criteria.\16


--------------------
\11 Section 301 of FDICIA amended section 29 of the Federal Deposit
Insurance Act to make a distinction between well-capitalized and
adequately capitalized institutions regarding brokered deposits. 
Well-capitalized institutions can accept brokered deposits without
restriction.  Adequately capitalized institutions can accept brokered
deposits if they receive a waiver from FDIC.  Section 301 also
imposes certain interest rate restrictions for brokered deposits
accepted by institutions that are not well-capitalized. 

\12 Section 38 requires regulators to treat undercapitalized
institutions that fail to submit or implement a capital restoration
plan as significantly undercapitalized. 

\13 Any determination to take other action in lieu of receivership or
conservatorship for a critically undercapitalized institution is
effective for no more than 90 days.  The regulator is then required
to place the institution into receivership (or conservatorship) or
make a new determination to take other action.  Each new
determination is subject to the same 90-day restriction.  If the
institution is critically undercapitalized, on average, during the
calendar quarter beginning 270 days after the date on which the
institution first became critically undercapitalized, the regulator
is required to appoint a receiver for the institution.  Section 38
contains an exception to this requirement if, among other things, the
regulator and chairperson of the FDIC Board of Directors both certify
that the institution is viable and not expected to fail. 

\14 The term "covered transactions" refers to the following
transactions between a depository institution and its affiliates: 
(1) a loan or extension of credit to the affiliate; (2) a purchase of
or an investment in securities issued by the affiliate; (3) a
purchase of assets--including assets subject to an agreement to
repurchase from the affiliate--except such purchase of real and
personal property that may be specifically exempted by the Federal
Reserve Board by order or regulation; (4) the acceptance of
securities issued by the affiliate as security for a loan or
extension of credit to any person or company; or (5) the issuance of
a guarantee, acceptance, or letter of credit--including an
endorsement or standby letter of credit--on behalf of an affiliate. 
See section 23A(b)(7) of the Federal Reserve Act, 12 U.S.C.  section
371c(b)(7). 

\15 An exception to the prohibition on making payments on
subordinated debt can be made by FDIC on the basis of conditions
specified in section 38(h)(2)(B). 

\16 FDICIA's section 133 amended section 11(c)(5) of the Federal
Deposit Insurance Act to add additional grounds for the appointment
of a conservator or receiver for troubled institutions.  Among the 12
factors listed, one factor provides for the appointment of a receiver
or conservator for institutions that are undercapitalized under
section 38 and that (1) have no reasonable prospect of becoming
adequately capitalized, (2) fail to become adequately capitalized
when required to do so by the regulator, (3) fail to submit an
acceptable capital restoration plan within the required time frames,
or (4) materially fail to implement a capital restoration plan
submitted and accepted under section 38. 


         SECTION 39 PROVISIONS
------------------------------------------------------ Chapter 1:1.2.2

To limit deposit insurance losses caused by factors other than
inadequate capital, section 39 directs each regulator to establish
standards defining safety and soundness in three overall areas:  (1)
operations and management; (2) asset quality, earnings, and stock
valuation; and (3) compensation.  Section 39 originally made the
safety-and-soundness standards applicable to both insured depository
institutions and their holding companies, but the reference to
holding companies was deleted in 1994. 

The section originally required regulators to prescribe
safety-and-soundness standards through the use of regulations.  For
the operations and management standards, section 39 did not provide
specific requirements other than requiring regulators to prescribe
standards on internal controls, internal audit systems, loan
documentation, credit underwriting, interest rate exposure, and asset
growth.  For asset quality, earnings, and--to the extent
feasible--stock valuation, the section initially required regulators
to establish quantitative standards.  (See the next section for a
discussion of amendments made to section 39's original provisions.)
Under compensation standards, regulators were to prescribe, among
other things, standards specifying when compensation, fees, or
benefits to executive officers, employees, directors, or principal
shareholders would be considered excessive or could lead to material
financial loss. 

Section 39 initially contained a number of provisions concerning the
failure to meet the regulators' prescribed safety-and-soundness
standards.  One key provision of the section directed regulators to
require a corrective action plan from institutions or holding
companies that fail to meet any of the standards.  Such plans were to
specify the steps an institution or a holding company was taking or
intended to take to correct the deficiency.  Section 39 directed the
regulators to establish specific deadlines for submission and review
of the plans.  If an institution or a holding company failed to
submit or implement the plan, regulators were mandated to issue an
order requiring the institution or holding company to correct the
deficiency and to take one or more of the following remedial actions
as considered appropriate: 

  -- restrict the institution's or holding company's asset growth,

  -- require the institution or holding company to increase its ratio
     of tangible equity to assets,

  -- restrict interest rates paid on deposits, and/or

  -- require the institution or holding company to take any other
     action that the regulator determines would prevent or minimize
     losses to the insurance fund. 

Section 39 also initially required regulators to take at least one of
the first three previously mentioned remedial actions against
institutions that (1) fail to meet any of the operational and/or
asset quality standards listed in FDICIA, (2) have not corrected the
deficiency, and (3) either commenced operations or experienced a
change in control within the preceding 24 months or experienced
extraordinary growth during the prior 18 months of failing to meet
the standards. 


         RIEGLE COMMUNITY
         DEVELOPMENT AND
         REGULATORY IMPROVEMENT
         ACT OF 1994 AMENDED
         SECTION 39'S PROVISIONS
------------------------------------------------------ Chapter 1:1.2.3

The Riegle Community Development and Regulatory Improvement Act of
1994 (CDRI)\17 was passed on September 23, 1994, and contains more
than 50 provisions that were intended to reduce bank regulatory
burden and paperwork requirements.  Among its provisions, CDRI
amended some of section 39's requirements to provide regulators with
greater flexibility and to respond to concerns that section 39 would
subject depository institutions to undue "micromanagement" by the
regulators.  The CDRI amendments allow regulators to issue the
standards in the form of guidelines instead of regulations.  If
guidelines are used, the amendments give the regulators the
discretion to decide whether a corrective action plan will be
required from institutions that are found not to be in compliance
with the standards.  Finally, the amendments eliminate the
requirement that regulators issue quantitative standards for asset
quality and earnings and exclude holding companies from the scope of
the standards. 

CDRI did not change section 39's original provisions regarding the
content and review of any plan required as a result of noncompliance
with section 39's safety-and-soundness standards.  Thus, regulators
still are required to issue regulations governing the contents of the
plan, time frames for the submission and review of the plans, and
enforcement actions applicable to the failure to submit or implement
a required plan.\18


--------------------
\17 Public Law 103-325. 

\18 Under section 39, regulators are required to issue regulations
establishing reasonable deadlines for the submission of the plan
(generally not later than 30 days after the entity fails to meet a
standard) and for acting on it (generally not later than 30 days
after the plan is submitted). 


      CONDITION OF THE BANK AND
      THRIFT INDUSTRIES HAS
      IMPROVED
-------------------------------------------------------- Chapter 1:1.3

Since the passage of FDICIA in 1991, the financial condition of the
bank and thrift industries has improved substantially.  As shown in
table 1.1, the net income of banks more than doubled between 1991 and
1995, reaching a record high of $48.8 billion in 1995. 



                               Table 1.1
                
                 Annual Net Income of Federally Insured
                       Banks and Thrifts, 1991-95

                         (Dollars in billions)


                                              Net income    Net income
Year                                            of banks    of thrifts
------------------------------------------  ------------  ------------
1995                                               $48.8          $7.6
1994                                                45.7           6.6
1993                                                45.2           7.1
1992                                                34.4           7.2
1991                                                19.8           1.0
----------------------------------------------------------------------
Source:  FDIC-published statistics. 

Table 1.1 also shows that the net income of thrifts grew dramatically
in 1992 from the 1991 level, decreased slightly in 1993 and 1994, and
grew to a record $7.6 billion in 1995.  In the period from 1992
through 1995, the number of bank and thrift failures declined from
their 1980 to 1990 levels.  For example, 6 banks failed in 1995,
compared with 169 bank failures in 1990. 

The low number of bank failures in recent years has allowed the bank
insurance fund to rebuild its reserve level.  After falling to a
record low of negative $7 billion in 1991, the fund grew to over $25
billion in 1995.  The recapitalization of the bank insurance fund
allowed FDIC to reduce the deposit insurance assessment rate paid by
commercial banks twice in the latter part of 1995.  As a result,
commercial banks are paying the lowest average assessment rate in
history. 

Despite the improved performance of the thrift industry, the thrift
insurance fund remained undercapitalized as of December 1995.  FDICIA
required FDIC to increase the bank and thrift insurance funds'
reserve balances to at least 1.25 percent of the estimated insured
deposits of insured institutions within 15 years of enactment of a
recapitalization schedule.\19 FDIC achieved this reserve ratio for
the bank insurance fund on May 31, 1995.  However, SAIF is not
expected to achieve its required reserve ratio until 2002, according
to FDIC.  Thus, insurance fund premiums paid by thrifts remain
significantly higher than those paid by commercial banks. 


--------------------
\19 This requirement was subsequently amended by the Resolution Trust
Corporation Completion Act, Public Law 103-204.  This amendment
allows FDIC to extend the 15-year recapitalization schedule for SAIF
if FDIC determines that the extension will, over time, maximize the
amount of semiannual assessments received by SAIF, net of insurance
losses incurred by the fund. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:2

The principal objective of this review was to assess the progress and
results of the federal regulators' implementation of FDICIA's Prompt
Regulatory Action provisions.  Specifically, we assessed (1) the
efforts of federal regulators to implement sections 38 and 39 and (2)
the impact of sections 38 and 39 on federal oversight of the bank and
thrift industries. 

To assess the federal regulators' efforts to implement sections 38
and 39, we compared the legislative provisions with the implementing
regulations and guidelines developed and issued by the regulators. 
In addition, we asked for and reviewed additional guidance developed
by OCC and FRS.  We concentrated our assessment on OCC and FRS
because the FDIC and Treasury Offices of the Inspector General (OIG),
respectively, had performed similar reviews of FDIC's and OTS'
implementation of section 38.  To the extent possible, we used the
results of the FDIC OIG effort to compare and contrast with the
results of our review of OCC's and FRS' implementation of section 38. 
We did not include the Treasury OIG's results because the OIG was in
the process of finalizing its evaluation.  However, the OIG reviews
did not assess FDIC's or OTS' implementation of section 39. 

We also assessed OCC's and FRS' implementation of section 38 by
analyzing the supervisory actions used on the 61 banks that were
undercapitalized (including those that were significantly and
critically undercapitalized) for section 38 purposes.  We identified
the 61 banks using financial data (call reports)\20

obtained from FDIC for the quarters ending December 1992 through
December 1994.  In the case of OCC, we looked at all of the 52
undercapitalized banks that were located in OCC's Western, Southwest,
and Northeast districts.  These data provided us with coverage of 68
percent of all OCC-regulated banks that were undercapitalized during
that period.  For FRS, we looked at all nine undercapitalized banks
under the jurisdiction of FRS' Atlanta, Dallas, and San Francisco
district banks.  Doing so resulted in a coverage of 56 percent of all
FRS-regulated banks that were undercapitalized during that period. 
While our results are not projectable to all undercapitalized banks
under OCC's and FRS' jurisdiction, our results are representative of
the OCC and FRS locations that we visited. 

As part of our assessment of (1) OCC's and FRS' efforts to implement
sections 38 and 39 and (2) the impact of the sections on regulatory
oversight, we interviewed OCC and FRS officials in the previously
mentioned locations as well as in Washington, D.C.  We obtained the
officials' views on the legislative intent underlying sections 38 and
39 and the evolution of the final regulations and guidelines.  We
also had discussions with the officials about regulatory actions,
both under their traditional enforcement and section 38 authority,
taken against the 61 banks that we reviewed.\21 Additionally, we
interviewed FDIC and OTS officials to obtain information on the
interagency process used to develop the safety-and-soundness
standards required to implement section 39. 

To assess the impact of sections 38 and 39 on the regulatory
oversight of banks and thrifts, we used the 61 banks that we
determined were undercapitalized for section 38 purposes to evaluate
OCC's and FRS' use of their section 38 authority (reclassification
and directives) versus the use of traditional enforcement tools.  In
addition, we reviewed OCC's and FRS' internal guidance and policies
regarding the use of section 38 versus their other enforcement tools. 
We also obtained and analyzed information on the number of banks that
the regulators had determined were undercapitalized for section 38
purposes versus the number of banks they had identified as being
"problem" banks.\22 We analyzed various articles and economic
literature issued on (1) the impact of sections 38 and 39 on the
regulatory process and (2) the implications of a capital-based
regulatory approach in general.  Additionally, we used OIG and our
prior report results and recommendations to assess the content of the
implementing regulations and guidelines as well as the likely impact
of section 38 on the regulatory process. 

We did our work from November 1994 to September 1996 in accordance
with generally accepted government auditing standards.  We provided a
draft of this report to the Federal Reserve Board, the Comptroller of
the Currency, the Federal Deposit Insurance Corporation, and the
Office of Thrift Supervision for their review and comment.  A summary
of the agencies' comments and our evaluation are included at the end
of chapter 3.  The agencies' comment letters are reprinted in
appendixes III to VI.  Staff of OCC and FDIC also provided additional
technical comments on the draft report, which were incorporated as
appropriate. 


--------------------
\20 Call reports are statements of a bank's financial condition and
income that are submitted to federal regulators.  Thrifts submit a
Thrift Financial Report, which contains similar information to a call
report.  Both banks and thrifts prepare and submit the reports on a
quarterly basis. 

\21 Regulators have a variety of actions prescribed by law and
regulations that they can take against depository institutions. 
Traditional enforcement actions include (1) formal written agreements
between regulators and bankers; (2) orders to cease and desist unsafe
practices and/or violations; (3) assessments of civil money
penalties; and (4) orders of removal, prohibition, or suspension of
individuals from bank operations.  (See 18 U.S.C.  1818.) In
addition, regulators can issue directives.  Directives are orders
issued by regulators to insured institutions that fail to satisfy
minimum capital standards, which require the institutions to take one
or more actions to achieve required minimum capital levels.  (See 57
Fed.  Reg.  44891, Sept.  29, 1992.)

\22 Federal regulators assign a composite rating to each financial
institution on the basis of an evaluation of financial and
operational criteria.  The rating is based on a scale from 1 to 5 in
ascending order of supervisory concern.  Problem institutions are
those with financial, operational, or managerial weaknesses that
threaten the institutions' continued financial viability.  Depending
on the degree of risk and supervisory concern, the institutions are
rated either "4" or "5."


FEW INSTITUTIONS HAVE BEEN SUBJECT
TO ENFORCEMENT ACTIONS UNDER
SECTIONS 38 AND 39
============================================================ Chapter 2

Regulators have taken steps to implement FDICIA's Prompt Regulatory
Action provisions.  However, the financial condition of banks and
thrifts has improved since the passage of FDICIA in 1991 because
relatively few institutions have been considered undercapitalized
under section 38 as of September 1996.  Our review of a sample of 61
undercapitalized banks found that OCC and FRS have generally met
section 38 requirements regarding the identification of
undercapitalized institutions, the receipt and review of capital
restoration plans, and the closure of critically undercapitalized
institutions.  Our finding was consistent with the FDIC OIG's
conclusions regarding FDIC's implementation of section 38.  All three
regulators (OCC, FRS, and FDIC) had virtually no experience in using
their section 38 reclassification authority and had used their
section 38 authority to take enforcement actions on a relatively
small number of institutions. 

As of September 1996, none of the regulators had used section 39
enforcement powers.  All but two of the safety-and-soundness
standards required for the implementation of section 39 became
effective in August 1995.  The remaining two standards--asset quality
and earnings--became effective on October 1, 1996, allowing for the
full implementation of section 39.  The regulators explained that
they missed the December 1993 statutory deadline for the
implementation of section 39 due to (1) the complication of
developing standards on an interagency basis, (2) the concern of
ensuring that the standards did not unnecessarily add to the existing
regulatory burden of depository institutions, and (3) the knowledge
that Congress was considering amending section 39's requirements
governing the standards. 


   FEW FINANCIAL INSTITUTIONS HAVE
   BEEN UNDERCAPITALIZED UNDER
   SECTION 38
---------------------------------------------------------- Chapter 2:1

Regulations issued by the four regulators to implement section 38
requirements are intended to ensure that prompt regulatory action is
taken whenever an institution's capital condition poses a threat to
federal deposit insurance funds.  Banks and thrifts have increased
their capital levels since the passage of FDICIA so that relatively
few financial institutions have been subject to section 38 regulatory
actions in the 3 years that the regulations were in effect.  Between
December 1992--the effective date of the regulations--and December
1995, the number and total assets of institutions that were
undercapitalized had decreased from about 2 percent in 1992 to less
than one-quarter of 1 percent of all banks and thrifts by 1995. 

The regulators jointly developed the implementing regulations for
section 38 and based the criteria for the five capital categories on
international capital standards and section 38 provisions.  The four
regulators specifically based the benchmarks for an adequately
capitalized institution on the Basle Committee\1

requirement, which stipulates that an adequately capitalized
international bank must have at least 8 percent total risk-based
capital and 4 percent tier 1 capital.\2 For the definition of a
critically undercapitalized institution, the regulators adopted
section 38's requirement of a tangible equity ratio of at least 2
percent of total assets.  The regulators based the criteria for the
remaining three capital categories on these two benchmarks. 

As shown in table 2.1, three capital ratios are used to determine if
an institution is well-capitalized, adequately capitalized,
undercapitalized, or significantly undercapitalized.  A
well-capitalized or adequately capitalized institution must meet or
exceed all three capital ratios for its capital category.  To be
deemed undercapitalized or significantly undercapitalized, an
institution need only fall below one of the ratios listed for its
capital category.  Although not shown in the table, a fourth
ratio--tangible equity--is used to categorize an institution as
critically undercapitalized.  Any institution that has a 2-percent or
less tangible equity ratio is considered critically undercapitalized,
regardless of its other capital ratios. 



                               Table 2.1
                
                   Summary of Four Section 38 Capital
                   Categories and Ratio Requirements


                  Total risk-       Tier 1 risk-
Capital category  based             based             Leverage
----------------  ----------------  ----------------  ----------------
Well-             10 percent or     6 percent or      5 percent or
capitalized\a     more and          more and          more

Adequately        8 percent or      4 percent or      4 percent or
capitalized       more and          more and          more\

Undercapitalized  Less than 8       Less than 4       Less than 4
                  percent or        percent or        percent\b

Significantly     Less than 6       Less than 3       Less than 3
undercapitalized  percent or        percent or        percent
----------------------------------------------------------------------
Note:  Only the tangible equity ratio is used to determine whether an
institution is critically undercapitalized.  Institutions with a
tangible equity ratio of 2 percent or less are considered to be
critically undercapitalized. 

\a An institution cannot be considered to be well-capitalized if it
is subject to a formal regulatory enforcement action that requires
the institution to meet and maintain a specific capital level. 

\b The leverage ratio can be as low as 3 percent if the institution
has a regulator-assigned composite rating of 1.  Regulators are to
assign a composite rating of 1 only to institutions considered to be
sound in almost every aspect of operations, condition, and
performance. 

Source:  Interagency regulations issued on September 29, 1992 (57
Fed.  Reg.  44866). 

So far, relatively few financial institutions have been categorized
as undercapitalized and, thus, subject to section 38 regulatory
actions.  This situation was due, in part, to the improved financial
condition of the bank and thrift industries.  The implementation of
section 38 also provided institutions with strong incentives to
increase their capital levels to avoid the mandatory restrictions and
supervisory actions associated with being undercapitalized.  As shown
in table 2.2, the number of financial institutions whose reported
financial data indicated undercapitalization, based on section 38
implementing regulations, steadily declined between December 1992 and
December 1995.  The beginning of the decline coincided with the
December 1992 implementation of section 38. 



                                    Table 2.2
                     
                      Federally Insured Banks and Thrifts by
                      Section 38 Capital Category, Year-End
                                     1992-95



                          Percen          Percen          Percen          Percen
Capital category  Number       t  Number       t  Number       t  Number       t
----------------  ------  ------  ------  ------  ------  ------  ------  ------
Well-             12,990    93.8  12,873    97.4  12,328    97.8  11,783    98.4
 capitalized
Adequately           609     4.4     275     2.1     224     1.8     158     1.3
 capitalized
Undercapitalized     109     0.8      32     0.2      27     0.2      21     0.2
Significantly         83     0.6      24     0.2      14     0.1       5     0.0
 undercapitalized
Critically            60     0.4      16     0.1       9     0.1       3     0.0
 undercapitalized
================================================================================
Total             13,851   100.0  13,220   100.0  12,602   100.0  11,970   100.0
--------------------------------------------------------------------------------
Note:  Percentages may not total 100 percent due to rounding. 

Source:  FDIC. 

Data reported by financial institutions indicated that 252 banks and
thrifts, or about 2 percent of those institutions, were
undercapitalized in December 1992, including those that were
significantly and critically undercapitalized.  As of December 1995,
only 29 banks and thrifts, or about one-quarter of 1 percent of all
banks and thrifts, fell into the undercapitalized categories. 


--------------------
\1 The Basle Committee is made of representatives from Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Sweden, Switzerland, the United Kingdom, and the United States.  The
chief purpose of the committee has been "to close gaps in the
supervisory net and to improve supervisory understanding and the
quality of banking supervision worldwide." The committee issued its
final version of capital standards for international banks on July
15, 1988, under the title International Convergence of Capital
Measure and Capital Standards. 

\2 The total risk-based capital ratio consists of the sum of tier 1
and tier 2 capital divided by risk-weighted assets.  Tier 1 capital
consists primarily of tangible equity capital--equity capital plus
cumulative preferred stock (including related surplus)--minus all
intangible assets, except for some amount of purchased mortgage
servicing rights.  Tier 2 capital includes subordinated debt, loan
loss reserves (both subject to maximum limits), and certain other
instruments.  Risk-weighted assets are calculated using a risk
weighing to each asset, on the basis of the asset's relative default
risk.  These weights range from 0 percent for assets, such as cash
and U.S.  Treasury securities, to 100 percent for most loans. 


   REGULATORS COMPLIED WITH THE
   BASIC REQUIREMENTS OF SECTION
   38
---------------------------------------------------------- Chapter 2:2

Our review of regulatory actions at 61 sample banks indicated that
OCC and FRS complied with the basic requirements of section 38 and
its implementing regulations.  Specifically, OCC and FRS categorized
the banks in accordance with section 38 criteria and notified
undercapitalized banks of the restrictions and regulatory actions
associated with their capital category.  In addition, OCC and FRS
typically obtained and reviewed the required capital restoration
plans within the time frames specified by section 38.  Moreover, the
two regulators generally took action to close the critically
undercapitalized banks as required by section 38.  Both regulators
had limited experience with issuing section 38 directives or using
their reclassification authority.  The FDIC OIG reported similar
results regarding FDIC's implementation of section 38. 


      OCC AND FRS CLASSIFIED BANKS
      IN ACCORDANCE WITH SECTION
      38 REQUIREMENTS
-------------------------------------------------------- Chapter 2:2.1

OCC and FRS correctly identified and categorized the 61 sampled banks
using criteria specified in section 38 legislation and implementing
regulations.  While primarily relying on call reports, they also used
the on-site examination process to identify undercapitalized banks. 
The regulators then sent notices to those banks to inform the banks
of their undercapitalized status and the associated section 38
mandatory restrictions, requirements, and regulatory responses. 

In the jurisdictions of the offices that we visited,\3 OCC and FRS
identified a total of 61 banks as being undercapitalized at some
point from December 1992 through December 1994.  The two regulators
identified 60 banks as undercapitalized on the basis of the call
report data reported to the regulators on a quarterly basis.  FRS
identified an additional bank as being undercapitalized on the basis
of the results of an on-site safety-and-soundness examination.  Table
2.3 shows the distribution of the banks in our sample by regulator
and section 38 capital category. 



                               Table 2.3
                
                Section 38 Capital Categories of the 61
                   Undercapitalized Banks We Reviewed


                                 Total
Capital                      number of  Status of banks as of December
category         OCC   FRS       banks  1995
--------------  ----  ----  ----------  ------------------------------
Undercapitaliz    18     2          20  4 merged, 1 voluntarily
 ed                                      liquidated, 5 remained
                                         problem banks,\a 10 improved
Significantly     11     5          16  4 merged, 1 voluntarily
 undercapitali                           liquidated, 6 remained
 zed                                     problem banks,\a 5 improved
Critically        23     2          25  18 failed, 1 merged, 1
 undercapitali                           remained a problem bank,\a 5
 zed                                     improved
======================================================================
Total/Status      52     9          61  18 failed, 9 merged, 2
                                         voluntarily liquidated, 12
                                         remained problem banks,\a 20
                                         improved
----------------------------------------------------------------------
\a Problem banks have one or more of the following attributes:  (1)
the banks have a regulator-assigned composite rating of 4 or 5, (2)
the banks are under a formal enforcement agreement because of
safety-and-soundness problems, and/or (3) the banks continue to be
undercapitalized according to section 38 implementing regulations. 

Source:  GAO analysis of OCC and FRS files. 

OCC and FRS sent the required notices to the management of the 61
banks in our sample informing them of their banks' undercapitalized
status.  The notification letters advised the banks of the mandatory
requirements and restrictions associated with their section 38
capital category.  For significantly and critically undercapitalized
banks, the notification letters also pointed out the additional
mandatory and discretionary regulatory responses or actions
associated with their section 38 capital categorization. 


--------------------
\3 We visited the OCC and FRS offices located in San Francisco and
Dallas.  In addition, we performed work in OCC's New York/Boston
office and FRS' Atlanta office. 


      CAPITAL RESTORATION PLAN
      REQUIREMENTS WERE GENERALLY
      MET
-------------------------------------------------------- Chapter 2:2.2

OCC and FRS generally met section 38 requirements governing capital
restoration plans (CRP).  Section 38 requires banks to prepare a CRP
within 45 days of becoming undercapitalized and allows regulators 60
days to review the CRP.  For the 61 banks that we reviewed, OCC and
FRS were generally successful in getting banks to submit the plans on
time and in meeting the required time frames for reviewing and
approving or rejecting the plans. 

Section 38 provisions require that CRPs prepared by undercapitalized
institutions contain certain elements.  Specifically, the section
requires that CRPs specify

  -- the steps that the institution will take to become adequately
     capitalized,

  -- the levels of capital the institution will attain during each
     year the plan will be in effect,

  -- how the institution will comply with the restrictions or
     requirements applicable to its undercapitalization capital
     category, and

  -- the types and levels of activities in which the institution will
     engage. 

Section 38 prohibits regulators from accepting a CRP unless it (1)
contains the previously mentioned required elements, (2) is based on
realistic assumptions and is otherwise likely to succeed, and (3)
would not appreciably increase the institution's riskiness.  Holding
companies are required to guarantee the institution's compliance with
the CRP and to provide adequate assurance of performance. 

Although the notification letters sent to the 61 undercapitalized
banks in our review indicated that a CRP was required, only 44 banks
submitted a CRP.  Of the 17 banks that did not submit CRPs, 15
experienced conditions within the first few months of becoming
undercapitalized that, according to the regulator, precluded the need
for a CRP.  Specifically, nine failed, two merged with other banks,
one was voluntarily liquidated, and three became adequately
capitalized. 

OCC chose not to pursue obtaining CRPs from the remaining two banks. 
In one case, OCC deferred its enforcement efforts pending the results
of an ongoing investigation by the Federal Bureau of Investigation
and local enforcement authorities into potential criminal activity by
the bank's management.  In the second case, OCC issued a section 38
directive instead of formally enforcing the requirement that the bank
submit a CRP to achieve corrective action in a more timely fashion. 

OCC and FRS were generally successful in getting the 44 institutions
that submitted CRPs to meet the 45-day requirement.  As shown in
table 2.4, 10 banks exceeded the 45-day requirement, but most had
submitted CRPs within 55 days. 



                               Table 2.4
                
                  Sampled Institutions' Timeliness in
                Submitting Capital Restoration Plans to
                               Regulators


Time frame for the receipt of the CRP                      OCC     FRS
------------------------------------------------------  ------  ------
Received in 45 days or less                                 26       7
Received between 46 and 55 days                              4       2
Received after 55 days                                       4       0
Unable to determine\a                                        1       0
======================================================================
Total                                                       35       9
----------------------------------------------------------------------
\a We were unable to calculate the time frame for submission of one
CRP because critical data were not available in OCC's files. 

Source:  GAO analysis of OCC and FRS files. 

OCC and FRS were typically successful in meeting the 60-day time
frame for reviewing the 44 CRPs submitted by the banks in our sample. 
As shown in table 2.5, the regulators met the 60-day requirement on
all but one applicable case where data were available to make a
determination. 



                               Table 2.5
                
                 OCC's and FRS' Timeliness in Reviewing
                 Capital Restoration Plans Submitted by
                          Sampled Institutions


Time frame for the review of the CRP                   OCC         FRS
----------------------------------------------  ----------  ----------
Reviewed in 60 days or less                             30           9
Reviewed in 75 days                                      1           0
Not applicable\a                                         3           0
Unable to determine\b                                    1           0
======================================================================
Total                                                   35           9
----------------------------------------------------------------------
\a According to the regulators, the review of CRPs was "not
applicable" for three banks because (1) one improved to the
adequately capitalized level within 60 days of submitting its CRP,
(2) another failed within 60 days of submitting a CRP, and (3) the
last was undergoing a change in ownership that, if successful, would
have resulted in the bank's becoming well- or adequately capitalized. 

\b We were unable to calculate the time frames for the review of one
CRP due to the lack of available documentation in OCC's files. 

Source:  GAO analysis of OCC and FRS files. 

Of the 44 CRPs submitted by the banks that we looked at, OCC and FRS
rejected 30 of the CRPs as inadequate and required those banks to
revise and resubmit them.  The regulators used the criteria specified
in section 38 legislation to determine whether a CRP was acceptable. 
Ultimately, the regulators approved 29 of the CRPs submitted by the
undercapitalized banks that we reviewed.  Of the 15 banks whose CRPs
were not approved, 10 ultimately failed.  One of the 15 banks merged
with another bank, and the remaining 4 banks obtained enough capital
to eliminate the need for a CRP. 


      OCC AND FRS CLOSED
      CRITICALLY UNDERCAPITALIZED
      BANKS WITHIN THE REQUIRED
      TIME FRAME
-------------------------------------------------------- Chapter 2:2.3

As required by section 38, OCC and FRS have generally taken action to
close critically undercapitalized banks within a specified time
frame.  Under section 38, regulators are required to close critically
undercapitalized institutions within 90 days of the institutions'
becoming critically undercapitalized unless the regulator and FDIC
concur that other actions would better protect the insurance funds
from losses. 

As previously shown in table 2.3, there were 25 critically
undercapitalized banks in our sample.  OCC and FRS closed 17 of these
banks because they were critically undercapitalized.\4

Fifteen of the 17 banks were closed within the prescribed 90-day
period.  In the case of the two banks that were closed after the
90-day deadline had expired, regulators approved the delay to allow
FDIC more preparation time for the orderly closure of the banks.  For
the remaining 8 critically undercapitalized banks in our sample, 1
merged and the other 7 improved their capital position above the
critically undercapitalized level before the end of the 90-day
period. 


--------------------
\4 An additional bank ultimately failed, but this occurred after the
bank had received a capital injection, which put it into the
adequately capitalized category for section 38 purposes. 


      FEW INSTITUTIONS WERE
      SUBJECT TO SECTION 38
      ENFORCEMENT ACTIONS
-------------------------------------------------------- Chapter 2:2.4

From December 1992 to September 1996, OCC and FRS used their section
38 authority to initiate directives against 8 of the 61 banks in our
sample.  Section 38 requires regulators to take specific regulatory
actions against significantly undercapitalized institutions and to
make the use of these actions discretionary for other
undercapitalized institutions.  In those instances in which section
38 directives were used, both OCC and FRS complied with the governing
requirements of section 38 legislation and implementing regulations. 

As previously discussed in chapter 1, section 38 mandates regulators
to take at least 1 of 10 specified actions against significantly
undercapitalized institutions.\5 The section also provides regulators
with discretionary authority to take any of the 10 specified actions
that they consider appropriate against undercapitalized institutions. 

OCC used directives against a relatively small number of the banks in
our sample.  Of the 52 OCC-regulated banks we reviewed, 16 were
significantly undercapitalized at some time between December 1992 and
December 1994, according to their call report data.\6 Thus, unless
the status of the banks changed, OCC would have been expected to have
initiated a directive against the 16 banks to take the enforcement
actions mandated by section 38.  However, OCC only initiated
directives against five of these banks.  Seven of the remaining 11
banks either failed, merged, or improved their capital status within
90 days of becoming significantly undercapitalized, thus eliminating
the need for OCC to issue a directive.  OCC officials told us that
directives were not initiated against the remaining four
significantly undercapitalized banks because they were already
subject to formal enforcement actions that OCC believed were similar
to those that would be covered by directives.  Thus, initiating a
directive would have duplicated the existing, ongoing enforcement
actions. 

FRS initiated directives against three of the seven\7

FRS-regulated banks in our sample that were categorized as
significantly undercapitalized at some point between December 1992
and December 1994.\8 According to FRS, the need for it to issue
directives was precluded for three significantly undercapitalized
banks because they improved their capital status, merged with another
institution, or were voluntarily liquidated shortly after becoming
significantly undercapitalized.  FRS did not initiate a directive
against the remaining significantly undercapitalized bank because the
applicable corrective actions were already under way in connection
with existing federal and state enforcement actions and in connection
with the bank's CRP. 


--------------------
\5 Of the 10 specific actions authorized, FDICIA established the
presumption that the regulator take the following three actions
unless the regulator determines that the actions would not further
the purpose of section 38:  (1) require recapitalization through the
sale of stocks or obligations or require that the institution be
acquired by or combined with another institution, (2) restrict
transactions with affiliates, and (3) restrict interest rates paid by
the institution.  These mandatory action requirements also apply to
an undercapitalized institution that fails either to submit an
acceptable CRP or implement one accepted by the regulator. 

\6 The 16 OCC-regulated significantly undercapitalized banks that we
looked at included 5 banks that subsequently became critically
undercapitalized. 

\7 The seven FRS-regulated significantly undercapitalized banks that
we looked at included two banks that subsequently became critically
undercapitalized. 

\8 Of the three directives FRS initiated, one was never issued
because the bank complied with all of the provisions contained in the
Notice of Intent to Issue a Directive, and the directive was not
needed.  Section 38 implementing regulations require the regulator to
notify the institution before issuing a directive to give the
institution time to comment on the proposed action. 


      OCC AND FRS RECLASSIFIED TWO
      BANKS
-------------------------------------------------------- Chapter 2:2.5

From December 1992 to September 1996, OCC and FRS used their
reclassification authority in two instances.  Section 38 authorizes
bank regulators under certain circumstances to downgrade, or treat as
if downgraded, an institution's capital category if (1) it is in an
unsafe or unsound condition or (2) it is deemed by the regulator to
be engaging in an unsafe or unsound practice.  Reclassifying an
institution to the next lower capital category allows regulators to
subject the institution to more stringent restrictions and
sanctions.\9

According to OCC officials, OCC would use its section 38
reclassification authority only if its traditional enforcement
actions had not been successful in correcting a bank's problems.  OCC
officials told us that they prefer to use their traditional
enforcement authority for several reasons.  One reason was the
broader range of options that OCC's traditional enforcement actions
provide both in the areas covered by the enforcement action as well
as in the degree of severity of the action.  Another reason that OCC
prefers to use its traditional enforcement actions is the bilateral
nature of these actions.  According to OCC officials, traditional
enforcement actions, such as a formal written agreement between the
regulator and an institution, may achieve greater acceptance by the
institution for taking corrective action than the unilateral nature
of section 38 reclassifications and/or directives.  However, OCC
officials said that reclassification under section 38 can sometimes
allow them to initiate certain actions faster (i.e., through
directives) than would be possible using their traditional
enforcement actions. 

In the one case involving OCC reclassification, the agency
reclassified a bank from adequately capitalized to undercapitalized
because (1) OCC believed the bank was operating in an unsafe and
unsound condition that would impair its capital levels and (2) the
bank had not complied with earlier OCC enforcement actions.  The
reclassification allowed OCC to initiate a directive that, among
other requirements, mandated the dismissal of a senior bank official
and a director who OCC believed were responsible for the bank's
deteriorated condition.  Despite OCC's use of its reclassification
authority and a section 38 directive, the bank's condition
deteriorated further until it failed 8 months later. 

FRS has an internal policy that requires all problem banks, which it
defined as banks with a composite rating of 4 or 5, to be considered
operating in an unsafe and unsound condition and, thus, candidates
for reclassification.  Between December 1992 and December 1994, 58
banks\10 had a FRS-assigned composite rating of 4 or 5.  In its only
use of its reclassification authority, FRS reclassified a
well-capitalized bank to adequately capitalized because of continuous
deterioration in the bank's asset quality, earnings, and liquidity. 
This bank's capital levels subsequently deteriorated to the point
where it was considered significantly undercapitalized.  The bank has
since improved its capital to the well-capitalized category and is no
longer considered to be a problem institution by FRS. 


--------------------
\9 Section 38 does not provide for regulators to reclassify or treat
a significantly undercapitalized institution as critically
undercapitalized. 

\10 The 58 banks reviewed exclude composite-rated 4 or 5 banks whose
capital ratios indicated that they were already considered
undercapitalized according to section 38 standards. 


      OIG REPORTED SIMILAR SECTION
      38 COMPLIANCE BY FDIC
-------------------------------------------------------- Chapter 2:2.6

In September 1994, the FDIC OIG reported that FDIC had generally
complied with the provisions of section 38 and its implementing
regulations.\11 Table 2.6 compares the three regulators'
implementation of specific section 38 provisions. 



                               Table 2.6
                
                Comparison of the Implementation of Key
                   Section 38 Provisions by Regulator


                                            Institutio
                          CRPs        CRPs          ns
                      received    reviewed   receiving       Number of
                     within 45   within 60  directives  reclassificati
Regulator                 days        days          \a             ons
------------------  ----------  ----------  ----------  --------------
OCC\b                       75          86          10               1
FRS\b                       77         100          33               1
FDIC\c                      73          74          30               0
----------------------------------------------------------------------
\a The percentage is calculated on the basis of the total number of
institutions reviewed by GAO or the OIG. 

\b Information is based on GAO's analysis of 52 OCC-regulated banks
and 9 FRS-regulated banks as of February 1996. 

\c Information is based on the FDIC OIG's analysis of 43
FDIC-regulated banks as of July 1994. 

Source:  FDIC OIG and GAO. 


--------------------
\11 Audit of FDIC's Implementation of the Prompt Corrective Action
Provisions of FDICIA (Sept.  23, 1994). 


   REGULATORS HAD NOT USED THEIR
   SECTION 39 ENFORCEMENT
   AUTHORITY
---------------------------------------------------------- Chapter 2:3

As of September 1996, regulators had not used their section 39
enforcement authority against an institution.  In July 1995,
regulators issued final guidelines and regulations to implement parts
of section 39.  Specifically, the regulators issued standards
governing operations and management and compensation.  They also
issued requirements for submission and review of compliance plans.\12
The regulators issued the remaining standards required for the full
implementation of section 39--asset quality and earnings--in August
1996.\13

FDICIA had established a deadline of December 1, 1993, for the
implementation of section 39.  Regulators said they were unable to
meet that deadline because of (1) the difficulty of jointly
developing the standards, (2) the concerns of regulators and
financial institutions that the implementation of section 39 could
increase existing regulatory burden for banks and thrifts, and (3)
the knowledge that Congress was considering amending the section 39
requirements to provide regulators with greater flexibility and
discretion in their implementation of the section. 


--------------------
\12 60 Fed.  Reg.  35673 (July 10, 1995). 

\13 61 Fed.  Reg.  43948 (Aug.  27, 1996). 


      INTERAGENCY PROCESS AND
      CONCERNS ABOUT REGULATORY
      BURDEN COMPLICATED THE
      DEVELOPMENT OF REQUIRED
      STANDARDS
-------------------------------------------------------- Chapter 2:3.1

According to the regulators, developing and issuing
safety-and-soundness standards was complicated by the interagency
process and by concerns about the potential regulatory burden
associated with the standards.  Unlike the process for promulgating
capital standards under section 38, which used the Basle Accord as a
reference point, the regulators had no generally accepted standards
to use as the basis for the safety-and-soundness standards.  In
addition, the regulators told us that the legislative history for
section 39 did not provide specific guidance on the standards
envisioned by Congress.  Furthermore, the regulators wanted to ensure
that the section 39 standards did not increase the bank and thrift
industries' regulatory burden without a corresponding benefit to the
federal deposit insurance funds and taxpayers. 

OCC and FRS officials said that the lack of generally agreed upon
standards for the areas covered by section 39 contributed to delays
in developing and issuing the section's standards.  They explained
that regulators consider numerous variables in assessing an
institution's safety and soundness.  As a result, developing
standards on an interagency basis for areas such as internal controls
and interest rate exposure was difficult.  According to the
officials, the various regulators had different viewpoints as to how
specific or general the standards should be. 

On July 15, 1992, the regulators issued a joint solicitation of
comments on the section 39 safety-and-soundness standards.\14 In
soliciting the views of the banking industry on the form and content
of the standards, the regulators said that they were concerned with
"establishing unrealistic and overly burdensome standards that
unnecessarily raise costs within the regulated community." The four
regulators collectively received over 400 comment letters, primarily
from banks and thrifts.\15 According to the regulators, the comments
strongly favored adopting general standards, rather than specific
standards, to avoid regulatory "micromanagement."

The regulators considered the public comments in developing the
proposed standards that were published on November 18, 1993.\16

The regulators proposed standards for the following three areas
required by section 39:  (1) operations and management, (2) asset
quality and earnings, and (3) compensation.  According to the notice
of proposed rulemaking, regulators proposed general standards, rather
than detailed or quantitative standards, to "avoid dictating how
institutions are to be managed and operated."

However, as required by section 39 before its amendment in 1994, the
regulators proposed two quantitative standards--a maximum ratio of
classified assets-to-capital\17 and a formula to determine minimum
earnings sufficient to absorb losses without impairing capital. 
Section 39 also required the regulators to set, if feasible, a
minimum ratio of market-to-book value for publicly traded shares of
insured institutions as a third quantitative standard.  The
regulators determined that issuing such a standard was technically
feasible, but they concluded that it was not a reasonable means of
achieving the objectives of the Prompt Regulatory Action provisions. 
The regulators explained that an institution's stock value can be
affected by factors that are not necessarily indicative of an
institution's condition, such as the performance of the general stock
market and industry conditions.  As a result, the regulators believed
that a market-to-book value ratio would not be an operationally
reliable indicator of safety and soundness.  Therefore, the
regulators ultimately decided against proposing a market-to-book
value ratio as a third quantitative standard. 

The proposed regulations also described procedures for supervisory
actions that were consistent with those contained in the section 39
legislation for institutions failing to comply with standards. 
Specifically, the proposed regulations required institutions to
prepare and submit a compliance plan within 30 days of being notified
by the regulator of their noncompliance.  The plan was to include a
description of the steps the institution intended to take to correct
the deficiency.  Regulators would then have 30 days to review the
plan.  In addition, the proposed regulations specified enforcement
actions regulators would take if an institution failed to submit an
acceptable compliance plan or failed to implement the plan. 

The regulators collectively received 133 comment letters, primarily
from financial institutions, in response to the November 18, 1993,
notice of proposed rulemaking.  According to the four regulators,
those who commented generally found the agencies' proposed standards,
including the two quantitative standards, acceptable.  However, some
of those who commented criticized the proposed quantitative standards
as inflexible and overly simplistic. 


--------------------
\14 57 Fed.  Reg.  31336. 

\15 The 400 comment letters received by the regulators included
multiple copies of some of the comment letters that were sent to more
than one regulator. 

\16 58 Fed.  Reg.  60802. 

\17 Classified assets are loans and other assets that are at risk to
some degree.  Such assets fail to meet acceptable credit standards
and are reported separately in bank call reports and thrift financial
reports. 


      CONSIDERATION OF LEGISLATIVE
      AMENDMENTS TO SECTION 39
      CONTRIBUTED TO ADDITIONAL
      DELAYS IN ITS IMPLEMENTATION
-------------------------------------------------------- Chapter 2:3.2

OCC and FRS officials attributed further delays in implementing
section 39 to their knowledge that in the period from late 1993 to
mid-1994, Congress was considering legislation that would amend
section 39's requirements.  Congress was considering amending section
39 to reduce the administrative requirements for insured depository
institutions consistent with safe-and-sound banking practices.  After
CDRI was passed in September 1994, regulators needed additional time
to revise the standards they proposed in November 1993 to take
advantage of the additional flexibility provided by the section 39
amendments. 

On July 10, 1995, the regulators published final and proposed
guidelines and regulations to implement section 39, as amended.  The
final guidelines covered

  -- operational and managerial standards, including internal
     controls, information systems, internal audit systems, loan
     documentation, credit underwriting, interest rate exposure, and
     asset growth, and

  -- compensation standards.\18

The final guidelines were effective in August 1995.  Along with the
final guidelines, regulators proposed new standards for asset quality
and earnings.  The final standards for asset quality and earnings
were issued on August 27, 1996, with an effective date of October 1,
1996. 

The final standards contained in the guidelines are less prescriptive
on the institutions than those proposed in November 1993.  For
example, under internal controls and information systems, the
guidelines specified that the "institution should [in lieu of shall]
have internal controls and information systems, that are appropriate
to the size of the bank and the nature and scope of its activities."
[Underscoring supplied.] In addition, the regulators used the
additional flexibility provided by CDRI to eliminate the two
previously proposed quantitative standards for classified assets and
earnings.  According to the regulators, the use of general rather
than specific standards was supported by the overwhelming number of
commenters responding to the regulators' request for comments on the
section 39 safety-and-soundness standards.  Moreover, the use of
guidelines instead of regulations gives the regulators flexibility in
deciding whether to require a compliance plan from an institution
found to be in noncompliance with the standards. 

The regulators issued regulations addressing the (1) required content
of compliance plans, (2) time frames governing the preparation and
review of a plan, and (3) regulatory actions applicable to the
failure to submit or comply with a plan.  The compliance plan
regulations were issued jointly on July 10, 1995, with the section 39
guidelines governing the operational, managerial, and compensation
standards.  Both the guidelines and regulations became effective in
August 1995. 


--------------------
\18 In these guidelines, the regulators did not establish stock
valuation standards for publicly traded institutions because they
believed such standards would not be appropriate given that
institutions do not have direct control over the marketplace's
evaluation of their stocks' value. 


THE EFFECTIVENESS OF SECTIONS 38
AND 39 IS YET TO BE DETERMINED
============================================================ Chapter 3

FDICIA's Prompt Regulatory Action provisions granted additional
enforcement tools to regulators and provided more consistency in the
treatment of capital-deficient institutions.  However, sections 38
and 39, as implemented, raise questions about whether regulators will
act early and forcefully enough to prevent or minimize losses to the
insurance funds.  Section 38 does not require regulators to take
action until an institution's capital drops below the adequately
capitalized level.  However, depository institutions typically
experience problems in other areas, such as asset quality and
management, long before these problems result in impaired capital
levels.  Moreover, regulators have wide discretion governing the
application of section 39 because the guidelines and regulations
implementing section 39, as amended, do not (1) establish clear and
specific definitions of unsound conditions and practices or (2) link
such conditions or practices to specific mandatory regulatory
actions. 

Other initiatives that have been undertaken as a result of FDICIA, as
well as the regulators' recognition of the need to be more proactive
in preventing unsafe and unsound practices, may help increase the
likelihood that sections 38 and 39 will be used to provide prompt and
corrective regulatory action.  FDICIA's corporate governance and
accounting reform provisions were designed to improve management
accountability and facilitate early warning of safety-and-soundness
problems.  In addition, FDICIA requires regulators to revise the
risk-based capital standards to ensure that reported capital
accurately reflected the institution's risk of operations. 
Regulators have also announced new initiatives to improve monitoring
and control of bank risk-taking, but these initiatives have not been
fully implemented or tested.  The success of these initiatives,
coupled with the regulators' willingness to use their various
enforcement authorities, including sections 38 and 39, will be
instrumental in determining whether losses to the insurance funds are
prevented or minimized in the future. 


   SECTION 38 APPEARS TO HAVE
   PRODUCED SOME BENEFITS
---------------------------------------------------------- Chapter 3:1

Available evidence suggests that the implementation of the section 38
capital standards between 1992 and 1995, along with other factors,
has benefited the bank and thrift industries and may have helped
improve federal oversight.  Specifically, the section 38 standards
(1) provide financial institutions with incentives to raise equity
capital, (2) should help regulators prevent seriously troubled
institutions from taking actions that could compound their losses,
and (3) should help ensure more timely closure of near-insolvent
institutions.  In addition, regulatory officials have stated that
section 38 serves as an important supplemental enforcement tool. 

According to the regulators and banking industry analysts, section 38
provides depository institutions with strong incentives to raise
additional equity capital.  These officials explained that financial
institutions were concerned about the potential ramifications of
becoming undercapitalized, and the institutions raised additional
equity capital to avoid potential sanctions.  Once the implementing
regulations were issued, depository institutions had clear benchmarks
as to the levels of capital they needed to achieve to avoid mandatory
regulatory intervention.  Since the implementation of section 38,
thanks in part to record industry profits, the capital levels of
banks and thrifts have reached their highest levels since the 1960s. 

Another benefit of the section 38 capital standards is that they
should help prevent certain practices and conditions that rapidly
eroded the capital of troubled institutions from 1980 to 1990 and
contributed to deposit insurance fund losses.  For example, section
38 standards impose growth restrictions to prevent undercapitalized
and significantly undercapitalized institutions from trying to "grow"
their way out of financial difficulty.  As a result, it should be
more difficult for these institutions to rapidly expand their asset
portfolios and increase potential insurance fund losses, as many
thrifts did during the 1980s.  Section 38 also requires regulators to
prohibit undercapitalized institutions from depleting their remaining
capital by paying dividends. 

OCC and FRS officials told us that another benefit of section 38 is
the mandatory closure rule for critically undercapitalized
institutions.  These officials explained that before the
implementation of section 38, regulators typically waited until an
institution had 0-percent equity capital before closing it as
insolvent.  The officials also said that under section 38, they now
have a clear legal mandate for closing problem institutions at
2-percent tangible equity capital, which should provide the insurance
funds with a greater cushion against losses. 

Regulatory officials we contacted also said that section 38 serves as
a useful supplement to their traditional enforcement authority.  For
example, OCC officials said that section 38 directives allow for the
prompt removal of bank officials when the agency believes such
officials are responsible for the bank's financial and operational
deterioration.  OCC officials said that before FDICIA, removing such
individuals took longer, sometimes up to several months. 


   SECTION 38'S CAPITAL-BASED
   REGULATORY APPROACH HAS
   INHERENT LIMITATIONS
---------------------------------------------------------- Chapter 3:2

Although the capital-based regulatory approach strengthens federal
oversight in several ways, by itself it has significant limitations
as a mechanism to provide early intervention to safeguard the
insurance funds.  Capital is a lagging indicator of a financial
institution's deterioration.  Troubled institutions may already have
irreversible financial and operational problems that would inevitably
result in substantial insurance fund losses by the time their capital
deteriorates to the point where mandatory enforcement actions are
triggered under section 38.  In addition, troubled institutions often
fail to report accurate information on their true financial
conditions.  As a result, many troubled institutions that have
serious safety-and-soundness problems may not be subject to section
38 regulatory actions. 


      CAPITAL IS A LAGGING
      INDICATOR OF FINANCIAL AND
      OPERATIONAL DETERIORATION
-------------------------------------------------------- Chapter 3:2.1

Capital has been a traditional focus for regulatory oversight because
it is a reasonably obvious and accepted measure of financial health. 
However, our work over the years has shown that, although capital is
an important focus for oversight, it does not typically begin to
decline until an institution has experienced substantial
deterioration in other components of its operations and finances.\1
It is not unusual for an institution's internal controls, asset
quality, and earnings to deteriorate for months, or even years,
before conditions require that capital be used to absorb losses.  As
a result, regulatory actions, such as requirements for capital
restoration plans or growth limits, may have only marginal effects
because of the extent of deterioration that may have already
occurred. 


--------------------
\1 Deposit Insurance:  A Strategy for Reform (GAO/GGD-91-26, Mar.  4,
1991) and GAO/GGD-91-69. 


      REPORTED CAPITAL LEVELS DO
      NOT ALWAYS ACCURATELY
      REFLECT INSTITUTIONS'
      FINANCIAL TROUBLES
-------------------------------------------------------- Chapter 3:2.2

Relating regulatory actions to capital alone has another inherent
limitation in that reported capital levels do not always accurately
reflect troubled institutions' actual financial conditions.  Troubled
institutions have little incentive to report the true level of
problem assets or to establish adequate reserves for potential
losses.  As a result, some institutions' reported capital levels were
often artificially high.  The reporting of inaccurate capital levels
was evident from 1980 to 1990 as many of the troubled institutions,
which reported some level of capital before failing, ultimately
generated substantial losses to the insurance fund.  Thus,
capital-driven regulatory responses would likely have had limited
effectiveness since the institutions were already functionally
insolvent.  As illustrated by the following example, troubled
institutions' reported capital levels can plummet rapidly in times of
economic downturn. 


         PROBLEMS EXPERIENCED BY
         REGULATORS IN THE 1980S
         WITH NEW ENGLAND BANKS
------------------------------------------------------ Chapter 3:2.2.1

In the 1980s, many New England banks, with average equity capital
ratio levels exceeding the regulatory minimum requirements then in
existence, were engaged in aggressive high-risk commercial real
estate lending.  These banks frequently ignored basic risk
diversification principles by committing a substantial percentage of
their lending portfolios to construction, multifamily housing, and
commercial real estate lending--in some cases as high as 50
percent.\2 This practice tied their future financial health to those
industries. 

When the New England economy fell into recession in the late 1980s
and early 1990s, many of the poorly managed banks in the region
experienced a deterioration in their asset quality, earnings, and
liquidity well before their capital levels declined.  For example,
once regulators recognized the recession's effect on the Bank of New
England\3 portfolios, examiners required the bank to adversely
classify\4 an increasing number of loans--especially commercial real
estate loans whose repayment was questionable due to the economic
downturn.  As the level of classified loans increased, the examiners
required the Bank of New England to establish reserves for potential
loan losses, which reduced the bank's earnings.  Subsequently, the
bank suffered continued earnings deterioration and had to use its
capital to absorb those losses. 

The Bank of New England's managers and regulators had few options for
maintaining solvency and, ultimately, for minimizing insurance fund
losses.  The available options included reducing the institution's
inventory of classified loans by selling assets, raising capital
through public offerings, or selling the institution to a healthy
buyer.  The managers' and regulator's ability to carry out these
strategies was constrained by the region's economic downturn, since
few investors were willing to purchase the assets of problem banks or
to inject new capital into them without some form of financial
assistance from FDIC.  Ultimately, the bank failed, resulting in a
loss to the bank insurance fund of $841 million.  Other failed banks
in the New England area followed a similar pattern, resulting in
substantial losses to the insurance fund. 


--------------------
\2 Many banks in other parts of the country, including Texas and
California, also had overconcentrated portfolios in commercial real
estate and energy investments. 

\3 The Bank of New England was one of the largest bank failures
during the period from 1986 to 1994 both in terms of the size of the
bank ($22.4 billion in total assets) and the loss to the insurance
fund ($841 million). 

\4 Adversely classified loans are put into one of three categories to
reflect their risk classification:  (1) substandard, where some loss
is probable unless corrective actions are taken; (2) doubtful, where
repayment in full is questionable; and (3) loss, where a complete
write-off of the loan is expected. 


      MOST TROUBLED INSTITUTIONS
      WERE NOT SUBJECT TO SECTION
      38 CAPITAL STANDARDS
-------------------------------------------------------- Chapter 3:2.3

Another reason that section 38, used alone, is a limited mechanism to
protect deposit insurance funds, is that most troubled institutions
do not fall into undercapitalized categories, including some that
ultimately fail.  Consequently, regulators overseeing even the most
troubled institutions generally would not be compelled to initiate
mandatory enforcement actions under section 38. 

We reviewed data compiled by FDIC that showed that many severely
troubled institutions in the period from December 1992 to December
1995 did not fall into section 38's undercapitalized categories. 
Therefore, these institutions were not subject to the section's
mandatory enforcement actions.  On a quarterly basis, FDIC reports on
the number of "problem" institutions.  These institutions have
regulator-assigned composite ratings of 4 or 5 because they typically
have severe asset quality, liquidity, and earnings problems that make
them potential candidates for failure.  These institutions are also
typically subject to more intensive oversight, including more
frequent examinations by regulators and more frequent required
reporting by the institutions on their financial conditions. 

As of December 31, 1995, 193 banks and thrifts were on FDIC's problem
institution list.  However, only 29 institutions were categorized as
undercapitalized under section 38 criteria.  We made similar
comparisons for 1992 through 1995 and found that only 15 to 24
percent of the problem institutions were categorized as
undercapitalized under section 38 criteria (see table 3.1). 



                               Table 3.1
                
                Number of Undercapitalized Institutions
                 Versus Problem Institutions, December
                         1992 to December 1995

                                                        Undercapitaliz
                                                                    ed
                                                          institutions
                             Number of                            as a
                        undercapitaliz       Number of   percentage of
                                    ed         problem         problem
Year-ending               institutions    institutions    institutions
----------------------  --------------  --------------  --------------
December 1995                       29             193            15.0
December 1994                       50             318            15.7
December 1993                       72             572            12.6
December 1992                      252           1,063            23.7
----------------------------------------------------------------------
Source:  GAO analysis of FDIC Quarterly Banking Profile Reports. 

Moreover, a recent study assessed the effectiveness of the current
section 38 capital standards in identifying problem institutions and
mandating enforcement actions by applying the section 38 standards to
the troubled banks of an earlier period.\5 The study concluded that
the majority of banks that experienced financial problems between
1984 and 1989 would not have been subject to the capital-based
enforcement actions of section 38, if they had been in effect.  For
example, the study found that 54 percent of the banks that failed
within the subsequent 2 years would have been considered to be well-
or adequately capitalized between 1984 and 1989.  Thus, even if the
section 38 standards had been in place in the 1980s, these troubled
banks would not have been subject to section 38's mandatory
restrictions and supervisory actions. 

The study attributed the limitations that the current section 38
standards have in identifying troubled financial institutions to
weaknesses in the risk-based capital ratio used by the regulators. 
Specifically, the study stated that the risk-based ratio does not (1)
account for the fact that many banks do not adequately reserve for
potential loan losses or (2) assign an adequate risk weight to cover
the level of adversely classified assets that a bank may have on its
books.  Although the regulators are in the process of revising the
risk-based capital standards, the revisions announced as of September
1996 do not address the two previously mentioned factors.  The
regulators' efforts to revise the risk-based capital standards are
discussed later in this chapter and in appendix I. 


--------------------
\5 D.S.  Jones and K.K.  King, The Implementation of Prompt
Corrective Action (Journal of Banking and Finance, June 1995). 


      MECHANICS NATIONAL BANK'S
      FAILURE ILLUSTRATES
      LIMITATIONS OF CAPITAL
      STANDARDS
-------------------------------------------------------- Chapter 3:2.4

The 1994 failure of one of the banks reviewed by the Treasury OIG,
Mechanics National Bank of Paramount, California, illustrated some of
the limitations of section 38 capital standards.\6 The Treasury OIG
found that despite OCC's aggressive use of section 38 enforcement
actions, OCC did not reverse the bank's decline or prevent material
loss to the bank insurance fund.  The bank's failure also
demonstrated that severely troubled banks may not be subject to
section 38's restrictions and mandatory enforcement actions for a
substantial period. 

According to the Treasury OIG report, the Mechanics National Bank
pursued an aggressive growth strategy between 1988 and 1991 that
contributed substantially to its failure.  The bank concentrated its
loan portfolio in risky service station loans and speculative
construction and development projects.  Under a Small Business
Administration lending program, the bank also developed a significant
portfolio of loans that was poorly underwritten and inadequately
documented.  In 1990, a downturn in the California economy generated
a substantial deterioration in the bank's loan portfolio.  In 1991,
OCC issued a cease-and-desist order against the bank that required
substantial improvements in the bank's operations and financial
condition.  Despite the cease-and-desist order, the bank's asset
quality and earnings continued to deteriorate over the next several
years. 

The Treasury OIG report said that when section 38 capital standards
became effective in December 1992, the Mechanics National Bank had a
ratio of classified assets-to-capital of about 309 percent and had
experienced losses of $4.3 million during 1992.  OCC had just
completed an examination of the bank in December 1992, which
concluded that the bank was likely to fail.  At that time, despite
apparent asset quality and earnings problems, the bank's capital had
not deteriorated to the point where it was undercapitalized according
to section 38 criteria.  The bank's capital ratios fell within the
adequately capitalized category.  The bank continued to be
categorized as adequately capitalized during the first and second
quarters of 1993, despite its high levels of classified assets and
mounting losses.  In July 1993, OCC reclassified the bank to the
undercapitalized level.  On January 10, 1994, OCC notified the bank
that it was critically undercapitalized because its total
capital-to-asset ratio had fallen below 2 percent.  The regulators
closed the bank in April 1994. 

Although the Treasury OIG report criticized OCC's supervision and
enforcement activities for the period between 1988 and 1991,\7

the report found that the agency's use of section 38 enforcement
authority during 1993 and 1994 was appropriate.  For example, the OIG
report highlighted OCC's use of its section 38 reclassification
authority to remove two Mechanics National Bank officers who were
thought to be largely responsible for the bank's problems.  OCC also
used its section 38 authority to close the bank on April 1, 1994,
within 90 days of the notification of its critically undercapitalized
status.  Nevertheless, OCC's enforcement actions under section 38
were largely ineffective in minimizing the losses that were already
embedded in the bank's loan portfolio before it fell to the
undercapitalized level.  The bank's estimated loss to the insurance
fund of $37 million represented 22 percent of the bank's total assets
of $167 million. 


--------------------
\6 Office of Inspector General, U.S.  Department of the Treasury,
Material Loss Review Under FDIA:  Mechanics National Bank of
Paramount, California (Sept.  29, 1995).  Under the Federal Deposit
Insurance Act as amended by FDICIA section 38(k), the Inspectors
General for the responsible regulatory agencies are required to issue
reports on bank failures that cause "material losses" to the
insurance fund.  Among other requirements, these reports are to
determine the cause of each bank's failure and to assess the
regulator's oversight of that bank. 

\7 For example, the Treasury OIG report found that OCC did not
comprehensively examine the Mechanics National Bank between 1989 and
1990.  The OIG report also stated that OCC failed to adequately
enforce the cease-and-desist order that was signed in 1991 because
the bank continued to make poorly underwritten loans. 


      THE BANK INSURANCE FUND
      CONTINUES TO ABSORB LOSSES
      DESPITE THE IMPLEMENTATION
      OF SECTION 38
-------------------------------------------------------- Chapter 3:2.5

The impact of section 38's implementation on minimizing losses to the
insurance funds is difficult to assess.  Between 1985 and 1989,
losses to the bank insurance fund ranged from approximately 12 to 23
percent of the assets of failed banks with a 5-year weighted average
of about 16 percent.  As we reported in 1991,\8

this high rate of losses indicated that regulators were not (1)
taking forceful actions that effectively prevented dissipation of
assets or (2) closing institutions when they still had some residual
value. 

There have been some signs of improvement since the 1985-to-1989
period as illustrated in table 3.2.  During the first 2 full years
that section 38 was in effect, 1993 and 1994, the rates of loss were
17 and 10 percent, respectively, for a weighted average of 15
percent.  While these loss rates are still significant, it is too
early to assess section 38's long-term effectiveness in reducing
losses to the insurance funds compared with preceding years. 
However, it does suggest that the implementation of section 38 alone
is likely to provide only limited assurance that bank failures will
not have significant effects on the insurance funds. 



                               Table 3.2
                
                   Number of Failed Banks and Losses
                  Absorbed by the Bank Insurance Fund,
                                1985-94


                      Number                   Estimated
                          of  Total assets          bank    Percentage
                      failed     of failed     insurance       loss of
Year                   banks         banks     fund loss  total assets
------------------  --------  ------------  ------------  ------------
1985                     120        $8,735        $1,008          11.5
1986                     145         7,663         1,725          22.5
1987                     203         9,234         2,021          21.9
1988                     221        52,620         6,872          13.1
1989                     207        29,395         6,123          20.8
1990                     169        15,705         2,813          17.9
1991                     127        63,198         6,269           9.9
1992                     122        45,447         3,960           8.7
1993                      41         3,524           584          16.6
1994                      13         1,392           139          10.0
----------------------------------------------------------------------
Source:  FDIC. 


--------------------
\8 GAO/GGD-91-26. 


   SECTION 39 SAFETY-AND-SOUNDNESS
   STANDARDS DO LITTLE TO INCREASE
   THE LIKELIHOOD OF EARLY
   REGULATORY ACTION
---------------------------------------------------------- Chapter 3:3

As discussed in chapter 2, the full implementation of section 39
began on October 1, 1996.  However, the guidelines and regulations
developed by regulators to implement section 39 do little to reduce
the degree of discretion regulators exercised from 1980 to 1990.  In
particular, the safety-and-soundness standards contained in the
guidelines are general in nature and do not identify specific unsafe
or unsound conditions and practices even though the regulators have
already established measures that could have served as a basis for
more specific requirements.  Moreover, the guidelines and regulations
do not require regulators to take corrective action against
institutions that do not meet the standards for safety and soundness. 


      UNSAFE AND UNSOUND
      CONDITIONS AND PRACTICES ARE
      NOT SPECIFICALLY DEFINED
-------------------------------------------------------- Chapter 3:3.1

In two 1991 reports,\9 we recommended that Congress and regulators
develop a formal, regulatory trip wire system that would require
prompt and forceful regulatory action tied to specific unsafe banking
practices.  The trip wire system we envisioned would have been
specific enough to provide clear guidance about what actions should
be taken to address specified unsafe banking practices and when the
actions should be taken.  The intent was to increase the likelihood
that regulators would take forceful action to stop risky practices
before the capital of the bank begins to fall and it is too late to
do much about the condition of the bank or insurance fund losses. 
The trip wire system was also to consist of objective criteria
defining conditions that would trigger regulatory action. 

In contrast, the safety-and-soundness standards, contained in the
guidelines developed to implement section 39, as amended, consist of
broad statements of sound banking principles that are subject to
considerable interpretation by the regulators.  For example, the
standards for asset quality state that the institution should
establish and maintain a system to identify problem assets and
prevent deterioration of those assets in a manner commensurate with
its size and the nature and scope of its operations.  Specifically,
the guidelines direct institutions to do the following: 

  -- conduct periodic asset quality reviews to identify problem
     assets and estimate the inherent losses of those assets,

  -- compare problem asset totals to capital and establish reserves
     that are sufficient to absorb estimated losses,

  -- take appropriate corrective action to resolve problem assets,

  -- consider the size and potential risks of material asset
     concentrations, and

  -- provide periodic asset reports containing adequate information
     for management and the board of directors to assess the level of
     asset risk. 

Although the asset quality standards identify general controls and
processes the regulators expect institutions to have, the standards
do not provide specific, measurable criteria of unsafe conditions or
practices that would trigger mandatory enforcement actions.  In our
1991 report on deposit insurance reform,\10 we suggested that the
classified assets-to-capital ratio could serve as an objective
criterion because the ratio is routinely used by bank examiners to
identify deteriorating asset quality.  For example, we reported that
the regulators become increasingly concerned when a bank's classified
assets-to-capital ratio increased to 50 percent or more.  Similarly,
during the interagency process used to develop the section 39
safety-and-soundness standards, FRS had proposed that the regulators
take mandatory enforcement actions when a bank's classified
assets-to-capital ratio reached 75 to 100 percent.  However, the
regulators decided not to include this requirement after CDRI
provided them with the option of omitting quantifiable measures of
unsafe and unsound conditions.  Without such specific criteria,
regulators will continue to exercise wide discretion in determining
whether a depository institution's asset quality deterioration is at
a point where enforcement actions are necessary. 

Similarly, the section 39-based loan documentation standards do not
establish specific criteria for regulators to use to assess an
institution's safety and soundness.  The regulators believed that
general standards provide an acceptable gauge against which
compliance can be measured, while at the same time allowing for
differing approaches to loan documentation.  However, this approach
to loan documentation standards differs from the long-standing
approach that the regulators have established in their examination
manuals.  These standards contain specific loan documentation
requirements that examiners are to use in assessing the safety and
soundness of depository institutions.  For example, real-estate
construction loan files are to include current financial statements,
inspection reports, and written appraisals.  Since the section 39
standards do not contain similar documentation requirements, we
believe the standards are open to considerable interpretation and do
little to limit the wide discretion regulators have in determining
whether banks have adequate loan documentation practices. 

Furthermore, the loan documentation standards do not provide or state
a specific level of noncompliance at which enforcement actions will
be required.  Although it may be difficult to develop quantifiable
criteria for making such enforcement decisions, there are various
regulatory "rules of thumb" in place that we believe could serve as
the basis for triggering mandatory actions.  For example, in its 1988
report on the reasons why banks fail, OCC found that banks with loan
documentation problems in 15 to 20 percent or more of their loan
portfolios were typically operating in an unsafe and unsound
manner.\11


--------------------
\9 GAO/GGD-91-26 and GAO/GGD-91-69. 

\10 GAO/GGD-91-26. 

\11 OCC, Bank Failures:  An Evaluation of the Factors Contributing to
the Failures of National Banks (June 1988). 


      REGULATORS HAVE DISCRETION
      TO REQUIRE SECTION 39
      COMPLIANCE PLANS, AND
      REQUIREMENTS ARE NOT
      SPECIFIC
-------------------------------------------------------- Chapter 3:3.2

As discussed earlier, CDRI amended the section 39 mandate that
regulators require a depository institution to file a compliance plan
if the institution is found not to be in compliance with the
standards.  The new provision allows regulators greater flexibility
in deciding whether to impose such a requirement.  In the July 10,
1995, Notice of Final Rulemaking, the four regulators (OCC, FRS,
FDIC, and OTS) stated that they expect to require a compliance plan
from any institution with deficiencies severe enough to threaten the
safety and soundness of the institution.  However, as discussed in
the previous section, regulators have not developed quantifiable
criteria or other specific guidance for measuring an institution's
compliance with the section 39 safety-and-soundness standards. 
Therefore, it is not clear how regulators would determine whether an
institution's noncompliance with generally accepted management
principles is "severe" enough to warrant regulatory action. 

In addition, the implementing regulations do not provide any specific
criteria for compliance plans beyond those contained in the section
39 legislation.  The regulations merely state that compliance plans
should identify steps that the institution is to take to correct the
identified problems and the time by which the steps are to be taken. 
In contrast, section 38 and its implementing regulations establish
more specific criteria for CRPs.  For example, CRPs must specify
capital levels that the institution expects to achieve for each year
the plans are in effect.  In addition, CRPs must show how the
institution will comply with any restrictions on its activities under
section 38 and the types of businesses and activities in which the
institution will engage.  Section 38 requires regulators to reject
any CRP unless it contains such information, is based on realistic
economic assumptions, and would not appreciably increase risk to the
institutions.  In the absence of similar criteria, there is less
assurance that the compliance plans developed under section 39 will
consistently result in the prompt remediation of deficiencies. 


   VARIOUS ONGOING INITIATIVES MAY
   RESULT IN IMPROVED REGULATORY
   OVERSIGHT
---------------------------------------------------------- Chapter 3:4

FDICIA contained a number of reforms and provisions that were
designed to complement sections 38 and 39.  FDICIA's corporate
governance and accounting reform provisions directed depository
institutions to improve their corporate governance and the
information they report to the regulators.  FDICIA also required
regulators to revise their risk-based capital standards to ensure
that those standards take adequate account of interest rate risk,
concentrations of credit, and nontraditional activities.  In
addition, regulators have stated that their oversight of depository
institutions has improved, and they are in the process of modifying
their examination approaches to emphasize the monitoring of
risk-taking by depository institutions.  However, we did not evaluate
the effectiveness of these various initiatives because many had not
been fully implemented or tested. 


      FDICIA'S CORPORATE
      GOVERNANCE REQUIREMENTS CAN
      ENHANCE MANAGEMENT
      ACCOUNTABILITY AND
      REGULATORY OVERSIGHT
-------------------------------------------------------- Chapter 3:4.1

FDICIA placed a number of new requirements on depository institutions
to improve their corporate governance and the information they
provide to the regulators.  As previously discussed, FDICIA requires
all but small (total assets of less than $500 million) depository
institutions to submit annual reports to the regulator on the
institutions' financial conditions and management.  The report is to
include management's assessment of (1) the effectiveness of the
institution's internal controls and (2) the institution's compliance
with the laws and regulations designated by the regulator.  In
addition, FDICIA required the institution's external auditors to
report separately on these assertions made by management.\12
Furthermore, FDICIA requires depository institutions to have an
independent audit committee composed of outside directors who are
independent of institutional management. 

As we reported in 1993,\13 these new requirements have the potential
to significantly enhance the likelihood that regulators will identify
emerging problems in banks and thrifts earlier.  For example,
regulators can use the result of an institution's management
assessments and external auditor's reviews to identify those areas
with the greatest risk exposure.  This identification process should
allow the regulators to improve the quality and efficiency of their
examinations.  While these FDICIA requirements may result in the
early identification of troubled institutions, they do not ensure
that regulators will take consistent supervisory actions to address
safety-and-soundness problems before they adversely affect an
institution's capital levels. 


--------------------
\12 Section 2301(a) of the Economic Growth and Regulatory Paperwork
Reduction Act of 1996 repealed the requirement that an institution's
external auditors report on compliance with designated laws and
regulations. 

\13 Bank and Thrift Regulation:  Improvements Needed in Examination
Quality and Regulatory Structure (GAO/AFMD-93-15, Feb.  16, 1993). 


      REGULATORS ARE REVISING
      THEIR RISK-BASED CAPITAL
      STANDARDS
-------------------------------------------------------- Chapter 3:4.2

In response to FDICIA section 305 requirements, regulators have
recently undertaken revisions of the risk-based capital standards
that they use to implement provisions of section 38.  Specifically,
regulators have revised or are revising the risk-based capital
standards to cover risks associated with concentrations of credit,
nontraditional financial products, and interest rate movements.\14 As
of September 1996, the revisions to the risk-based capital standards
announced by the regulators will not change the capital ratios used
for section 38 purposes.  Instead, regulators plan to use the
examination process to identify institutions that have excessive and
poorly managed risk exposure, due to concentrations of credit,
nontraditional products, or interest rate risk.  Regulators said that
they will require such institutions to hold greater levels of capital
than those required of other institutions.  See appendix I for a more
detailed discussion of section 305's requirements and the regulators'
planned revisions to risk-based capital standards. 


--------------------
\14 The term "concentrations of credit" refers to situations when an
institution has a large portion of its loan portfolio involving one
borrower, industry, location, collateral, or loan type. 
Nontraditional financial product risks are the risks associated with
activities or products that have not customarily been part of the
banking business but that begin to be conducted as a result of
developments in, for example, technology or financial instruments. 
The term "interest rate movement" refers to the risk that changes in
market interest rates will have an adverse effect on an institution's
earnings and its underlying economic value. 


      OTHER REGULATORY INITIATIVES
      MAY IMPROVE DEPOSITORY
      INSTITUTION OVERSIGHT
-------------------------------------------------------- Chapter 3:4.3

Regulators have stated that they have learned from their experiences
in the 1980s and that their approach to depository institution
oversight has changed.  The regulators said that they have recognized
the need to take proactive steps to prevent institutions from
engaging in unsafe and unsound practices.  For example, OCC, FRS, and
FDIC are developing new examination procedures to better monitor and
control bank risk-taking (see app.  II).  A July 1996 proposal to
revise the rating system used by the regulators also reflects the
increased emphasis on evaluating an institution's risk exposure and
the quality of its risk management systems.\15

Efforts by the regulators to improve federal oversight through
examinations focused on risk management, along with the accounting
and corporate governance provisions of FDICIA, could help provide
early warning signals of potential safety-and-soundness problems. 
However, whether this potential for earlier detection will be
translated into corrective action is subject to some question because
the regulators still have a great deal of discretion under section
39, as amended.  Although the section 38 capital standards appear to
have played some role in strengthening the condition of the banks and
thrifts, other factors have also contributed to this improvement,
including lower interest rates and an improving economy.  Despite the
apparently sound financial condition of the bank and thrift industry,
the possibility cannot be ruled out that the current strong
performance of the bank and thrift industry is masking management
problems or excessive risk-taking that is not being addressed by
regulators.  For example, the financial press reported in November
1995 and March 1996 that delinquent consumer loans, such as credit
card loans, grew considerably during these years and that this growth
was partially attributed to lower credit standards.\16 Whether the
regulators are more successful in detecting risk management problems
and then taking the requisite corrective actions may not be fully
known until another downturn in the economy affects the bank and
thrift industry. 


--------------------
\15 61 Fed.  Reg.  37472 (July 18, 1996). 

\16 The regulators have indicated that they are closely monitoring
delinquencies by loan type.  For example, FDIC testified before the
House Committee on Banking and Financial Services on September 12,
1996, that consumer lending did not pose a significant risk to the
deposit insurance funds at this time and that it would continue to
closely monitor industry trends in consumer loan delinquencies and
consumer loan portfolios at individual institutions. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 3:5

In 1991, Congress enacted FDICIA, in part, because of concerns that
the exercise of regulatory discretion during the 1980s did not
adequately protect the safety and soundness of the banking system or
minimize insurance fund losses.  FDICIA's Prompt Regulatory Action
provisions were originally enacted to limit regulatory discretion in
key areas and to mandate regulatory responses against financial
institutions with safety-and-soundness problems.  The implementation
of section 38 has provided capital categories and mandated actions
that regulators should take if banks or thrifts fall into specific
categories.  However, section 39, as amended, appears to leave
regulatory discretion largely unchanged from what existed before the
passage of FDICIA. 

Sections 38 and 39 provide regulators with additional enforcement
tools that they can use to obtain corrective action or close
institutions with serious capital deficiencies and/or
safety-and-soundness problems.  These provisions include the
enforcement tool that allows regulators to remove bank officials
believed to be the cause of the institution's problems as well as
other actions intended to stop the institution from engaging in risky
practices.  Moreover, section 38 appears to have encouraged
institutions to raise additional equity capital and should help
prevent capital-deficient institutions from compounding losses. 

Despite such benefits, severely troubled institutions may not be
subject to mandatory restrictions and supervisory actions under
section 38 due to its reliance on capital as the basis for regulatory
intervention.  In addition, section 39 does not require regulators to
take actions against poorly managed institutions that have not yet
reached the point of capital deterioration.  Legislative and
regulatory changes have resulted in the guidelines' taking the form
of broad statements of general banking principles rather than as
specific measures of unsafe and unsound conditions.  Furthermore,
regulators have not established criteria for determining when a
institution is in noncompliance with the guidelines. 

The implementation of FDICIA's other provisions and various
initiatives undertaken by the regulators to improve their examination
process may help to increase the likelihood that regulators will take
prompt and corrective regulatory action.  FDICIA's accounting and
supervisory reforms provide a structure to strengthen corporate
governance and to facilitate early warning of safety-and-soundness
problems.  In addition, regulators have stated that their approach to
supervision has changed since the 1980s, and they are developing new
examination procedures to be more proactive in monitoring and
assessing bank risk-taking.  However, we did not evaluate the
effectiveness of these initiatives because many of them have not been
fully implemented or tested.  Therefore, at present, it is difficult
to determine if these initiatives will result in the earlier
detection of safety-and-soundness problems and, if so, whether
regulators will take strong and forceful actions early enough to
prevent or minimize future losses to the insurance funds due to
failures. 


   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 3:6

In its comments on our report, OCC agreed with our conclusion that
sections 38 and 39 may not always result in prompt and corrective
regulatory action.  Nonetheless, OCC believes that FDICIA's
combination of section 38 mandatory restrictions and the regulatory
discretion retained under section 39 allows regulators to tailor
their supervision to suit an institution and its particular problems. 

The Federal Reserve Board of Governors stated that it had no formal
comments but that the report appeared to accurately describe the
Federal Reserve's policies, procedures, and practices with respect to
the implementation of FDICIA's Prompt Regulatory Action provisions,
as amended. 

OTS stated that section 38 effectively encourages institutions to
avoid becoming or remaining undercapitalized.  OTS emphasized that
the section 39 standards are untested, and it supported the
flexibility built into section 39.  OTS believes that existing
discretionary supervisory and enforcement tools are adequate to deal
with most safety-and-soundness issues, apart from capital. 

FDIC also supported the discretionary and flexible nature of the
section 39 safety-and-soundness standards.  FDIC pointed out that the
overwhelming number of comments that the regulators received on the
section 39 standards were in favor of general rather than specific
standards.  FDIC stated that the section 39 standards adopted by the
regulators minimize regulatory burden while recognizing that there is
more than one way to operate in a safe-and-sound manner. 

We do not disagree that there is a need for some degree of regulatory
discretion.  Rather, we see the issue as one of striking a proper
balance between the need for sufficient regulatory discretion to
respond to circumstances at a particular institution and the need for
certainty for the banking industry about what constitutes an unsafe
or unsound condition and what supervisory actions would be expected
to result from those conditions.  The subjective nature of the
standards continues the wide discretion that regulators had in the
1980s over the timing and severity of enforcement actions.  Such
discretion resulted in the regulators' not always taking strong
actions early enough to address safety-and-soundness problems before
they depleted an institution's capital.  However, we note that the
implementation of FDICIA along with various regulatory initiatives
undertaken since the passage of FDICIA may help in the earlier
detection of institutions with safety-and-soundness problems.  These
initiatives, along with the regulators' willingness to use their
various enforcement authorities--including sections 38 and 39--to
prevent or minimize potential losses to the deposit insurance funds,
will be instrumental in determining whether the proper balance
between discretion and certainty has been attained. 


REVISIONS TO RISK-BASED CAPITAL
STANDARDS
=========================================================== Appendix I

Section 305 of FDICIA requires regulators to review their risk-based
capital standards biennially to facilitate section 38's ability to
prevent or minimize insurance fund losses.  The section also requires
regulators to revise the risk-based capital standards to ensure that
the standards take adequate account of interest rate risk,
concentrations of credit risk, and the risks of nontraditional
financial products.  Regulators are required to revise the risk-based
capital standards to reflect the actual performance and risk of loss
on multifamily mortgages.  Section 305 required regulators to issue
regulations prescribing the new standards no later than June 19,
1993.  In addition to the actions taken in response to section 305's
requirements, regulators have revised their risk-based capital
standards by adding a market risk component in conformance with a
recent amendment to the Basle Committee's capital standards for
international banks.\1


--------------------
\1 The Basle Committee amendment defined market risk as the risk of
losses in on- and off-balance-sheet positions arising from movements
in market prices.  Specifically, the risks related to (1) interest
rate-related instruments and equities in the trading book and (2)
foreign exchange risk and commodities risk throughout the bank. 


   CAPITAL STANDARDS FOR CREDIT
   CONCENTRATION AND
   NONTRADITIONAL PRODUCT RISKS
--------------------------------------------------------- Appendix I:1

On December 15, 1994, regulators issued final rules on revised
risk-based capital standards to ensure that the standards account for
credit concentrations and nontraditional products risks.\2

Loan concentrations pose substantial risks to depository institutions
because problems with one borrower, industry, location, collateral,
or loan type could cause substantial asset quality deterioration. 
Nontraditional product risks are associated with activities that have
not customarily been part of the banking business (e.g.,
sophisticated financial instruments, such as derivatives). 

In the course of developing the final rule on credit concentrations,
regulators concluded that there is no generally accepted approach to
identifying and quantifying the magnitude of risk associated with
concentrations of credit.  Therefore, regulators determined that it
was not currently feasible to include a formula-based calculation to
quantify the risk related to concentrations of credit.  Instead, the
final rule directs examiners to assess each bank's concentrations of
credit and its ability to manage those concentrations.  Under the
final rule, institutions found to have excessive concentrations that
are inadequately managed will be required to hold capital in excess
of the regulatory minimums established by section 38. 

Like concentrations of credit, regulators did not issue quantitative
formulas or standards for nontraditional products risk.  Under the
final rule, regulators will take into account the risks posed by
nontraditional activities during the examination process.  The
regulators explained that the final rule recognized that the effect
of a nontraditional activity on an institution's capital adequacy
depends on the activity, the profile of the institution, and the
institution's ability to monitor and control the risks arising from
that activity.  Regulators may require higher minimum capital ratios
from those institutions found to have excessive risk due to
nontraditional banking activities.  The regulators stated that they
will continue their efforts to incorporate nontraditional activities
into risk-based capital. 


--------------------
\2 59 Fed.  Reg.  64561. 


   INTEREST RATE RISK CAPITAL
   REVISIONS
--------------------------------------------------------- Appendix I:2

On August 2, 1995, regulators issued a final rule that amended their
capital guidelines for interest rate risk.\3 Interest rate risk is
the risk that changes to market interest rates will have an adverse
effect on a bank's earnings and its underlying economic value.  The
final rule does not make explicit or quantitative changes to
risk-based capital standards.  Instead, the final rule directs
examiners to consider, in their evaluation of a bank's capital
adequacy, the exposure of the bank's capital and economic value to
changes in interest rates. 

The August 2, 1995, final rule did not adopt a measurement framework
for assessing the level of an institution's interest rate exposure,
nor did it specify a formula for determining the amount of capital
that would be required.  The intent of the regulators at that time
was to implement an explicit minimum capital charge for interest rate
risk at a future date, after the regulators and industry had gained
more experience with a proposed supervisory measure that the agencies
issued for comment in August 1995.\4

At that time, regulators sought comments on their proposed framework
for measuring and monitoring the level of interest rate risk at
individual banks.  The proposed system would, on a standardized
basis, measure the risk of all banks not exempted from reporting
additional information on their call reports.\5

In addition, regulators proposed encouraging banks to report the
results of their own internal, interest rate risk measurement systems
on a voluntary and confidential basis.  Examiners would then use the
information from both sources in their assessments of the bank's
interest rate risk management and capital adequacy.  The results
would also provide regulators with information on industry trends and
patterns that would better inform both present and future supervisory
efforts related to interest rate risk, such as the development of
explicit minimum risk-based capital requirements for interest rate
risk. 

On June 26, 1996,\6 the regulators issued a joint policy statement on
interest rate risk that did not incorporate the standardized
measurement framework proposed by the regulators in August 1995. 
According to the regulators, the decision not to pursue a
standardized measurement system reflected (1) concerns about the
burden, accuracy, and complexity of a standardized measure and (2)
the recognition that industry techniques for measuring interest rate
risk were continuing to evolve.  Instead, the June 1996 policy
statement identified the key elements of sound interest rate risk
management and described the prudent principles and practices for
each of these elements.  The regulators stated their intent to
continue to place significant emphasis on the level of an
institution's interest rate risk exposure and the quality of its risk
management process when evaluating its capital adequacy. 


--------------------
\3 60 Fed.  Reg.  39490. 

\4 60 Fed.  Reg.  39495. 

\5 The only proposed exemption from the expanded reporting
requirements was for banks with (1) total assets under $300 million,
(2) composite supervisory ratings of 1 or 2, and (3) moderate or low
holdings of assets with intermediate and long-term maturity or
repricing characteristics. 

\6 61 Fed.  Reg.  33166. 


   MARKET RISK MEASURE
--------------------------------------------------------- Appendix I:3

OCC, FRS, and FDIC have issued a final rule amending their risk-based
capital standards to include market risk.\7 The final rule was
intended to expand the existing credit-based focus of the regulators'
risk-based capital standards.  The regulators took this action in
response to the Basle Committee's January 1996 amendment to its
capital standards for international banks.\8

That amendment requires international banks to start incorporating
market risk in their risk-based capital by the end of 1997. 

The final rule issued by the regulators requires an institution that
meets specific applicability criteria\9 to measure its exposure to
market risk and hold capital in support of that exposure by January
1, 1998.  Specifically, an institution must adjust its risk-based
capital ratio to take into account the general market risk of all
positions located in its trading accounts and of foreign exchange and
commodity positions whether they are on- or off-balance sheet. 
Additionally, the institution must account for the specific risk of
debt and equity positions located in its trading account. 

The final rule on market risk allows an institution to use its own
internal models to measure its exposure to market risk.  However, the
institution is required to determine the capital charges for its
specific risks using a standardized approach methodology specified by
the regulators.  The regulators will then use the adjusted risk-based
capital ratio to determine the institution's capital category under
section 38 as well as for other statutory and regulatory purposes. 


--------------------
\7 61 Fed.  Reg.  47357 (Sept.  6, 1996). 

\8 Amendment to the Capital Accord to Incorporate Market Risks, Basle
Committee on Banking Supervision, January 1996. 

\9 Any bank or holding company whose trading activity equals 10
percent or more of its total assets, or whose trading activity equals
$1 billion or more is required to adjust its risk-based capital to
account for market risk. 


NEW EXAMINATION PROCEDURES AND
RATING SYSTEM TO BETTER MONITOR
BANK RISK-TAKING
========================================================== Appendix II

OCC, FRS, and FDIC have announced or were developing new bank
examination policies and/or procedures to better monitor bank
risk-taking.  The primary objective of the new banking examination
procedures was to identify potential areas of risk and concentrate
regulatory resources on those areas with the greatest potential risk. 
As of September 1996, these initiatives had not been fully
implemented.  In addition, the Federal Financial Institutions
Examination Council (FFIEC)\1 issued a proposal in July 1996 that
would revise the supervisory rating system used by regulators to,
among other things, reflect changes that have occurred in supervisory
policies and procedures. 


--------------------
\1 FFIEC is an interagency group of depository institution regulators
(OCC, FDIC, FRS, OTS, and the National Credit Union Association) that
was formed in 1979 to maintain uniform standards for the federal
examination and supervision of federally insured depository
institutions. 


   RISK-BASED EXAMINATION
   INITIATIVES
-------------------------------------------------------- Appendix II:1

As shown in table II.1, OCC's initiative requires its examiners to
separate risk into nine categories, ranging from credit and interest
rate risk to compliance and reputation risk.  Although similar in
content, FRS' risk-based examination approach divides bank risk into
six categories.  Under both approaches, examiners rate each bank in
each risk category, as well as overall, and analyze how well each
category is managed.  The risk rating of each institution would
supplement and not replace traditional examination approaches, which
focus on assessing bank asset quality, capital adequacy, and
profitability.  OCC and FRS developed the new examination system, in
part, to better respond to developments in the financial services
industry over recent years.  For example, the new examination system
is intended to help OCC and FRS better monitor banks' use of complex
derivative financial products. 



                               Table II.1
                
                  Risk Factors Used in OCC's and FRS'
                   Risk-Based Examination Procedures


Risk category                                        OCC           FRS
------------------------------------------  ------------  ------------
Credit: risk that borrower will default              yes           yes
Liquidity: risk that bank will not meet              yes           yes
 its obligation without selling assets at
 below-market rates
Interest rate: risk from fluctuating                 yes            no
 interest rates
Market: risk from shifts in interest rates            no           yes
 and foreign exchange rates
Price: risk from changing values in a                yes            no
 securities portfolio
Reputation: risk of bad publicity                    yes           yes
Strategic: risk of making bad business               yes            no
 decisions
Operational: risk of trouble from regular             no           yes
 business practices
Transactions: risk from product delivery             yes            no
 problems
Foreign Exchange: risk from changing                 yes            no
 exchange rates
Compliance (OCC)/Legal (FRS): risk of                yes           yes
 violating laws or regulations
----------------------------------------------------------------------
Source:  OCC and FRS. 

According to a senior FDIC official, FDIC was also developing a new
examination policy on assessing bank risks.  He said that the policy
is to be based largely on a current policy statement, issued by FDIC
in March 1994, that provides guidance on examining and assessing the
risks of financial derivatives.  In addition, FDIC was examining the
new risk-based examination procedures announced by OCC and FRS as
possible models for FDIC's new examination policy on assessing bank
risk.  The official said he was not certain when the new examination
policy would be issued. 


   PROPOSED SUPERVISORY RATING
   SYSTEM REVISIONS
-------------------------------------------------------- Appendix II:2

On July 18, 1996, FFIEC requested comments on proposed revisions to
the Uniform Financial Institutions Rating System, which is commonly
referred to as the CAMEL (Capital, Asset, Management, Earnings, and
Liquidity) rating system.\2 The proposed revisions reflected changes
occurring in the financial services industry and in supervisory
policies and procedures since the rating system was first adopted in
1979. 

The proposed revisions included (1) the reformatting and
clarification of the existing component rating descriptions; (2) the
addition of a sixth rating component addressing sensitivity to market
risks; (3) an increase in emphasis on the quality of risk management
processes in each of the rating components, particularly in the
management component; (4) the addition of language in composite
rating definitions to parallel the proposed changes in component
rating definitions; and (5) the explicit identification of the risk
types that are to be considered in assigning component ratings. 
FFIEC established September 16, 1996, as the deadline for receiving
comments on its proposal. 



(See figure in printed edition.)Appendix III

--------------------
\2 61 Fed.  Reg.  37472. 


COMMENTS FROM THE OFFICE OF THE
COMPTROLLER OF THE CURRENCY
========================================================== Appendix II



(See figure in printed edition.)




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FEDERAL RESERVE
BOARD
========================================================== Appendix II




(See figure in printed edition.)Appendix V
COMMENTS FROM THE FEDERAL DEPOSIT
INSURANCE CORPORATION
========================================================== Appendix II



(See figure in printed edition.)




(See figure in printed edition.)Appendix VI
COMMENTS FROM THE OFFICE OF THRIFT
SUPERVISION
========================================================== Appendix II



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix VII

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Thomas J.  McCool, Associate Director
Mark Gillen, Assistant Director
James R.  Black, Senior Evaluator
Wesley M.  Phillips, Evaluator

BOSTON FIELD OFFICE

Kevin F.  Murphy, Senior Evaluator

DALLAS FIELD OFFICE

Ronald Haun, Senior Evaluator

SAN FRANCISCO-SEATTLE FIELD OFFICE

Kane Wong, Assistant Director
Harry Medina, Evaluator-in-Charge
Bruce K.  Engle, Evaluator
Gerhard C.  Brostrom, Communications Analyst


*** End of document. ***