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United States Government Accountability Office: 
GAO: 

Report to Congressional Committees: 

June 2011: 

Bank Regulation: 

Modified Prompt Corrective Action Framework Would Improve 
Effectiveness: 

GAO-11-612: 

GAO Highlights: 

Highlights of GAO-11-612, a report to congressional committees. 

Why GAO Did This Study: 

More than 300 insured depository institutions have failed since the 
current financial crisis began in 2007, at an estimated cost of almost 
$60 billion to the deposit insurance fund (DIF), which covers losses 
to insured depositors. Since 1991, Congress has required federal 
banking regulators to take prompt corrective action (PCA) to identify 
and promptly address capital deficiencies at institutions to minimize 
losses to the DIF. The Dodd-Frank Wall Street Reform and Consumer 
Protection Act requires GAO to study federal regulators’ use of PCA. 
This report examines (1) the outcomes of regulators’ use of PCA on the 
DIF; (2) the extent to which regulatory actions, PCA thresholds, and 
other financial indicators help regulators address likely bank trouble 
or failure; and (3) options available to make PCA a more effective 
tool. GAO analyzed agency and financial data to describe PCA and DIF 
trends and assess the timeliness of regulator actions and financial 
indicators. GAO also reviewed relevant literature and surveyed expert 
stakeholders from research, industry, and regulatory sectors on 
options to improve PCA. 

What GAO Found: 

Although the PCA framework has provided a mechanism to address 
financial deterioration in banks, GAO’s analysis suggests it did not 
prevent widespread losses to the DIF-—a key goal of PCA. Since 2008, 
the financial condition of banks has declined rapidly and use of PCA 
has grown tenfold. However, every bank that underwent PCA because of 
capital deficiencies and failed in this period produced a loss to the 
DIF. Moreover, these losses were comparable as a percentage of assets 
to the losses of failed banks that did not undergo PCA. While 
regulators and others acknowledged PCA’s limitations, regulators said 
that the PCA framework provides benefits, such as facilitating orderly 
closures and encouraging banks to increase capital levels. 

PCA’s triggers limit its ability to promptly address bank problems, 
and although regulators had discretion to address problems sooner, 
they did not consistently do so. Since the 1990s, GAO and others have 
noted that the effectiveness of PCA, as currently constructed, is 
limited because of its reliance on capital, which can lag behind other 
indicators of bank health. That is, problems with the bank’s assets, 
earnings, or management typically manifest before these problems 
affect bank capital. Once a bank falls below PCA’s capital standards, 
a bank may not be able to recover regardless of the regulatory action 
imposed. GAO tested other financial indicators, including measures of 
asset quality and liquidity, and found that they were important 
predictors of future bank failure. These indicators also better 
identified those institutions that failed and did not undergo the PCA 
process during the recent crisis. Although regulators identified 
problematic conditions among banks well before failure, the presence 
and timeliness of enforcement actions were inconsistent. For example, 
among the banks that failed, more than 80 percent were on a regulatory 
watch list for more than a year, on average, before bank failure. 
However, GAO’s analysis of regulatory data and material loss reviews 
showed that actions to address early signs of deterioration were 
inconsistent and, in many cases, regulators either took no enforcement 
action or acted in the final days before an institution was subject to 
PCA or failed. Without an additional early warning trigger, the 
regulators risk acting too late, thereby limiting their ability to 
minimize losses to the DIF. 

Most stakeholders (23 of 29) GAO surveyed agreed that PCA should be 
modified and identified three top options to make it more effective. 
The first option-—incorporating an institution’s risk profile into PCA 
capital categories-—would add a measure of risk to the capital 
category thresholds beyond the existing risk-weighted asset component. 
The second option was increasing the capital ratios that place banks 
in PCA capital categories. The third most popular option was including 
another trigger for PCA, such as asset quality or asset concentration. 
Each option has advantages and disadvantages. For example, while an 
additional trigger could account for other factors often found to 
precede capital deterioration, it might be difficult to implement. 
Although stakeholders supported these broad options, they cautioned 
that the manner in which any option was crafted would determine its 
success. 

What GAO Recommends: 

GAO recommends that the bank regulators consider additional triggers 
that would require early and forceful regulatory action to address 
unsafe banking practices as well as the other options identified in 
the report to improve PCA. The regulators generally agreed with the 
recommendation. 

View [hyperlink, http://www.gao.gov/products/GAO-11-612] or key 
components. For more information, contact A.Nicole Clowers at (202) 
512-8678 or clowersa@gao.gov. [End of section] 

Contents: 

Letter: 

Background: 

PCA Did Not Prevent Widespread Losses to the DIF: 

Other Indicators Provide Early Warning of Deterioration, and although 
Regulators Identified Conditions Early, Responses Were Inconsistent: 

While Most Stakeholders Favored Modifying PCA, Their Preferred Options 
Involve Some Trade-offs: 

Conclusions: 

Recommendation for Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: The Resolution Process Also Can Help Minimize Losses to 
the Deposit Insurance Fund: 

Appendix III: Econometric Analysis of Leading Indicators of Bank 
Failure and Determinants of Losses to the Deposit Insurance Fund: 

Appendix IV: PCA Survey Respondents: 

Appendix V: Responses to Questions from GAO's Second Delphi Survey on 
the Prompt Corrective Action Framework: 

Appendix VI: Comments from the Federal Deposit Insurance Corporation: 

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

Appendix VIII: Comments from the Office of the Comptroller of the 
Currency: 

Appendix IX: GAO Contact and Staff Acknowledgments: 

Tables: 

Table 1: PCA Capital Categories: 

Table 2: Select Leading Indicators of Bank Failure: 

Table 3: Key Regulatory Activities and Milestones of Case Studies, 
First Quarter 2006-Third Quarter 2010: 

Table 4: First Enforcement Action in Relation to Other Key Regulatory 
Milestones of Case Studies, First Quarter 2006ńThird Quarter 2010: 

Table 5: Rank Ordering of Survey Policy Options: 

Table 6: Select Leading Indicators of Bank Failure: 

Table 7: Logit Model of Bank Failure with Standard Financial Ratios, 
Four-Quarter Horizon: 

Table 8: Logit Model of Bank Failure with Standard Financial Ratios, 
Eight-Quarter Horizon: 

Table 9: Logit Model of Bank Failure with HHI 1, Four-Quarter Horizon: 

Table 10: Logit Model of Bank Failure with HHI 2, Four-Quarter Horizon: 

Table 11: Logit Model of Bank Failure with CRE, Four-Quarter Horizon: 

Table 12: Logit Model of Bank Failure with CRE and HHI 2, Four-Quarter 
Horizon: 

Table 13: Logit Model of Bank Failure with HHI 2, Eight-Quarter 
Horizon: 

Table 14: Logit Model of Bank Failure with CAMELS, Four-Quarter 
Horizon: 

Table 15: Logit Model of Bank Failure with CAMELS, Eight-Quarter 
Horizon: 

Table 16: Logit Model of Bank Failure with CAMELS and Financial 
Indicators, Four-Quarter Horizon: 

Table 17: Logit Model of Bank Failure with CAMELS and Financial 
Indicators, Eight-Quarter Horizon: 

Table 18: Potential Factors Affecting DIF Losses: 

Table 19: Model of DIF Losses with Nonperforming Loans and Total 
Deposits, First Quarter 2007-Third Quarter 2010: 

Table 20: Model of DIF Losses with Nonperforming Loans and Small 
Deposits, First Quarter 2007-Third Quarter 2010: 

Table 21: Model of DIF Losses with Nonperforming Assets and Small 
Deposits, First Quarter 2007-Third Quarter 2010: 

Table 22: Survey Respondents: 

Table 23: Stakeholder Views on Potential Positive Elements of the PCA 
Framework: 

Table 24: Stakeholder Views on Potential Shortcomings of the PCA 
Framework: 

Table 25: Stakeholder Views on Potential Impact of Each Option to Make 
the PCA Framework More Effective in Minimizing Losses to the DIF: 

Table 26: Stakeholder Views on Potential Feasibility for Federal 
Regulators to Implement Each Option: 

Table 27: Stakeholder Ranking of 12 Potential Options to Modify PCA: 

Table 28: Stakeholder Views on the Potential Impact of Potential 
Additional PCA Triggers: 

Figures: 

Figure 1: Key Regulatory Milestones Associated with Bank Deterioration: 

Figure 2: Number of Banks on FDIC's Problem Bank List, First Quarter 
2006 - Third Quarter 2010: 

Figure 3: Number of Banks by Composite CAMELS Rating, First Quarter 
2006 - Third Quarter 2010: 

Figure 4: Number of Failed Banks, 2006-2010: 

Figure 5: Deposit Insurance Fund Balance, First Quarter 2006 - Fourth 
Quarter 2010: 

Figure 6: Number of Banks That Underwent the PCA Process, First 
Quarter 2006 - Third Quarter 2010: 

Figure 7: Banks Undergoing the PCA Process for the First Time, First 
Quarter 2006 - Third Quarter 2010: 

Figure 8: Failures and Nonfailures of Banks That Underwent the PCA 
Process, First Quarter 2006 - Third Quarter 2010: 

Figure 9: Status of 569 Banks That Underwent the PCA Process, First 
Quarter 2006 - Third Quarter 2010: 

Figure 10: Median Loss to the Insurance Fund of Failed Banks That Did 
and Did Not Undergo the PCA Process, First Quarter 2006 - Third 
Quarter 2010: 

Figure 11: Nonperforming Loans (Asset Quality) at Failed and Peer 
Banks, First Quarter 2006-Second Quarter 2009: 

Figure 12: Liquidity at Failed and Peer Banks, First Quarter 2006- 
Second Quarter 2009: 

Figure 13: Loan Concentration at Failed and Peer Banks, First Quarter 
2008: 

Figure 14: Initial PCA Action of Failed Banks, First Quarter 2006-
Third Quarter 2010: 

Figure 15: Trends in Use of Shared-loss Agreements, First Quarter 2006-
Third Quarter 2010: 

Figure 16: Equity Capital and Regulatory Capital at Failed Banks, 
First Quarter 2006-Second Quarter 2009: 

Figure 17: Stakeholder Views on Potential Additional PCA Trigger That 
Would Have the Most Positive Impact on PCA Effectiveness: 

Figure 18: Stakeholder Overall Opinion of the PCA Framework: 

Abbreviations: 

ADC: acquisition, development, and construction: 

CAMELS: Uniform Financial Institutions Rating System: 

C&I: commercial and industrial: 

CRE: commercial real estate: 

DIF: deposit insurance fund: 

DRR: Division of Resolutions and Receiverships: 

FDIA: Federal Deposit Insurance Act: 

FDIC: Federal Deposit Insurance Corporation: 

FDICIA: Federal Deposit Insurance Corporation Improvement Act: 

FSOC: Financial Stability Oversight Council: 

HHI: Herfindahl-Hirschman Index: 

IG: inspector general: 

OCC: Office of the Comptroller of the Currency: 

OLS: ordinary least-squares: 

OTS: Office of Thrift Supervision: 

PCA: prompt corrective action: 

SCOR: Statistical CAMELS Off-site Rating: 

SR-SABR: Supervision and Regulation Statistical Assessment of Bank 
Risk: 

[End of section] 

United States Government Accountability Office: 
Washington, DC 20548: 

June 23, 2011: 

The Honorable Tim Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate: 

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

After the savings and loan crisis, federal regulators were criticized 
for failing to take timely and forceful action to address the causes 
of bank failures and prevent losses to taxpayers and the deposit 
insurance fund (currently and hereinafter referred to as the DIF). 
[Footnote 1] In response, Congress passed the Federal Deposit 
Insurance Corporation Improvement Act (FDICIA) of 1991, which made 
significant changes to the Federal Deposit Insurance Act (FDIA). 
[Footnote 2] In particular, FDICIA created sections 38 and 39 of FDIA 
to improve the ability of regulators to identify and promptly address 
deficiencies at depository institutions--banks and thrifts--and better 
safeguard and minimize losses to the DIF. Section 38 requires 
regulators to classify banks into one of five capital categories and 
take increasingly severe actions, known as prompt corrective action 
(PCA), as a bank's capital deteriorates. Section 38 primarily focuses 
on capital as an indicator of bank health; therefore, supervisory 
actions under it are designed to address a bank's deteriorating 
capital level.[Footnote 3] Section 39 requires the banking regulators 
to prescribe safety and soundness standards related to noncapital 
criteria, including operations and management; compensation; and asset 
quality, earnings, and stock valuation.[Footnote 4] Section 39 allows 
the regulators to take action if a bank fails to meet one or more of 
these standards. 

Before 2007, PCA was largely untested by a financial crisis that 
resulted in a large number of bank failures. After the passage of 
FDICIA, sustained growth in the U.S. economy meant that the financial 
condition of banks was generally strong. For instance, as a result of 
positive economic conditions, the number of bank failures declined 
from 180 in 1992 to 4 in 2004. And from June 2004 through January 
2007, no banks failed. 

Since 2007, failures have increased significantly. In 2010, 157 banks 
failed, the most in a single year since the savings and loan crisis of 
the 1980s and 1990s. The 157 banks had combined assets of 
approximately $93 billion, costing the DIF an estimated $24 billion. 
Overall, more than 300 banks have failed since the current financial 
crisis began in 2007, at an estimated cost of almost $60 billion to 
the DIF to cover losses to insured depositors. During this time, the 
balance of the DIF has declined dramatically, becoming negative in 
2009. As of December 31, 2010, the DIF had a negative balance of $7.4 
billion. During this same period, beginning late in 2008, the federal 
government provided significant financial assistance to many financial 
institutions through the Troubled Asset Relief Program and other 
actions taken by the Federal Reserve System and FDIC to stabilize the 
U.S. banking system.[Footnote 5] For example, regulators used certain 
emergency authorities to enable assistance to some large banks because 
in their view the failure of these institutions would have imposed 
large losses on creditors and threatened to undermine confidence in 
the banking system.[Footnote 6] 

The number and size of failures during the recent financial crisis 
have raised questions about the ability of PCA to help turn around 
troubled banks and minimize losses to the DIF. Section 202(g) of the 
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank 
Act) requires GAO to study the federal regulators' use of PCA and 
report our findings to the Financial Stability Oversight Council. 
[Footnote 7] The Dodd-Frank Act also requires that the Financial 
Stability Oversight Council report to the Committee on Banking, 
Housing, and Urban Affairs of the Senate and the Committee on 
Financial Services of the House of Representatives on actions taken in 
response to our report, including any recommendations made to the 
federal banking regulators. Specifically, this report (1) analyzes the 
outcomes of regulators' use of PCA on the DIF; (2) evaluates the 
extent to which regulatory actions, capital thresholds, and other 
financial indicators helped regulators to address likely bank trouble 
or failure; and (3) identifies options available to make PCA a more 
effective tool to prevent or minimize losses to the DIF. 

To describe trends in and outcomes from the implementation of PCA, we 
analyzed banking data from regulators, including FDIC Quarterly 
Banking Reports and the quarterly "problem" bank lists. We analyzed 
data on banks that underwent the PCA process, failed from the first 
quarter of 2006 through the third quarter of 2010 (i.e., from January 
1, 2006, through September 30, 2010), or both, and identified their 
outcomes.[Footnote 8] To determine the number of banks that produced 
losses to the DIF--including those banks that underwent the PCA 
process before failure and those that did not--we used the 2010 
estimate of losses to the DIF from loss data obtained from FDIC, which 
we determined to be sufficiently reliable for our purpose of 
enumerating failed banks and the losses associated with these failures 
based on our ongoing work related to the DIF.[Footnote 9] We also 
interviewed representatives from FDIC, the Board of Governors of the 
Federal Reserve System (Federal Reserve), the Office of the 
Comptroller of the Currency (OCC), and the Office of Thrift 
Supervision (OTS). 

To assess the utility of various financial indicators in predicting 
bank distress, we developed a model of leading indicators of bank 
failure based on financial ratios researchers identified in the 1990s 
that predicted bank failures in previous stress periods. We used these 
financial ratios, regulatory ratings, and an indicator we developed of 
sector loan concentration to forecast bank failure within 1 to 2 years 
(for failed banks and peers from 2006 through the third quarter of 
2010). We used this model to assess the predictive power of indicators 
other than bank capital. To do this, we relied on data from FDIC and 
SNL Financial. We assessed the reliability of data used in our 
analysis and found the data sufficiently reliable for our purposes. 

To examine the extent to which various regulatory activities and 
enforcement actions, including PCA, detected and addressed troubled 
banks, we examined the type and timing of regulatory actions across 
the oversight cycle. This work encompassed analyzing the extent to 
which existing regulatory steps provided warning of likely bank 
deterioration or failure. Specifically, we reviewed off-site 
monitoring tools and examined if these tools provided effective 
warnings of bank distress. For all bank failures that occurred from 
the first quarter of 2006 through the third quarter of 2010, we also 
reviewed formal and informal enforcement actions in the 2-year period 
before a bank failed to identify the earliest enforcement action taken 
in relation to other regulatory milestones associated with financial 
deterioration. We also reviewed the timing and nature of PCA 
enforcement actions in relation to bank failure. Upon receiving 
enforcement data provided by FDIC, the Federal Reserve, OCC, and OTS, 
we determined that the enforcement data provided could not be relied 
upon without additional verification. In particular, the enforcement 
data the Federal Reserve, OCC, and OTS provided could not be used 
alone to make distinctions among different types of enforcement 
actions that may or may not have been relevant to safety and soundness 
issues of banks that were deteriorating financially. While enforcement 
data provided by FDIC did make such distinctions, we did not rely 
exclusively on the enforcement data provided by the regulators, but 
rather, used these data to corroborate information on enforcement 
actions from material loss reports prepared by the inspectors general 
(IG) of the banking regulators and conducted case studies of 8 banks 
to highlight examples of oversight steps taken by each of the 
regulators and various outcomes. We selected a nongeneralizable sample 
of banks that is diverse with respect to geography, asset size, 
franchise value, primary regulator, date of failure, sequence of 
enforcement actions, outcome (failure or a return to financial 
stability), and losses to the DIF. The inspectors general for the 
FDIC, the Department of the Treasury, and the Board of Governors of 
the Federal Reserve System are currently conducting a joint evaluation 
of the PCA framework that will address the use of both sections 38 and 
39 of FDICIA during the last few years, among other issues. 

To identify options to make PCA more effective, we surveyed informed 
stakeholders from the regulatory agencies, research, and industry 
sectors. We used a two-part Delphi survey to gather ideas from the 
stakeholders, who were identified through professional credentials, 
authorship of research, and membership in relevant research and 
industry groups. The first survey, using open-ended questions, asked 
respondents to identify options, including those outside the PCA 
framework, which could be more effective in minimizing losses to the 
DIF. The second survey, through a set of closed-ended questions 
created from a content analysis of the responses from the first 
survey, asked the same stakeholders to rate and rank the options in 
terms of feasibility and impact. To further illustrate the options 
that may be considered to improve PCA effectiveness, we interviewed 
supervisory and research staff at the four regulators about PCA and 
bank failures during the financial crisis and any additional options 
that could improve PCA effectiveness. Finally, we conducted a 
literature review on PCA and early intervention and synthesized any 
additional options presented in the literature that could make PCA 
more effective. Appendix I contains a more detailed description of our 
scope and methodology. 

We conducted this performance audit from July 2010 through June 2011 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

Background: 

Bank Supervision: 

Four federal regulators oversee banks and savings associations 
(thrifts) in the United States. The Federal Reserve is the primary 
regulator for state-chartered member banks (i.e., state-chartered 
banks that are members of the Federal Reserve System) and bank holding 
companies, OCC is the primary regulator of federally chartered banks, 
and OTS is the primary regulator of federally and state-chartered 
thrifts and thrift holding companies.[Footnote 10] FDIC is the primary 
regulator for state-chartered nonmember banks (i.e., state-chartered 
banks that are not members of the Federal Reserve System). In 
addition, FDIC insures the deposits of all federally insured banks, 
generally up to $250,000 per depositor, and monitors their risk to the 
DIF.[Footnote 11] 

Regulators examine banks' risk management systems to help ensure the 
safe and sound operation of banks and protect the well-being of 
depositors--those individuals and organizations that act as creditors 
by "loaning" their funds in the form of deposits to banks for lending 
and other activities. Regulators are responsible for supervising the 
activities of banks and taking corrective action when their activities 
and overall performance present supervisory concerns or could result 
in financial losses to the DIF or violations of law. Losses to the DIF 
may occur when a bank does not have sufficient assets to reimburse 
customers' deposits and FDIC's administrative expenses in the event of 
closure or merger. 

All the regulators assess the condition of banks through off-site 
monitoring and on-site examinations. Examiners use Report of Condition 
and Income (Call Report) and Thrift Financial Report data to remotely 
assess the financial condition of banks and thrifts, respectively, and 
to plan the scope of on-site examinations. Historically, banking 
regulators have used tools to monitor the financial condition of banks 
between on-site bank examinations. The off-site monitoring or 
surveillance activities rely largely on self-reported information from 
banks, filed through quarterly Call Reports to the banking regulators. 
Off-site monitoring and surveillance activities help alert regulators 
to potentially problematic conditions arising in a financial 
institution. Using these tools, each of the regulators identifies and 
flags banks with potential signs of financial distress for further 
regulatory scrutiny and prepares lists or reports of such institutions 
requiring further regulatory scrutiny (e.g., watch list, review list, 
high risk profile list, etc.). 

As part of on-site examinations, regulators closely assess banks' 
exposure to risk and assign ratings, under the Uniform Financial 
Institutions Rating System, commonly known as CAMELS. The ratings 
reflect a bank's condition in six areas: capital, asset quality, 
management, earnings, liquidity, and sensitivity to market risk. Each 
component is rated on a scale of 1 to 5, with 1 being the best and 5 
the worst. The component ratings are then used to develop a composite 
rating, also ranging from 1 to 5. Banks with composite ratings of 1 or 
2 are considered to be in satisfactory condition, while banks with 
composite ratings of 3, 4, or 5 exhibit varying levels of safety and 
soundness problems. Banks with composite ratings of 4 or 5 are 
included on FDIC's problem bank list, which designates banks with 
weaknesses that threaten their continued financial viability. Also as 
part of the examination and general supervision process, regulators 
may direct a bank to address issues or deficiencies within specified 
time frames. However, as figure 1 illustrates, a bank's condition can 
rapidly deteriorate and bypass the various regulatory steps that 
usually occur as a bank's condition deteriorates. 

Figure 1: Key Regulatory Milestones Associated with Bank Deterioration: 

[Refer to PDF for image: illustration] 

Banks may deteriorate quickly and bypass key regulatory steps. 

Regulatory actions: 
* Off-site monitoring and surveillance; 
* On-site examinations; 
* CAMELS ratings downgrade; 
* Informal and formal enforcement actions. 

Key regulatory steps: Healthy bank; 
Potential Outcomes: Healthy bank; 
Status: Favorable. 

Key regulatory steps: Watch list bank; 
Potential Outcomes: Healthy bank; Watch list bank; 
Status: Less favorable. 

Key regulatory steps: Problem bank; 
Potential Outcomes: Healthy bank; Watch list bank; Problem bank; 
Status: Less favorable. 

Key regulatory steps: Banks that underwent the PCA process; 
Potential Outcomes: Healthy bank; Watch list bank; Problem bank; 
Status: Less favorable. 

Key regulatory steps: Nonsurviving failed banks; 
Potential Outcomes: No loss to DIF; Loss to DIF; 
Status: Unfavorable. 

Source: GAO analysis of data from federal banking regulatory agencies. 

[End of figure] 

When regulators determine that a bank or thrift's condition is less 
than satisfactory, they may take a variety of supervisory actions, 
including informal and formal enforcement actions, to address 
identified deficiencies and have some discretion in deciding which 
actions to take. Regulators typically take progressively stricter 
actions against more serious weaknesses. Informal actions generally 
are used to address less severe deficiencies or when the regulator has 
confidence that the bank is willing and able to implement changes. 
Examples of informal actions include commitment letters detailing a 
bank's commitment to undertake specific remedial measures, resolutions 
adopted by the bank's board of directors at the request of its 
regulator, and memorandums of understanding that note agreements 
between the regulator and the bank's board of directors. Informal 
actions are not public agreements (regulators do not make them public 
through their Web sites or other channels) and are not enforceable by 
sanctions. In comparison, regulators publicly disclose and enforce 
formal actions. The regulators use formal actions to address more 
severe deficiencies. Formal enforcement actions include PCA 
directives, cease-and-desist orders, removal and prohibition orders, 
civil money penalties, and termination of a bank's deposit insurance. 
[Footnote 12] 

PCA: 

A principal goal of PCA is to prevent losses to the DIF for the vast 
majority of bank failures. Section 38 of FDIA requires regulators to 
categorize banks into five categories on the basis of their capital 
levels (see table 1). Regulators use four different capital measures 
to determine a bank's capital category: (1) a total risk-based capital 
ratio, (2) a Tier 1 risk-based capital ratio, (3) a leverage ratio (or 
non-risk-based capital ratio). The fourth PCA measure is a tangible 
equity to assets ratio for the Critically Undercapitalized category. 
[Footnote 13] To be well capitalized, a bank must significantly exceed 
the minimum standard for all three capital measures. Depending on the 
level of deficiency, banks may be considered undercapitalized or 
significantly undercapitalized if they fail to meet any one of the 
ratios necessary to be considered at least adequately capitalized. A 
bank that fails to meet the tangible equity to total assets ratio is 
considered critically undercapitalized. For example, a bank that is 
experiencing significant growth, with 9 percent total risk-based 
capital and 6 percent Tier 1 risk-based capital but only 3.5 percent 
leverage capital, would be undercapitalized for PCA purposes. 

Table 1: PCA Capital Categories: 

Capital category: Well capitalized[C]; 
Total risk-based capital[A]: 10% or more and; 
Tier 1 risk-based capital: 6% or more and; 
Leverage capital[B]: 5% or more. 

Capital category: Adequately capitalized; 
Total risk-based capital[A]: 8% or more and; 
Tier 1 risk-based capital: 4% or more and; 
Leverage capital[B]: 4% or more[D]. 

Capital category: Undercapitalized; 
Total risk-based capital[A]: Less than 8% or; 
Tier 1 risk-based capital: Less than 4% or; 
Leverage capital[B]: Less than 4%. 

Capital category: Significantly undercapitalized; 
Total risk-based capital[A]: Less than 6% or; 
Tier 1 risk-based capital: Less than 3% or; 
Leverage capital[B]: Less than 3%. 

Capital category: Critically undercapitalized; 
Total risk-based capital[A]: An institution is critically 
undercapitalized if its tangible equity is equal to or less than 2% of 
total assets regardless of its other capital ratios.[E] 

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

[A] 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 (see note e). Tier 2 capital 
includes limited amounts of subordinated debt, loan loss reserves, and 
certain other instruments. 

[B] Leverage capital is Tier 1 capital divided by average total assets. 

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

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

[E] Tangible equity is equal to the amount of Tier 1 capital elements 
plus outstanding cumulative perpetual preferred stock minus all 
intangible assets not previously deducted, except certain purchased 
mortgage-servicing rights. Cumulative perpetual preferred stock is 
stock that has no maturity date, cannot be redeemed at the option of 
the holder, has no other provisions that will require future 
redemption of the issue, and provides for the accumulation or future 
payment of unpaid dividends. Intangible assets are those assets that 
are required to be reported as intangible assets in a bank's Call 
Report or thrift's Thrift Financial Report. 

[End of table] 

Under section 38, regulators must take increasingly stringent 
supervisory actions as a bank's capital level deteriorates. For 
example, all undercapitalized banks must implement capital restoration 
plans to restore capital to at least the adequately capitalized level, 
and regulators generally must close critically undercapitalized banks 
within a 90-day period.[Footnote 14] Section 38 also authorizes 
several non-capital-based supervisory actions designed to allow 
regulators some flexibility in achieving the purpose of section 38. 
Specifically, under section 38(g) regulators can reclassify or 
downgrade a bank's capital category to apply more stringent operating 
restrictions or requirements if they determine, after notice and 
opportunity for a hearing, that a bank is in an unsafe and unsound 
condition or engaging in an unsafe or unsound practice.[Footnote 15] 
Under section 38(f)(2)(F), regulators can require a bank to make 
improvements in management--for example, by dismissing officers and 
directors who are not able to materially strengthen a bank's ability 
to become adequately capitalized. 

Section 39 directs regulatory attention to a bank's operations and 
activities in three areas aside from capital that also can affect 
safety and soundness: (1) operations and management; (2) compensation; 
and (3) asset quality, earnings, and stock valuation. Under section 
39, if a regulator determines that a bank has failed to meet a 
prescribed standard, the regulator may require that the institution 
file a safety and soundness plan specifying how it will correct the 
deficiency. If the bank fails to submit an acceptable plan or fails to 
materially implement or adhere to an approved plan, the regulator must 
require the institution, through the issuance of a public order, to 
correct identified deficiencies and may place other restrictions or 
requirements on the bank pending the correction of the deficiency. We 
previously reported that regulators made limited use of their section 
39 authority.[Footnote 16] 

Changing Condition of the Banking Industry: 

During the last few years, the condition of the bank and thrift 
industry has declined, particularly when compared with conditions in 
the relatively positive period beginning in the early 1990s following 
the passage of FDICIA. Indicators of bank health, such as the number 
of banks on FDIC's problem bank list, show the deteriorating condition 
of banks since 2007 (see figure 2). For example, in the first quarter 
of 2007, 53 banks were on the "problem" bank list, but by the third 
quarter of 2010, 860 banks were on this list. 

Figure 2: Number of Banks on FDIC's Problem Bank List, First Quarter 
2006 - Third Quarter 2010: 

[Refer to PDF for image: line graph] 

2006, Q1; 
Number of problem banks: 48. 

2006, Q2; 
Number of problem banks: 50. 

2006, Q3; 
Number of problem banks: 47. 

2006, Q4; 
Number of problem banks: 50. 

2007, Q1; 
Number of problem banks: 53. 

2007, Q2; 
Number of problem banks: 61. 

2007, Q3; 
Number of problem banks: 65. 

2007, Q4; 
Number of problem banks: 76. 

2008, Q1; 
Number of problem banks: 90. 

2008, Q2; 
Number of problem banks: 117. 

2008, Q3; 
Number of problem banks: 171. 

2008, Q4; 
Number of problem banks: 252. 

2009, Q1; 
Number of problem banks: 305. 

2009, Q2; 
Number of problem banks: 416. 

2009, Q3; 
Number of problem banks: 552. 

2009, Q4; 
Number of problem banks: 702. 

2010, Q1; 
Number of problem banks: 775. 

2010, Q2; 
Number of problem banks: 829. 

2010, Q3; 
Number of problem banks: 860. 

Source: GAO analysis of FDIC data. 

[End of figure] 

Moreover, the number of banks with CAMELS composite ratings of 1 and 2 
has declined steadily since 2007 and 2008, respectively, and the 
numbers of 3, 4, and 5 ratings have increased over this period (figure 
3). 

Figure 3: Number of Banks by Composite CAMELS Rating, First Quarter 
2006 - Third Quarter 2010: 

[Refer to PDF for image: multiple line graph] 

2006, Q1; 
CAMELS Rating 1: 3,137; 
CAMELS Rating 2: 5,069; 
CAMELS Rating 3: 360; 
CAMELS Rating 4: 48; 
CAMELS Rating 5: 6. 

2006, Q2; 
CAMELS Rating 1: 3,117; 
CAMELS Rating 2: 5,063; 
CAMELS Rating 3: 358; 
CAMELS Rating 4: 46; 
CAMELS Rating 5: 7. 

2006, Q3; 
CAMELS Rating 1: 3,088; 
CAMELS Rating 2: 5,064; 
CAMELS Rating 3: 353; 
CAMELS Rating 4: 43; 
CAMELS Rating 5: 7. 

2006, Q4; 
CAMELS Rating 1: 3,046; 
CAMELS Rating 2: 5,054; 
CAMELS Rating 3: 355; 
CAMELS Rating 4: 47; 
CAMELS Rating 5: 5. 

2007, Q1; 
CAMELS Rating 1: 2,994; 
CAMELS Rating 2: 5,077; 
CAMELS Rating 3: 353; 
CAMELS Rating 4: 59; 
CAMELS Rating 5: 5. 

2007, Q2; 
CAMELS Rating 1: 2,940; 
CAMELS Rating 2: 5,078; 
CAMELS Rating 3: 361; 
CAMELS Rating 4: 63; 
CAMELS Rating 5: 6. 

2007, Q3; 
CAMELS Rating 1: 2,869; 
CAMELS Rating 2: 5,072; 
CAMELS Rating 3: 390; 
CAMELS Rating 4: 64; 
CAMELS Rating 5: 6. 

2007, Q4; 
CAMELS Rating 1: 2,805; 
CAMELS Rating 2: 5,064; 
CAMELS Rating 3: 402; 
CAMELS Rating 4: 77; 
CAMELS Rating 5: 12. 

2008, Q1; 
CAMELS Rating 1: 2,686; 
CAMELS Rating 2: 5,050; 
CAMELS Rating 3: 484; 
CAMELS Rating 4: 99; 
CAMELS Rating 5: 10. 

2008, Q2; 
CAMELS Rating 1: 2,578; 
CAMELS Rating 2: 5,008; 
CAMELS Rating 3: 566; 
CAMELS Rating 4: 136; 
CAMELS Rating 5: 24. 

2008, Q3; 
CAMELS Rating 1: 2,440; 
CAMELS Rating 2: 4,922; 
CAMELS Rating 3: 692; 
CAMELS Rating 4: 183; 
CAMELS Rating 5: 32. 

2008, Q4; 
CAMELS Rating 1: 2,286; 
CAMELS Rating 2: 4,790; 
CAMELS Rating 3: 819; 
CAMELS Rating 4: 254; 
CAMELS Rating 5: 60. 

2009, Q1; 
CAMELS Rating 1: 2,115; 
CAMELS Rating 2: 4,717; 
CAMELS Rating 3: 960; 
CAMELS Rating 4: 295; 
CAMELS Rating 5: 88. 

2009, Q2; 
CAMELS Rating 1: 1,968; 
CAMELS Rating 2: 4,606; 
CAMELS Rating 3: 1,046; 
CAMELS Rating 4: 376; 
CAMELS Rating 5: 145. 

2009, Q3; 
CAMELS Rating 1: 1,824; 
CAMELS Rating 2: 4,383; 
CAMELS Rating 3: 1,189; 
CAMELS Rating 4: 462; 
CAMELS Rating 5: 202. 

2009, Q4; 
CAMELS Rating 1: 1,674; 
CAMELS Rating 2: 4,219; 
CAMELS Rating 3: 1,293; 
CAMELS Rating 4: 541; 
CAMELS Rating 5: 259. 

2010, Q1; 
CAMELS Rating 1: 1,552; 
CAMELS Rating 2: 4,131; 
CAMELS Rating 3: 1,377; 
CAMELS Rating 4: 564; 
CAMELS Rating 5: 292. 

2010, Q2; 
CAMELS Rating 1: 1,478; 
CAMELS Rating 2: 4,026; 
CAMELS Rating 3: 1,438; 
CAMELS Rating 4: 581; 
CAMELS Rating 5: 300. 

2010, Q3; 
CAMELS Rating 1: 1,422; 
CAMELS Rating 2: 3,993; 
CAMELS Rating 3: 1,437; 
CAMELS Rating 4: 604; 
CAMELS Rating 5: 296. 
					
Source: GAO analysis of FDIC data. 

[End of figure] 

Since the financial crisis began, the number of bank failures 
increased yearly from 2007 to 2010, with more than 300 banks failing 
during this time (see figure 4). In 2010, 157 banks failed. 

Figure 4: Number of Failed Banks, 2006-2010: 

[Refer to PDF for image: vertical bar graph] 

Year: 2006; 
Number of failed banks: 0. 

Year: 2007; 
Number of failed banks: 3. 

Year: 2008; 
Number of failed banks: 25. 

Year: 2009; 
Number of failed banks: 140. 

Year: 2010; 
Number of failed banks: 157. 

Source: GAO analysis of FDIC data. 

[End of figure] 

As a result of the rise in bank failures, the DIF balance has 
decreased dramatically (see figure 5). Since the first quarter of 
2007, the DIF balance has decreased by about $57 billion. The DIF 
balance was $50.7 billion at the start of 2007, hit a low point of 
negative $20.8 billion in the fourth quarter of 2009, and had a 
balance of negative $7.4 billion as of December 31, 2010. 

Figure 5: Deposit Insurance Fund Balance, First Quarter 2006 - Fourth 
Quarter 2010: 

[Refer to PDF for image: vertical bar graph] 

2006, Q1; 
DIF balance: $49.193 billion. 

2006, Q2; 
DIF balance: $49.654 billion. 

2006, Q3; 
DIF balance: $49.992 billion. 

2006, Q4; 
DIF balance: $50.165 billion. 

2007, Q1; 
DIF balance: $50.745 billion. 

2007, Q2; 
DIF balance: $51.227 billion. 

2007, Q3; 
DIF balance: $51.754 billion. 

2007, Q4; 
DIF balance: $52.413 billion. 

2008, Q1; 
DIF balance: $52.843 billion. 

2008, Q2; 
DIF balance: $45.217 billion. 

2008, Q3; 
DIF balance: $34.588 billion. 

2008, Q4; 
DIF balance: $17.276 billion. 

2009, Q1; 
DIF balance: $13.007 billion. 

2009, Q2; 
DIF balance: $10.368 billion. 

2009, Q3; 
DIF balance: -$8.243 billion. 

2009, Q4; 
DIF balance: -$20.862 billion. 

2010, Q1; 
DIF balance: -$20.717 billion. 

2010, Q2; 
DIF balance: -$15.247 billion. 

2010, Q3; 
DIF balance: -$8.009 billion. 

2010, Q4; 
DIF balance: -$7.352 billion. 

Source: GAO analysis of FDIC data. 

[End of figure] 

PCA Did Not Prevent Widespread Losses to the DIF: 

Most Banks That Underwent the PCA Process Either Failed or Remained 
Troubled: 

As the recent financial turmoil unfolded, the number of banks that 
fell below one of the three lowest PCA capital thresholds-- 
undercapitalized, significantly undercapitalized, or critically 
undercapitalized--increased dramatically. All four regulators told us 
that PCA was not designed for the type of precipitous economic decline 
that occurred in 2007 and 2008. As figure 6 illustrates, the total 
number of banks in undercapitalized and lower capital categories 
averaged fewer than 10 per quarter in 2006 and 2007, whereas the total 
averaged approximately 132 from 2008 through the third quarter of 2010. 

Figure 6: Number of Banks That Underwent the PCA Process, First 
Quarter 2006 - Third Quarter 2010: 

[Refer to PDF for image: vertical bar graph] 

2006; Q1; 
PCA Banks: 7. 

2006; Q2; 
PCA Banks: 4. 

2006; Q3; 
PCA Banks: 4. 

2006; Q4; 
PCA Banks: 8. 

2007; Q1; 
PCA Banks: 12. 

2007; Q2; 
PCA Banks: 13. 

2007; Q3; 
PCA Banks: 13. 

2007; Q4; 
PCA Banks: 16. 

Average, 2006-2007: 9.6. 

2008; Q1; 
PCA Banks: 22. 

2008; Q2; 
PCA Banks: 33. 

2008; Q3; 
PCA Banks: 45. 

2008; Q4; 
PCA Banks: 102. 

2009; Q1; 
PCA Banks: 125. 

2009; Q2; 
PCA Banks: 164. 

2009; Q3; 
PCA Banks: 177. 

2009; Q4; 
PCA Banks: 222. 

2010, Q1; 
PCA Banks: 197. 

2010, Q2; 
PCA Banks: 199. 

2010, Q3; 
PCA Banks: 172. 

Average 2008-2010: 132.5. 

Source: GAO analysis of FDIC data. 

[End of figure] 

The number of banks that entered the PCA process for the first time 
each quarter also increased dramatically. In 2006 and 2007, the number 
of banks newly entering undercapitalized or lower capital categories 
averaged fewer than 5 per quarter, compared with an average of 48 from 
2008 through the third quarter of 2010 (see figure 7). 

Figure 7: Banks Undergoing the PCA Process for the First Time, First 
Quarter 2006 - Third Quarter 2010: 

[Refer to PDF for image: vertical bar graph] 

2006; Q1; 
PCA Banks: 7. 

2006; Q2; 
PCA Banks: 1. 

2006; Q3; 
PCA Banks: 1. 

2006; Q4; 
PCA Banks: 7. 

2007; Q1; 
PCA Banks: 7. 

2007; Q2; 
PCA Banks: 2. 

2007; Q3; 
PCA Banks: 4. 

2007; Q4; 
PCA Banks: 9. 

Average, 2006-2007: 4.8. 

2008; Q1; 
PCA Banks: 10. 

2008; Q2; 
PCA Banks: 24. 

2008; Q3; 
PCA Banks: 29. 

2008; Q4; 
PCA Banks: 73. 

2009; Q1; 
PCA Banks: 57. 

2009; Q2; 
PCA Banks: 63. 

2009; Q3; 
PCA Banks: 64. 

2009; Q4; 
PCA Banks: 95. 

2010, Q1; 
PCA Banks: 35. 

2010, Q2; 
PCA Banks: 48. 

2010, Q3; 
PCA Banks: 32. 

Average 2008-2010: 48.3. 

Source: GAO analysis of FDIC data. 

[End of figure] 

The vast majority of banks that underwent the PCA process from 2006 
through the third quarter of 2010 had not returned to a condition of 
financial stability by the end of this period. As shown in figure 8, 
of the 569 banks that fell into the undercapitalized or lower capital 
categories of PCA, 270 failed. Another 25 banks failed without first 
being identified as falling into the undercapitalized or lower capital 
categories of PCA, bringing total bank failures to 295 during this 
period. Banking regulators told us that because of the sharp economic 
downturn in 2008, banks could deteriorate more rapidly than PCA was 
designed to handle.[Footnote 17] For example, nearly half failed after 
being undercapitalized for two or fewer quarters. In addition, three 
regulators told us that early in the economic turmoil, banks that 
encountered sudden liquidity problems often did not trigger the PCA 
process before failure. 

Figure 8: Failures and Nonfailures of Banks That Underwent the PCA 
Process, First Quarter 2006 - Third Quarter 2010: 

[Refer to PDF for image: concentric circles] 

Underwent PCA: 299 (did not fail); 
Underwent PCA and then failed: 270; 
Failed (did not first undergo the PCA process): 25; 
Total failed: 295. 

Source: GAO analysis of FDIC data. 

[End of figure] 

Although the remaining banks that underwent the PCA process did not 
fail, most of them continue to struggle financially. Specifically, 299 
of the 569 banks that underwent the PCA process did not fail during 
the period of analysis. Of these 299 banks, 223 remained 
undercapitalized or on the problem bank list through the third quarter 
of 2010 (see figure 9). According to regulators and industry 
representatives, the large number of troubled banks may be due to 
sustained economic weakness during the period of analysis, which 
likely has hindered the ability of these banks to raise additional 
capital. Another 46 of the 299 undercapitalized banks were dissolved 
with minimal or no losses to the DIF.[Footnote 18] And the remaining 
30 banks remained open and were neither undercapitalized nor on the 
problem bank list at the end of the period. 

Figure 9: Status of 569 Banks That Underwent the PCA Process, First 
Quarter 2006 - Third Quarter 2010: 

[Refer to PDF for image: horizontal bar graph] 

Failed: 270; 
Not failed: 299 (Dissolved: 46; Active: 253). 

Active: On problem bank list? 
* No: 32: 
- Still undercaptialized: No: 32; Yes: 2; 
* Yes: 
- Still undercaptialized: No: 51; Yes: 170. 

Source: GAO analysis of FDIC data. 

[End of figure] 

All Banks That Failed after Undergoing the PCA Process Caused Losses 
to the Deposit Insurance Fund: 

Although PCA was intended to prevent or minimize losses to the DIF 
when banks failed, this goal was not achieved during the recent 
financial crisis. All 270 banks that failed after undergoing the PCA 
process during the period we reviewed caused losses to the fund, and 
these losses were comparable as a percentage of assets with those of 
the generally larger banks that did not undergo PCA. Thus, whether or 
not a bank underwent the PCA process before failure, its losses to the 
fund totaled approximately a third of its assets. Specifically, for 
banks that underwent the PCA process before failure, the minimum loss 
to the DIF as a percentage of assets was 1 percent, the median loss 
was 27.7 percent, and the maximum loss was 87 percent (see figure 10). 
For banks that did not undergo the PCA process before failure, the 
minimum loss to the DIF as a percentage of assets was 0 percent, the 
median loss was 29.1 percent, and the maximum loss was 61 percent. 
[Footnote 19] However, after controlling for the financial condition 
of banks before they failed, we found that PCA had a small, positive 
impact on losses to the DIF as a percentage of assets. In particular, 
banks that went through PCA had losses that were 1 to 3 percentage 
points lower than those that did not undergo PCA before failure, but 
this difference was not statistically significant.[Footnote 20] 

Figure 10: Median Loss to the Insurance Fund of Failed Banks That Did 
and Did Not Undergo the PCA Process, First Quarter 2006 - Third 
Quarter 2010: 

[Refer to PDF for image: horizontal bar graph] 

Hit PCA: 
Minimum loss: 1%; 
Median loss: 27.7%; 
Maximum loss: 87%. 

Dit not hit PCA: 
Minimum loss: 0%; 
Median loss: 29.1%; 
Maximum loss: 61%. 

Source: GAO analysis of FDIC data. 

Note: The mean loss to the DIF for banks that did not undergo the PCA 
process was 25.6 percent versus 28 percent for banks that did undergo 
the PCA process, though this difference was not statistically 
significant. After controlling for the financial condition of banks 
before they failed, we found that PCA had a small, positive (1-3 
percent) impact on losses to the DIF as a percentage of assets, but 
the difference remained statistically insignificant. 

[End of figure] 

The 25 banks that failed without first being identified as 
undercapitalized or in lower capital categories generated losses that 
were larger in absolute terms, averaging $443 million compared with 
$246 million for the 270 banks that underwent PCA before failure. 
However, the 25 banks that did not first undergo the PCA process 
tended to be larger--their median size, as measured by assets held the 
quarter before failure, was $372 million, versus $263 million for the 
270 banks that underwent the PCA process.[Footnote 21] In addition, 
our analysis suggests that the banks that did not undergo PCA before 
failure may have had characteristics that made them less likely to 
trigger the undercapitalized or lower capital thresholds of PCA 
because these banks may have possessed more capital. However, they 
also may have held fewer liquid securities or relied to a greater 
degree on unstable sources of funding, such as high-yield deposits 
from large financial investors. 

Regulators Highlighted Benefits and Limitations of the PCA Framework: 

According to federal banking regulators, the PCA framework has 
provided them with a useful tool to address deteriorating banks. 
Federal regulators told us that the PCA process is most effective in 
combination with other enforcement tools and it has multiple benefits 
in addressing financial deterioration in bank. They most frequently 
cited the following benefits: 

* First, the PCA process may serve as a backstop or a safeguard to be 
used if other enforcement actions were delayed (for example, because a 
troubled bank contested a consent order). 

* Second, the PCA program empowers state banking regulators to close 
critically undercapitalized banks--often in the face of significant 
pressure to forbear--and provides a road map for doing so.[Footnote 
22] Furthermore, officials from FDIC told us that state regulatory 
agencies had few occasions to close banks since the savings and loan 
crisis of the 1980s and 1990s, making such a road map more important 
because they could not draw on recent institutional memory of bank 
closures. 

* Third, the 90-day closure provision in PCA facilitates an orderly 
resolution from the perspective of FDIC's Division of Resolutions and 
Receiverships (DRR), which manages the closures of failed federally 
insured banks. FDIC DRR officials told us that the 90-day provision 
provides advance notice of a potential failure, enabling both FDIC DRR 
and potential buyers to conduct due diligence on the assets and 
liabilities of the deteriorating bank. According to FDIC DRR 
officials, the PCA advance notice results in higher bids for the 
failed bank. For more information on the resolution methods used to 
close failed banks, see appendix II. 

* Fourth, the PCA framework encourages banks to hold more capital than 
otherwise would be the case. According to FDIC officials, banks often 
hold capital in excess of the required PCA capital thresholds to 
minimize the possibility of triggering mandatory supervisory action 
under section 38 of FDIA. 

The banking regulators cited other benefits of PCA, including the 
specific authorities that section 38 affords. For example, OTS, OCC, 
and Federal Reserve officials said the ability to dismiss officers and 
directors from deteriorating banks was helpful, and FDIC officials 
said it was useful to be able to restrict the use of brokered deposits 
by banks categorized as adequately capitalized under the PCA 
framework.[Footnote 23] Regulators also noted that PCA increases 
consistency across the various regulatory agencies, which creates 
shared expectations about the process of monitoring, managing, and 
closing deteriorating banks. However, they emphasized that the 
effectiveness of PCA depended on making early and forceful use of 
their other enforcement tools. 

Although regulators cited benefits of the PCA framework, they and 
industry groups also recognized several potential drawbacks of it. 
Some representatives specifically noted that PCA may discourage 
potential investors from investing in the troubled bank because of 
concerns that the bank's closure will wipe out their investment. In 
addition, some officials and an industry group said that large banks 
with capital deficiencies are more likely to receive financial 
assistance or time to recapitalize than are smaller banks.[Footnote 
24] Finally, one industry group said that PCA is procyclical--that is, 
it magnifies the impact of wider economic trends on banks by 
compelling them to maintain, rather than draw down, their capital 
buffers. According to this industry group, by preventing banks from 
using their capital cushions, PCA hinders their ability to recover 
from financial distress. 

Other Indicators Provide Early Warning of Deterioration, and although 
Regulators Identified Conditions Early, Responses Were Inconsistent: 

Because they rely on capital, PCA's triggers have weaknesses, and the 
PCA framework does not take full advantage of early warning signs of 
bank distress that other financial indicators we tested can provide. 
Capital can lag behind other indicators of bank health, and once a 
bank's capital has deteriorated to the undercapitalized level, it may 
be too late for the bank to recover. Leading indicators of bank 
failure beyond capital--including measures of asset quality and 
liquidity--provided early warning of bank distress during the period 
we reviewed. Collectively, we found these indicators better identified 
those banks that did not undergo the PCA process before failure. 
Regulators generally were successful in identifying early warning 
signs of bank distress, but the presence and timeliness of subsequent 
enforcement actions were often inconsistent. While their off-site 
monitoring tools and CAMELS ratings often indicated deteriorating 
conditions more than a year before banks failed, regulators did not 
consistently take enforcement actions before banks underwent the PCA 
process. 

PCA's Triggers Have Weaknesses: 

PCA's triggers have weaknesses in terms of initiating regulatory 
action upon early warning signs of bank distress. In the 1990s, 
several researchers at the bank regulatory agencies, as well as GAO, 
identified significant concerns associated with using the PCA bank 
capital thresholds to determine when to intervene in troubled banks. 
For example, one study found that capital is likely to trigger 
intervention after examiners already were aware of problems at a bank. 
[Footnote 25] Another study found that most banks with a significant 
risk of failure in 1984-1989 (prior to the existence of PCA) would not 
have been considered undercapitalized under PCA.[Footnote 26] 
Similarly, we have found that while capital was a valid measure of a 
bank's financial health, waiting until the capital standards have been 
violated may be too late for a bank to be able to address its 
problems. Banks had other identifiable issues before they were 
reflected in capital.[Footnote 27] As discussed earlier we found that 
most banks that underwent the PCA process either failed or remained on 
the problem bank list. Furthermore, nearly 1 in 10 banks failed 
without undergoing the PCA process. 

Other Leading Indicators or a Composite Indicator Provided Early 
Warning of Bank Distress and Impending Failure: 

Other leading indicators, or a composite indicator, provided 
additional early warning of bank distress.[Footnote 28] Several 
studies published in the 1990s demonstrated that in addition to 
capital, indicators based on earnings, asset quality, liquidity, and 
reliance on unstable funding provide early warning of bank distress. 
Capital on its own may provide some early warning of bank failure but 
does not capture weaknesses that manifest--perhaps earlier--in other 
areas of the bank's operations. We developed a model based on this 
earlier research to determine if these leading indicators would have 
been useful tools to predict bank failures during the current crisis. 
[Footnote 29] As discussed below, our analysis confirmed that these 
same indicators (see table 2), as well as an indicator we developed 
based on sector loan concentration, would have provided early warning 
of problems in the banking system during this crisis. 

Table 2: Select Leading Indicators of Bank Failure: 

Indicator: Capital; 
Definition: Equity capital divided by assets; 
Explanation: Measure of the net worth or solvency of the institution. 

Indicator: Earnings; 
Definition: Net income divided by assets; 
Explanation: Measure of the profitability of the institution. 

Indicator: Nonperforming loans; 
Definition: The sum of past due loans, nonaccrual loans, and real 
estate owned divided by assets; 
Explanation: Measures the quality of loans (asset quality) held by the 
institution that may include losses not yet reflected in capital. 

Indicator: Securities; 
Definition: Securities divided by liabilities; 
Explanation: Measures the capacity of the institution to sell assets 
quickly to meet obligations. 

Indicator: Unstable funding; 
Definition: Large ($100,000 plus) certificates of deposit divided by 
liabilities; 
Explanation: Measures the reliance of the institution on certain high-
cost and volatile funding sources. 

Source: GAO analysis of academic studies. 

Note: We relied on two widely cited studies. See Cole and Gunther, 
"Separating the Likelihood and Timing of Bank Failure," and Cole and 
Gunther, "Predicting Bank Failure: A Comparison of On-and Off-site 
Monitoring Systems." 

[End of table] 

In general, those key indicators identified by researchers in the 
1990s are both statistically and practically significant predictors of 
bank failure during this crisis period (see appendix III for more 
information).[Footnote 30] Indicators of earnings, liquidity, and 
asset quality, in addition to capital, contain information about the 
condition of the bank that provides warning of bank distress up to 1-2 
years in advance. For example, large differences in the level of 
nonperforming loans between healthy banks (our peer group) and banks 
that ultimately failed were evident well before the bulk of bank 
failures in 2009-2010 (see figure 11). Starting in 2006, the 
difference between the two groups of banks increased as nonperforming 
loans grew dramatically over the next 3-4 years for banks that 
ultimately failed, but only modestly for healthy banks. 
Quantitatively, a one standard deviation increase in the level of 
nonperforming loans increased the chance of failure from roughly 2.8 
percent to 7.8 percent over the next year. 

Figure 11: Nonperforming Loans (Asset Quality) at Failed and Peer 
Banks, First Quarter 2006-Second Quarter 2009: 

[Refer to PDF for image: multiple line graph] 

2006, Q1; 
Failed banks: 0.72%; 
Peer banks: 0.52%. 

2006, Q2; 
Failed banks: 0.75%; 
Peer banks: 0.52%. 

2006, Q3; 
Failed banks: 0.9%; 
Peer banks: 0.56%. 

2006, Q4; 
Failed banks: 1.07%; 
Peer banks: 0.58%. 

2007, Q1; 
Failed banks: 1.29%; 
Peer banks: 0.64%. 

2007, Q2; 
Failed banks: 1.6%; 
Peer banks: 0.69%. 

2007, Q3; 
Failed banks: 2.22%; 
Peer banks: 0.78%. 

2007, Q4; 
Failed banks: 3.18%; 
Peer banks: 1%. 

2008, Q1; 
Failed banks: 4.54%; 
Peer banks: 1.25%. 

2008, Q2; 
Failed banks: 5.73%; 
Peer banks: 1.48%. 

2008, Q3; 
Failed banks: 6.9%; 
Peer banks: 1.78%. 

2008, Q4; 
Failed banks: 8.66%; 
Peer banks: 2.19%. 

2009, Q1; 
Failed banks: 10.13%; 
Peer banks: 2.67%. 

2009, Q2; 
Failed banks: 11.28%; 
Peer banks: 2.98%. 

Source: GAO analysis of FDIC and SNL Financial data. 

[End of figure] 

Similarly, large differences in the level of liquid assets 
(securities) between healthy banks and banks that ultimately would 
fail are evident well before the bulk of bank failures (see figure 
12). The degree of liquidity fell somewhat over time, both at banks 
that ultimately would fail and healthy banks. Quantitatively, a one 
standard deviation increase in the level of securities decreased the 
chance of failure from roughly 2.8 percent to 2.3 percent over the 
next year. The Basel Committee has proposed two liquidity standards 
designed to promote resilience in the banking system.[Footnote 31] 

Figure 12: Liquidity at Failed and Peer Banks, First Quarter 2006- 
Second Quarter 2009: 

[Refer to PDF for image: multiple line graph] 

2006, Q1; 
Failed banks: 15.08%; 
Peer banks: 23.43%. 

2006, Q2; 
Failed banks: 15.72%; 
Peer banks: 22.32%. 

2006, Q3; 
Failed banks: 14.4%; 
Peer banks: 22.7%. 

2006, Q4; 
Failed banks: 14.11%; 
Peer banks: 22.82%. 

2007, Q1; 
Failed banks: 13.36%; 
Peer banks: 26.1%. 

2007, Q2; 
Failed banks: 13.1%; 
Peer banks: 27%. 

2007, Q3; 
Failed banks: 13.49%; 
Peer banks: 24.26%. 

2007, Q4; 
Failed banks: 12.7%; 
Peer banks: 23.3%. 

2008, Q1; 
Failed banks: 12.32%; 
Peer banks: 21.97%. 

2008, Q2; 
Failed banks: 12.36%; 
Peer banks: 21.27%. 

2008, Q3; 
Failed banks: 11.73%; 
Peer banks: 20.45%. 

2008, Q4; 
Failed banks: 11.81%; 
Peer banks: 20.18%. 

2009, Q1; 
Failed banks: 10.88%; 
Peer banks: 19.82%. 

2009, Q2; 
Failed banks: 9.87%; 
Peer banks: 19.96%. 

Source: GAO analysis of FDIC and SNL Financial data. 

[End of figure] 

As with indicators of earnings, liquidity, and asset quality, a 
measure of sector loan concentration we developed contains information 
about the condition of the bank that provides warning of bank distress 
up to 1-2 years in advance. Sector loan concentration is calculated as 
an index that incorporates the shares of an institution's loan 
portfolio allocated to certain broad economic sectors (e.g., 
residential real estate, consumer lending, etc.).[Footnote 32] Our 
concentration index also proved to be an important predictor of bank 
failure--it is both statistically and practically significant (see 
appendix III for more information). Banks that ultimately failed had 
considerably more concentrated loan portfolios than healthy banks well 
before the bulk of bank failures. Specifically, a one standard 
deviation increase in the degree of concentration increased the chance 
of failure from roughly 2.8 percent to 3.7 percent over the next year. 
Our concentration index partly reflects banks heavily invested in 
commercial real estate (see figure 13)--a troubled sector during the 
recent downturn. Failed banks had roughly 20 percent more loans in 
commercial real estate than their peers. However, even among banks 
with the same degree of commercial real estate exposure, those with 
less diversified lending were more likely to fail. The concentration 
index we developed would be a more flexible forward-looking indicator 
than commercial real estate concentration alone because the next 
episode of banking stress will not necessarily be driven by commercial 
real estate. 

Figure 13: Loan Concentration at Failed and Peer Banks, First Quarter 
2008: 

[Refer to PDF for image: 2 pie-charts] 

Failed banks: 
Farm-related loans: 3%;
Consumer loans: 2%; 
Commercial and industrial loans: 12%; 
Residential real estate loans: 21%; 
Commercial real estate loans: 59%; 
Other loans: 3%. 

Peer banks: 
Farm-related loans: 5%; 
Consumer loans: 6%; 
Commercial and industrial loans: 14%; 
Residential real estate loans: 32%; 
Commercial real estate loans: 39%; 
Other loans: 4%. 

Source: GAO analysis of FDIC and SNL Financial data. 

[End of figure] 

The PCA framework does not take full advantage of early warning signs 
that financial indicators we tested can provide. Because PCA relies 
only on capital-based indicators, it may not capture institutional 
vulnerabilities that can manifest in, for example, limited liquidity, 
low asset quality, or high loan concentrations in particular sectors. 
Early warning signs in earnings, liquidity, asset quality, or 
concentration could be identified by assessing each indicator 
individually and setting indicator-specific thresholds. Later in this 
report we discuss indicators that could be used for triggers that 
respondents to our expert survey favored. 

Composite indicators based on the model we developed or based on an 
existing regulatory tool (such as CAMELS ratings) provide a convenient 
way of combining information from a number of financial indicators, 
and can better identify risks in banks that did not undergo the PCA 
process before failure. Our analysis showed that a model incorporating 
these well-known leading indicators of bank distress better identified 
those banks that did not undergo the PCA process before failure--that 
is, the model placed them at a much higher risk of failure than 
healthy banks--than capital-based triggers alone. The average failure 
rate estimated by our model over the next year was about 20 percent 
for banks that ultimately would fail without triggering PCA (similar 
to the rate for all failures), and about 3 percent for healthy banks, 
as of the first quarter of 2008. Similarly, CAMELS ratings were higher 
(inferior) than ratings of peers at banks that did not undergo the PCA 
process before failure. The CAMELS ratings were on average 2.13 for 
banks that failed without first undergoing the PCA process (similar to 
the ratings for all failures), and about 1.75 for healthy banks. While 
regulators use information from noncapital financial indicators in 
their supervision and off-site monitoring of banks, as we describe in 
the next section of this report, this does not always lead to timely 
enforcement action at problem banks. Two researchers also recently 
have suggested that PCA would benefit from the use of a composite 
indicator, such as those embodied in existing FDIC and Federal Reserve 
models, rather than only capital-based indicators.[Footnote 33] 

Regulators face a challenging trade-off between false positives (in 
this context, taking an action based on an incorrect prediction of 
bank distress) and false negatives (in this context, failing to take 
an action based on an incorrect prediction of bank health) in 
establishing a threshold or thresholds for capital or other indicators 
that might trigger intervention in potentially troubled banks. 
Striking the right balance between these two errors depends on the 
relative costs of each error, and other considerations. For example, 
the cost of acting on false positives could be quite high if healthy 
banks undertook costly and unnecessary measures to avoid regulatory 
triggers or similarly if regulators and banks expended significant 
resources during unnecessary interventions. Comparatively, the cost of 
failing to act on false negatives could be quite high if bank failures 
imposed dramatic costs on the DIF and the economy. In general, setting 
a high threshold for action only rarely would trigger unnecessary 
intervention in healthy banks but also might yield failures to 
intervene in some genuinely troubled banks. On the other hand, a low 
threshold would be more likely to trigger intervention unnecessarily 
in healthy banks but would correctly identify the bulk of troubled 
banks. 

Regulators Used Tools other than PCA to Identify Early Signs of Bank 
Distress: 

All of the regulators used off-site monitoring or surveillance tools 
as well as CAMELS ratings to identify early signs of potentially 
problematic conditions among banks. In general, these regulatory 
tools, which incorporate assessments of bank characteristics beyond 
capital, provided early warnings of bank distress. For instance, FDIC 
and Federal Reserve models are key tools used for off-site monitoring 
or surveillance activities and contain many similar indicators of 
capital, liquidity, asset quality, and earnings.[Footnote 34] As 
mentioned earlier, such models and other tools help regulators flag 
deteriorating conditions in banks for further regulatory scrutiny 
(e.g., placing banks on watch or review lists). 

In our review of 252 banks that failed from the first quarter of 2008 
through the third quarter of 2010, most (82.5 percent) had been 
identified on review or watch lists within 2 years of their failure. 
[Footnote 35] For these banks (regulated by FDIC, OCC, and the Federal 
Reserve), the median time between being placed on a watch or review 
list and failure was 631 days. 

CAMELS ratings also provided early warning signs of bank failure. As 
described earlier, regulators formulate the CAMELS composite ratings 
using the individual component ratings, but the rating is not a 
mathematical average of the components. Individual component ratings 
may be lower or higher compared with the overall composite rating 
assigned. Any factor bearing significantly on the condition and 
soundness of the institution may be incorporated.[Footnote 36] Banking 
regulators generally consider banks with a composite rating of 1 or 2 
to be healthy, while banks receiving an unsatisfactory examination 
warrant a composite rating of 3 or above. We found that most banks 
that failed degraded from a CAMELS composite rating of 2 to a 4 in one 
quarter, though they generally had at least one component rating of a 
3 prior to failure. 

Specifically, among the 292 failed banks we reviewed (across all 
regulators), most (76 percent) received at least one individual 
component CAMELS rating of a 3 before failure.[Footnote 37] At the 
same time, most (65 percent) also moved past the composite CAMELS 3 
rating in a single quarter (e.g. moving from a 2 to 4) before failure, 
as the CAMELS composite ratings generally deteriorated precipitously. 
Our case studies of 8 banks also provided examples of this phenomenon, 
as banks frequently received multiple downgrades in the CAMELS 
composite ratings in a single quarter (see table 3 below). 

For the failed banks that received either a CAMELS component or 
composite rating of 3, these ratings demonstrated the utility of 
CAMELS to provide early warning of bank distress. For example, among 
the failed banks that received a CAMELS component rating of 3, the 
median number of days between this component rating and bank failure 
was 459 days. Similarly, for failed banks that received a CAMELS 
composite rating of 3, the median number of days between banks 
receiving this composite rating and their subsequent failure was 508 
days. In a separate analysis comparing peer and failed banks, we found 
that CAMELS ratings were useful leading indicators of bank failure. 
See appendix III for more information. 

Table 3: Key Regulatory Activities and Milestones of Case Studies, 
First Quarter 2006-Third Quarter 2010: 

Institution: 1; 
Watch/review list: 12/31/07; 
CAMELS 3 component: 12/31/07; 
CAMELS 3 composite: DROP (2 to 4); 
CAMELS 4 component: 12/1/08; 
CAMELS 4 composite: 12/1/08; 
Problem bank list: 12/31/08; 
Failed (as of 3/30/11): Yes. 

Institution: 2; 
Watch/review list: 12/31/06; 
CAMELS 3 component: 4/2/07; 
CAMELS 3 composite: 4/2/07; 
CAMELS 4 component: 4/2/07; 
CAMELS 4 composite: 6/17/08; 
Problem bank list: 9/30/08; 
Failed (as of 3/30/11): No. 

Institution: 3; 
Watch/review list: 6/30/07; 
CAMELS 3 component: 7/9/07; 
CAMELS 3 composite: 7/9/07; 
CAMELS 4 component: 4/9/08; 
CAMELS 4 composite: 4/9/08; 
Problem bank list: 6/30/08; 
Failed (as of 3/30/11): Yes. 

Institution: 4; 
Watch/review list: 12/31/07; 
CAMELS 3 component: 7/14/08; 
CAMELS 3 composite: DROP (2 to 4); 
CAMELS 4 component: 7/14/08; 
CAMELS 4 composite: 7/14/08; 
Problem bank list: 9/30/08; 
Failed (as of 3/30/11): Yes. 

Institution: 5; 
Watch/review list: N/A; 
CAMELS 3 component: 4/10/06; 
CAMELS 3 composite: 4/10/06; 
CAMELS 4 component: 1/29/09; 
CAMELS 4 composite: 1/29/09; 
Problem bank list: 3/31/09; 
Failed (as of 3/30/11): Yes. 

Institution: 6; 
Watch/review list: N/A; 
CAMELS 3 component: 1/1/06[A]; 
CAMELS 3 composite: 1/1/06[A]; 
CAMELS 4 component: 11/13/07; 
CAMELS 4 composite: 3/17/09; 
Problem bank list: 3/31/09; 
Failed (as of 3/30/11): Yes. 

Institution: 7; 
Watch/review list: 1/1/06[A]; 
CAMELS 3 component: 1/1/06[A]; 
CAMELS 3 composite: 1/1/06[A]; 
CAMELS 4 component: 9/19/07; 
CAMELS 4 composite: DROP (3 to 5); 
Problem bank list: 3/31/08; 
Failed (as of 3/30/11): Yes. 

Institution: 8; 
Watch/review list: 9/16/09; 
CAMELS 3 component: 10/1/09; 
CAMELS 3 composite: DROP (2 to 5); 
CAMELS 4 component: 10/1/09; 
CAMELS 4 composite: DROP (2 to 5); 
Problem bank list: 12/31/09; 
Failed (as of 3/30/11): No. 

Source: GAO Summary of data from FDIC, OCC, OTS, and Federal Reserve. 

Note: N/A means not applicable. 

[A] Institutions placed on a watch/review list prior to the beginning 
of our review period for this analysis, beginning January 2006. 

[End of table] 

While the Presence and Timeliness of Enforcement Actions Were 
Inconsistent, Regulators Have Incorporated Lessons Learned from the 
Financial Crisis: 

Although regulators generally were successful in identifying early 
warning signs of bank distress, the presence and timeliness of 
subsequent enforcement actions were often inconsistent. Most banks 
that failed had received an enforcement action (informal or formal) 
before undergoing the PCA process. The banking regulators told us that 
they typically issued enforcement actions to troubled banks--such as 
an informal enforcement action when a bank was downgraded to a CAMELS 
composite score of 3, and a formal enforcement action when it was 
downgraded to a 4--before these banks received a PCA directive. 
However, some banks did not receive any enforcement action before 
undergoing the PCA process, and many did not receive timely 
enforcement action prior to bank failure. 

In our review of enforcement information available in material loss 
reviews or other evaluations on 136 failed banks, we found that the 
timeliness of enforcement actions was inconsistent.[Footnote 38] 
However, we also noted that the timeliness of enforcement actions 
appeared to have improved during the banking crisis. Specifically, 
among 60 banks that failed between January 2008 and June 2009, 
approximately 28 percent did not have an initial informal or formal 
non-PCA enforcement action until 90 days or less before bank failure. 
Further, 50 percent of these failed banks did not have an enforcement 
action until 180 days or less prior to failure. After June 2009, these 
percentages improved, with approximately 8 percent not having an 
enforcement action until 90 days or less before failure, and 
approximately 22 percent not having an action until 180 days or less 
before failure. 

Our case studies also provided examples of inconsistent enforcement 
actions. While some banks received an enforcement action before being 
subject to PCA, being placed on the problem bank list, or receiving a 
CAMELS 4 composite rating, others did not receive any enforcement 
action before these milestones. Table 4 highlights examples from our 
case studies of inconsistent regulatory attention tied to key 
regulatory activities and milestones. Furthermore, our findings 
related to presence and timeliness of enforcement actions were 
consistent with findings we reported in 1991.[Footnote 39] 
Specifically, we found then that the banking regulators did not always 
use the most forceful actions available to correct unsafe and unsound 
banking practices. 

Table 4: First Enforcement Action in Relation to Other Key Regulatory 
Milestones of Case Studies, First Quarter 2006ńThird Quarter 2010: 

Institution: 1; 
First enforcement action (non-PCA): 
Date: 6/30/09; 
Prior to CAMELS 4 composite?: No; 
Prior to problem bank list?: No; 
Prior to PCA?: Yes; 
Initial PCA: 9/30/09; 
Capital levelat initial PCA: Undercapitalized; 
Failed (as of 3/30/11): Yes. 

Institution: 2; 
First enforcement action (non-PCA): 
Date: 7/16/07; 
Prior to CAMELS 4 composite?: Yes; 
Prior to problem bank list?: Yes; 
Prior to PCA?: Yes; 
Initial PCA: 9/30/08; 
Capital levelat initial PCA: Undercapitalized; 
Failed (as of 3/30/11): No. 

Institution: 3; 
First enforcement action (non-PCA): 
Date: 7/15/08; 
Prior to CAMELS 4 composite?: No; 
Prior to problem bank list?: No; 
Prior to PCA?: N/A; 
Initial PCA: No PCA; 
Capital levelat initial PCA: N/A; 
Failed (as of 3/30/11): Yes. 

Institution: 4; 
First enforcement action (non-PCA): 
Date: 8/25/08; 
Prior to CAMELS 4 composite?: No; 
Prior to problem bank list?: Yes; 
Prior to PCA?: Yes; 
Initial PCA: 9/30/09; 
Capital levelat initial PCA: Critically undercapitalized; 
Failed (as of 3/30/11): Yes. 

Institution: 5; 
First enforcement action (non-PCA): 
Date: 1/8/08; 
Prior to CAMELS 4 composite?: Yes; 
Prior to problem bank list?: Yes; 
Prior to PCA?: N/A; 
Initial PCA: No PCA; 
Capital levelat initial PCA: N/A; 
Failed (as of 3/30/11): Yes. 

Institution: 6; 
First enforcement action (non-PCA): 
Date: 1/22/08; 
Prior to CAMELS 4 composite?: Yes; 
Prior to problem bank list?: Yes; 
Prior to PCA?: Yes; 
Initial PCA: 3/31/09; 
Capital levelat initial PCA: Critically undercapitalized; 
Failed (as of 3/30/11): Yes. 

Institution: 7; 
First enforcement action (non-PCA): 
Date: 1/17/08; 
Prior to CAMELS 4 composite?: N/A; 
Prior to problem bank list?: Yes; 
Prior to PCA?: No; 
Initial PCA: 12/31/07; 
Capital levelat initial PCA: Undercapitalized; 
Failed (as of 3/30/11): Yes. 

Institution: 8; 
First enforcement action (non-PCA): 
Date: 8/26/09; 
Prior to CAMELS 4 composite?: N/A; 
Prior to problem bank list?: Yes; 
Prior to PCA?: No; 
Initial PCA: 3/31/09; 
Capital levelat initial PCA: Significantly undercapitalized; 
Failed (as of 3/30/11): No. 

Source: GAO Summary of data from FDIC, OCC, OTS, and Federal Reserve. 

Note: N/A means not applicable. 

[End of table] 

Use of the current PCA mechanism as an enforcement tool was also 
inconsistent. As stated earlier, 25 banks (8 percent of the failed 
banks we reviewed) did not undergo the PCA process. For instance, in 
our case studies, we noted two institutions that were never subject to 
PCA prior to failure. For those that were, the initial PCA capital 
category triggering enforcement actions frequently occurred at a more 
distressed capital threshold--significantly or critically 
undercapitalized--than the undercapitalized level. For instance, of 
the 270 failed banks we reviewed that underwent the PCA process, 40 
percent were subject to an initial PCA enforcement action below the 
undercapitalized threshold, with 25.5 percent triggering PCA at the 
significantly undercapitalized level and 14.4 percent triggering PCA 
at the critically undercapitalized level. Figure 14 illustrates how 
PCA was used among 295 failed banks, including the initial capital 
thresholds triggering PCA enforcement actions. Similarly, our case 
studies provided examples of different initial capital thresholds that 
triggered PCA, including those occurring at the significantly 
undercapitalized and critically undercapitalized levels, as 
highlighted in table 4. 

Figure 14: Initial PCA Action of Failed Banks, First Quarter 2006-
Third Quarter 2010: 

[Refer to PDF for image: pie-chart and subchart] 

No PCA: 25; 
PCA: 270: 
- Undercapitalized: 162; 
- Significantly Undercapitalized: 69; 
- Critically Undercapitalized: 39. 

Source: GAO analysis of FDIC data. 

[End of figure] 

Regulators have begun to incorporate a number of lessons learned from 
the financial crisis into their regulatory processes, including IG 
report findings. For instance, FDIC has developed and initiated 
training to be delivered in phases to reinforce and enhance its 
supervisory program. These efforts include identifying lessons learned 
from the results of the IG material loss reviews, emphasizing the 
importance of implementing timely and effective corrective programs, 
mandatory training for risk management and compliance examination 
staff to emphasize a forward-looking approach to examination analysis 
and ratings assessment activities, and providing enhanced guidance 
regarding supervision and examination procedures for de novo 
institutions.[Footnote 40] At OCC, the Mid-Size and Community Banks 
Division issued a Matters Requiring Attention Reference Guide that 
provides examiners with OCC policy guidance on how to report, follow 
up on, and keep records related to Matters Requiring Attention. OTS 
has enhanced its Regulatory Action Data system to better flag matters 
requiring increased regulatory attention. We also noted that the 
Federal Reserve incorporated a new liquidity measure into its model 
used to identify banks that warrant being placed on its watch list. 

While Most Stakeholders Favored Modifying PCA, Their Preferred Options 
Involve Some Trade-offs: 

Most of the informed stakeholders we surveyed told us the PCA 
framework should be retained but changed. We asked stakeholders from 
research organizations, regulatory agencies, and the banking industry 
whether PCA should be changed and, if so, to identify and rank broad 
options to change the current framework to make it more effective in 
minimizing losses to the DIF. In response, 23 of 29 stakeholders said 
that PCA should be modified using one or more of the survey's listed 
options.[Footnote 41] More specifically, they preferentially ranked 
three options--incorporating additional risk measures, raising capital 
thresholds, and adding an additional trigger--to make the PCA 
framework more effective. See table 5 for the full list of options in 
the survey and appendix V for full survey results. While each of these 
three options could improve the PCA framework, each presents certain 
advantages and disadvantages to consider. Furthermore, a few 
stakeholders emphasized that if PCA were modified, the specific 
details to implement such a policy change would determine whether the 
goal of minimizing losses to the DIF would be realized. 

Table 5: Rank Ordering of Survey Policy Options: 

Option to change the PCA framework: Incorporate an institution's risk 
profile (concentration exposure, etc.) into the PCA capital category 
thresholds; 
Number of respondents indicating option among top three that should be 
considered: 
First: 5; 
Second: 6; 
Third: 1; 
Weighted score: 28. 

Option to change the PCA framework: Raise all capital category 
thresholds; 
Number of respondents indicating option among top three that should be 
considered: 
First: 7; 
Second: 2; 
Third: 1; 
Weighted score: 26. 

Option to change the PCA framework: Include an additional trigger for 
PCA (that is, another measure of bank soundness or performance); 
Number of respondents indicating option among top three that should be 
considered: 
First: 3; 
Second: 4; 
Third: 5; 
Weighted score: 22. 

Option to change the PCA framework: Change accounting rules used to 
measure capital levels (make greater use of market values to assess 
assets, change rules for loan loss reserves, etc.); 
Number of respondents indicating option among top three that should be 
considered: 
First: 3; 
Second: 3; 
Third: 1; 
Weighted score: 16. 

Option to change the PCA framework: Enhance restrictions and 
requirements at the holding company level; 
Number of respondents indicating option among top three that should be 
considered: 
First: 3; 
Second: 2; 
Third: 3; 
Weighted score: 16. 

Option to change the PCA framework: Make PCA restrictions and 
requirements less prescriptive (more flexibility in timelines, more 
discretion in application of restrictions, etc.); 
Number of respondents indicating option among top three that should be 
considered: 
First: 4; 
Second: 1; 
Third: 1; 
Weighted score: 15. 

Option to change the PCA framework: Raise the critically 
undercapitalized threshold; 
Number of respondents indicating option among top three that should be 
considered: 
First: 2; 
Second: 3; 
Third: 3; 
Weighted score: 15. 

Option to change the PCA framework: Encourage greater uniformity 
across regulators (more consistency in capital definitions across 
state regulators and in closure authority across federal regulators, 
etc.); 
First: 0; 
Second: 3; 
Third: 5; 
Weighted score: 11. 

Option to change the PCA framework: Raise capital category thresholds 
for larger institutions; 
Number of respondents indicating option among top three that should be 
considered: 
First: 0; 
Second: 3; 
Third: 2; 
Weighted score: 8. 

Option to change the PCA framework: Eliminate the PCA framework; 
Number of respondents indicating option among top three that should be 
considered: 
First: 1; 
Second: 0; 
Third: 1; 
Weighted score: 4. 

Option to change the PCA framework: Strengthen PCA restrictions and 
requirements (shorter time frames, earlier use of restrictions 
available under the significantly undercapitalized category, etc.); 
Number of respondents indicating option among top three that should be 
considered: 
First: 0; 
Second: 1; 
Third: 2; 
Weighted score: 4. 

Option to change the PCA framework: Make no changes to the PCA 
framework; 
Number of respondents indicating option among top three that should be 
considered: 
First: 0; 
Second: 0; 
Third: 0; 
Weighted score: 0. 

Source: GAO. 

Note: We calculated the weighted score by translating each 
respondent's ranking of options into points: 3 points to a first 
choice, 2 points to a second choice, and 1 point to a third choice. 
The process of assigning weights to ranked preferences can produce 
multiple outcomes. We acknowledge that alternate weights may change 
the sequencing of the top three options. 

[End of table] 

Incorporate an Institution's Risk Profile into the PCA Capital 
Category Thresholds: 

Stakeholders responding to our survey were most supportive of 
incorporating a bank's risk profile into the PCA capital category 
thresholds. Specifically, 12 stakeholders selected this option among 
the top three that should be considered, with 5 selecting it as their 
first option and 6 selecting it as their second option (see table 5). 
In addition, 21 of 29 stakeholders responded that incorporating an 
additional measure of risk into the PCA capital category thresholds 
would improve the effectiveness of PCA.[Footnote 42] This option would 
add an additional risk element to the PCA capital measures beyond the 
already existing risk-weighted asset component.[Footnote 43] All four 
federal regulators told us that they can require banks to hold 
additional capital through formal or informal enforcement actions, but 
as noted earlier in the report, such actions are not always taken or 
the actions are not timely. Stakeholders suggested a few ways this 
change could be made. For example, in formulating the most appropriate 
capital thresholds, banks could be required to maintain an appropriate 
level of tangible equity or a capital buffer based on the level of 
risk-weighted assets. Alternatively, specific risk areas such as 
liquidity or concentration could be factored into the determination of 
capital adequacy. Regulators already have the ability (on a case-by- 
case basis) to require banks to hold more capital than the amount 
required by PCA thresholds if they deem it necessary based on a bank's 
risk exposure. 

There are advantages and disadvantages to making this change to the 
PCA framework. 

* Potential advantages. Adding an additional risk component to PCA 
capital measures may make PCA more responsive to specific trends. For 
example, in the current crisis many banks failed, in part, because of 
risks associated with high asset concentrations. A stakeholder told us 
that incorporating early indicators of heightened risk into PCA 
capital thresholds could be an additional way to minimize losses to 
the DIF. Also, this change would not affect all banks but only those 
banks engaging in riskier activities. Moreover, incorporating a bank's 
risk profile into the PCA capital category thresholds would be an 
opportunity to broaden the scope of the PCA framework, helping 
mitigate the repeated concern among stakeholders that PCA, as 
currently constructed, is too narrowly focused. 

* Potential disadvantages. This option could complicate the process of 
determining capital adequacy for PCA purposes, according to one 
stakeholder responding to our survey. For example, banks would vary in 
the levels of capital they needed to meet PCA capital thresholds, 
depending on their risk level. A stakeholder also cautioned that risk- 
based measures were complex and dependent on information from banks. 
Finally, adding a risk component to PCA could be duplicative because 
regulators already use risk-based capital ratios in PCA. 

Raise All the PCA Capital Category Thresholds: 

Raising all the PCA capital category thresholds had the second-highest 
weighted score on our survey, and stakeholders selected it most often 
as a first choice. Specifically, 10 stakeholders selected this option 
among the top three that should be considered, with 7 selecting it as 
their first option (see table 5). In addition, 17 of 29 stakeholders 
told us increasing the capital category thresholds would improve the 
effectiveness of PCA.[Footnote 44] This option would increase the 
capital ratios required for a bank to be classified as well 
capitalized, adequately capitalized, undercapitalized, significantly 
undercapitalized, and critically undercapitalized. Federal regulatory 
agencies have amended and updated the regulations and rules on 
measuring a bank's capital level in the past, often in conjunction 
with recommendations from the Basel Committee on Banking Supervision. 
However, the capital thresholds have not changed since the 
implementation of the PCA provisions of FDICIA in 1992.[Footnote 45] 
The Basel Committee recently released guidelines recommending 
increased capital requirements to be phased in by January 1, 2015. 
Federal regulators typically adopt, with some national discretion, 
Basel Committee recommendations. 

Raising only the critically undercapitalized threshold also was on our 
list of options. Twenty of 29 stakeholders we surveyed told us that 
raising the critically undercapitalized threshold would improve the 
effectiveness of PCA, more than the number who told us raising all PCA 
capital category thresholds would improve PCA effectiveness. However, 
when asked to select top options to improve the PCA framework, fewer 
stakeholders selected raising only the critically undercapitalized 
threshold. Currently, a bank is categorized as critically 
undercapitalized if its tangible equity is 2 percent or less. 
Regulators generally must close critically undercapitalized banks 
within a 90-day period. 

Increasing PCA's capital category thresholds would change a nearly two-
decades-old policy and involve trade-offs among the following 
advantages and disadvantages. 

* Potential advantages. Raising thresholds would create an incentive 
for banks to increase capital levels. According to our previous work 
and the work of others, by holding more capital, a bank would have a 
greater capacity to absorb losses and remain solvent, particularly 
when a financial crisis occurred.[Footnote 46] Similarly, with more 
capital, banks should be able to survive higher levels of borrower 
defaults. Thus, if banks were required to hold more capital, this 
might limit losses to the DIF in the event of failure by shifting 
risks from the DIF and taxpayers to the providers of capital, 
according to researchers. Moreover, increasing capital levels might 
not be a major change, as banks sometimes hold more capital than PCA 
requires. 

* Potential disadvantages. If banks were required to hold more 
capital, they might change the way they conduct business. For example, 
banks might limit the amount of credit made available to businesses, 
households, and governments; charge higher interest rates on loans; or 
offer lower interest rates on deposits, according to 
researchers.[Footnote 47] In addition, some banks might compensate for 
having less to lend by investing in riskier assets to seek higher 
returns. An industry group told us that raising the capital category 
thresholds could be particularly harmful for community banks, which 
often face additional challenges raising capital. A stakeholder told 
us this option also could create more instances in which regulators 
intervened in the operation of healthy banks (false positives)--that 
is, more banks may fall below a higher set PCA capital ratio standard 
even though they are not in financial distress. Additionally, 22 of 28 
survey respondents said that PCA's focus on capital was a shortcoming 
of the process, and this option would not broaden the scope of PCA to 
other potential indicators of bank failure. 

Add an Additional PCA Trigger: 

As their third preference, our survey respondents selected adding 
another PCA trigger. Specifically, 12 stakeholders selected this 
option among the top three that should be considered, with 3 selecting 
it as their first option, 4 selecting it as their second option, and 5 
selecting it as their third option (see table 5). Overall, 18 of 29 
respondents said this option would improve the effectiveness of 
PCA.[Footnote 48] This option would require regulators to monitor 
other aspects of a bank's performance, such as asset concentration, 
asset quality, or liquidity, and if problems were identified, to take 
increasingly severe actions to address problems in that area. While 
regulators routinely monitor other aspects of bank safety and 
soundness, making these additional factors part of the PCA process 
would compel regulators to act when these areas were found to be 
deteriorating. However, as discussed previously in this report, we 
found that although regulators identified signs of bank distress, the 
timeliness of subsequent enforcement actions was inconsistent. 

Stakeholders responding to our survey who recommended adding an 
additional PCA trigger were most supportive of using asset quality and 
asset concentration triggers. As discussed earlier in this report, our 
analysis of leading indicators of bank health found asset quality and 
asset concentration provided early warning of bank deterioration. When 
asked about the impact of an asset quality trigger, 26 of 28 survey 
respondents told us that it would improve the effectiveness of PCA. 
[Footnote 49] Twenty of 29 survey respondents said an asset 
concentration trigger would improve the effectiveness of PCA. See 
appendix V for more information on how the survey respondents rated 
potential additional triggers. 

Regulators have attempted to adopt additional triggers in the past. 
For example, regulators and a stakeholder with whom we spoke said that 
in the 1990s regulators tried to modify risk-based capital measures to 
account for asset concentration but were unable to develop a 
sufficiently reliable concentration metric. Instead, regulators 
decided to take risky asset concentrations into account during bank 
examinations. Additionally, FDIA (section 39) requires banking 
regulators to prescribe safety and soundness standards related to 
noncapital criteria, including operations and management; 
compensation; and asset quality, earnings, and stock valuations, 
allowing regulators to take action if a bank fails to meet one or more 
of these standards. Initially, the standards for asset quality and 
earnings were to be quantitative and intended to increase the 
likelihood that regulators would address safety and soundness problems 
before capital deteriorated. However, changes to FDIA in the Riegle 
Community Development and Regulatory Improvement Act of 1994 gave 
regulators considerable flexibility over how and when to use their 
authority under the section to address safety and soundness 
deficiencies at banks.[Footnote 50] After this change, we reported 
that section 39, as amended, appeared to leave regulatory discretion 
largely unchanged from what existed before the passage of FDICIA. 
[Footnote 51] We also reported in 2007 that regulators made limited 
use of this authority, preferring other formal and informal 
enforcement actions.[Footnote 52] 

Including another PCA trigger could also produce advantages and 
disadvantages for regulators and banks. 

* Potential advantages. Adding another trigger could mitigate the 
limitations of capital as an indicator. As we discussed in this and 
prior reports, regulatory actions focused solely on capital may have 
limited effects because of the extent of deterioration that already 
may have occurred.[Footnote 53] Capital typically does not begin to 
decline until a bank has experienced substantial deterioration in 
other areas, such as asset quality and the quality of bank management. 
We previously recommended a "tripwire" approach to banking regulation, 
urging regulators to consider an array of factors such as assets, 
earnings, and capital deterioration and requiring banks to take 
specific actions to address problems in those areas.[Footnote 54] We 
concluded that complements to capital standards such as industrywide 
measures for asset, management, and earnings conditions and a 
prescribed set of enforcement responses would improve the outcomes of 
the bank regulatory process. 

* Potential disadvantages. Another trigger might duplicate other tools 
regulators already use in their supervision of banks, thereby creating 
inefficiencies in oversight. Also, the PCA trigger chosen might not be 
applicable to all banks. For example, one stakeholder cautioned that 
some triggers, such as asset concentration, sources of funding, and 
liquidity, might not apply uniformly to all banks. 

Finally, a few stakeholders responding to our survey and experts with 
whom we spoke said that if PCA were modified, the specific details 
that shape the broad policy ideas would ultimately determine if the 
goal of minimizing losses to the DIF was realized. For example, some 
regulatory officials told us that in order for an earlier trigger to 
be effective, legislative changes would be needed to allow regulators 
to use the same authorities under the current PCA framework, such as 
the authority to dismiss bank officers and directors. Stakeholders 
also told us that the details matter greatly and how regulators 
ultimately crafted and applied the policies would determine if the 
policies were successful. 

Conclusions: 

Before the current financial crisis, PCA was largely untested because 
the financial condition of banks generally had been strong since PCA 
was enacted. More than 300 bank failures later and despite some 
benefits in closing banks, the current PCA framework repeatedly has 
demonstrated its weaknesses for addressing deteriorating conditions in 
banks. In turn, PCA has not achieved a principal goal of preventing 
widespread losses to the DIF when banks fail. 

Weaknesses in the current PCA framework stem primarily from tying 
mandatory corrective actions to only capital-based indicators. We and 
others have argued since 1991 that capital-based indicators have 
weaknesses, particularly because they do not provide timely warnings 
of bank distress. A number of alternative indicators exist or could be 
developed, and their advantages derive primarily from the early 
warnings of distress they could provide. In particular, a composite 
indicator can integrate information from a number of noncapital 
indicators in a single number. Regulators have stressed that the 
effectiveness of the PCA framework depended on making early and 
forceful use of other enforcement tools. However, while regulators 
have their own authorities and PCA also authorizes other discretionary 
actions, the regulators have not used these enforcement tools 
consistently. Tying mandatory corrective actions to additional 
indicators could mitigate these current weaknesses of PCA and increase 
the consistency with which distressed banks would be treated. And, 
enhancing the PCA framework in such a way would allow both regulators 
and banks more time to address deteriorating conditions. More 
important, banks facing such corrective actions likely would not be in 
as weakened a condition as typically is the case when current capital 
thresholds are triggered. Thus, the banks might have more options 
available to them to bolster their safety and soundness and avoid 
failure. Moreover, without an additional PCA trigger, the regulators 
risk not acting soon enough to address a bank's deteriorating 
condition, thereby limiting their ability to minimize losses to the 
DIF. 

Expert stakeholders we surveyed also called for modifications to the 
PCA framework and identified several options for doing so. The top 
three options they identified include (1) adding a measure of risk to 
the capital category thresholds; (2) increasing the capital ratios 
that place banks into PCA capital categories and (3) adding an 
additional trigger. As the expert stakeholders noted and we also 
recognize, making any changes to the PCA framework would entail some 
trade-offs. Specifically, regulators would have to strike a balance 
between more corrective actions and unnecessary intervention in 
healthy banks. The Financial Stability Oversight Council could provide 
a forum for vetting changes to the PCA framework and proposing these 
changes to Congress. Building consensus for potential changes, 
including working through the details of the changes and the 
associated trade-offs, will not be easy. But, in light of significant 
losses to the DIF in recent years, including at banks that underwent 
the PCA process, changes to the PCA framework are warranted. 

Recommendation for Executive Action: 

To improve the effectiveness of the PCA framework, we recommend that 
the heads of the Federal Reserve, FDIC, and OCC consider additional 
triggers that would require early and forceful regulatory actions tied 
to specific unsafe banking practices and also consider the other two 
options--adding a measure of risk to the capital category thresholds 
and increasing the capital ratios that place banks into PCA capital 
categories--identified in this report to improve PCA. In considering 
such improvements, the regulators should work through the Financial 
Stability Oversight Council to make recommendations to Congress on how 
PCA should be modified. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to FDIC, the Federal Reserve, OCC, 
and OTS for review and comment. All of the agencies provided technical 
comments, which we considered and have incorporated as appropriate. 
FDIC, the Federal Reserve, and OCC also provided written comments that 
we have reprinted in appendices VI, VII, and VIII, respectively. 

In written comments, FDIC, the Federal Reserve and OCC agreed with our 
recommendation to consider options to make PCA more effective. All 
three regulators noted that future enhancements to regulatory capital 
requirements could lead to raising the PCA capital category 
thresholds. FDIC and the Federal Reserve specifically stated that 
enhancements to capital requirements will likely be addressed when the 
regulators consider Basel III standards and that the PCA capital 
category thresholds could be impacted by rules implementing the Basel 
III standards. FDIC's written comments also reflected a concern 
regarding using noncapital based triggers for PCA and suggested such 
triggers "appear to have greater risk of unintended consequences" and 
should not be implemented without further study. However, the basis 
for FDIC's concern that triggers such as measuring concentrations, 
liquidity, management, or overall risk profile would pose greater risk 
of unintended consequences is unclear. As discussed in the report any 
changes to PCA require considering both the advantages and 
disadvantages. Our analysis demonstrated that adopting additional 
triggers within PCA also offers the potential for valuable benefits 
that must be considered. For example, our analysis demonstrated that 
noncapital triggers are more effective in identifying those banks that 
failed without undergoing the PCA process. The Federal Reserve also 
commented that one of the other options covered in the survey--
changing accounting rules used to measure capital levels--but not 
discussed in detail in the report also offered promise in enhancing 
the effectiveness of PCA. As noted in the report, this was the fourth 
ranked option along with enhancing restrictions and requirements at 
the holding company level. 

All three regulators noted in their written comments that they take 
supervisory enforcement actions in addition to PCA, as discussed in 
the draft report. Specifically, FDIC stated in its written comments 
that it had taken many supervisory actions in response to problems 
identified at the institutions it supervises and that it has strived 
to improve its supervisory processes based on lessons learned from 
material loss reviews. The Federal Reserve wrote that it did not find 
its supervisory enforcement actions to be inconsistent. OCC commented 
that it already imposes higher minimum capital standards for national 
banks whose risk profile warrants it. The enforcement action 
information presented in our report is compiled in aggregate from all 
of the banking regulators where material loss reviews or other 
evaluation reports were prepared subsequent to bank failure. However, 
we found examples from each of the regulators where no enforcement 
action (formal or informal) occurred until less than 180 days prior to 
bank failure. The material loss reviews for all of the regulators also 
commonly cited that earlier and more forceful supervisory action could 
have helped address deteriorating conditions earlier. We also noted in 
our report improvements over time in the overall timeliness of 
enforcement actions and that all of the regulators had taken actions 
to address previous weaknesses and lessons learned. 

FDIC and the Federal Reserve also commented on the time period of our 
analysis. In written comments, FDIC noted that our results were 
"heavily influenced by the timing of the evaluation period" while the 
Federal Reserve similarly noted that because of the time period of 
analysis troubled banks had difficulty recovering due "to limited 
access to capital more than to the ineffectiveness of PCA." While we 
acknowledge that recent years have put considerable stress on the 
banking system, we believe that circumstances like this are critically 
important for assessing the performance of PCA--periods of bank 
distress are when PCA will be most seriously tested. In addition, 
changes to PCA based on options identified in our survey--such as 
higher capital thresholds--could assist banks in recovering during 
periods in which they have difficulty accessing capital from external 
sources. 

We are sending copies of this report to FDIC, the Federal Reserve, 
OTS, and OCC, the Financial Stability Oversight Council, and other 
interested parties. The report also is available at no charge on the 
GAO Web site at [hyperlink, http://www.gao.gov]. 

If you or your staffs have any questions about this report, please 
contact A. Nicole Clowers at (202) 512-8678 or clowersa@gao.gov. 
Contact points for our Offices of Congressional Relations and Public 
Affairs may be found on the last page of this report. GAO staff that 
made major contributions to this report are listed in appendix IX. 

Signed by: 

A. Nicole Clowers: 
Acting Director: 
Financial Markets and Community Investment: 

Signed by: 

Thomas J. McCool: 
Director, Center for Economics Applied Research and Methods: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

Data Sources and Period of Analysis: 

To describe outcomes from and issues related to bank failures and 
losses to the deposit insurance fund (DIF), we analyzed quarterly data 
on the capitalization levels of federally insured banks from the 
Federal Deposit Insurance Corporation (FDIC). We obtained these data 
from FDIC Quarterly Banking Reports, which publish industry statistics 
derived from Reports on Condition and Income (Call Reports) and Thrift 
Financial Reports. All banks and thrifts must file Call Reports and 
Thrift Financial Reports, respectively, with FDIC every quarter. We 
have assessed the reliability of FDIC's Call and Thrift Financial 
Report databases as part of previous studies and found the data to be 
reliable for the purposes of our review. 

Our period of analysis extended from January 2006, immediately after 
the ending point of our previous study, GAO-07-242, through the third 
quarter of September 2010. For this period, we calculated the total 
number of banks in any of the lowest three categories for prompt 
corrective action (PCA)--undercapitalized, significantly 
undercapitalized, or critically undercapitalized--in each quarter. We 
also calculated how many banks entered one of these capital categories 
for the first time in each quarter. 

Our analysis excludes 13 institutions that received other assistance, 
such as assistance pursuant to systemic risk determinations. Although 
FDIC classified these banks as resolved, we excluded them because they 
remained operational. 

Analysis of Bank Outcomes and Losses to the DIF: 

We reviewed bank failure data provided by FDIC to determine the number 
of banks that failed during our period of analysis, including their 
associated losses. We also reviewed data from FDIC that identified 
those banks that were subjected to PCA before failure and those that 
were not. We determined that the information from these datasets, 
related to DIF losses and capital levels from Call and Thrift 
Financial Reports, was sufficiently reliable for the purposes of our 
review based on ongoing and prior work using such data. 

In addition, we used loss data from FDIC to identify the losses that 
each failed bank caused to the DIF failure, which we determined to be 
sufficiently reliable for our purpose of enumerating failed banks and 
the losses associated with these failures. We also analyzed losses to 
the DIF relative to the size of each failed bank. To do so, we 
identified the total assets of each failed bank as reported on its 
Call Report or Thrift Financial Report in the quarter before failure. 
We used this measure and the losses that the bank caused the DIF (as 
estimated in 2010) to determine losses as a percentage of assets. 

To analyze the outcomes of banks in our analysis, we determined 
whether by the third quarter of 2010 a bank (1) had failed; (2) 
remained undercapitalized, was on the problem bank list, or both; (3) 
was dissolved; or (4) was not undercapitalized or on the problem bank 
list. We considered banks dissolved if they were not in the FDIC loss 
dataset or classified as active by FDIC by the end of this period. 
Many dissolved banks were merged into an acquiring bank without 
governmental assistance, although some were merged with assistance or 
were dissolved through a voluntary liquidation that did not result in 
a new institution. Although components of these dissolved banks may 
have remained active, they operated under the certification number of 
their acquiring bank. We did not count banks as dissolved if they 
operated under their original certification number and FDIC classified 
them as active, regardless of whether a new entity had gained a large 
or controlling stake in their operations. 

We used a number of econometric models to estimate the impact of PCA 
on losses to the DIF. We controlled for the financial condition of 
banks before they fail by holding constant factors affecting the 
quality of the balance sheet and the size of deposit liabilities. For 
more information, see appendix III. 

We also interviewed officials from FDIC, the Office of the Comptroller 
of the Currency (OCC), the Office of Thrift Supervision (OTS), and the 
Board of Governors of the Federal Reserve System (Federal Reserve) to 
obtain their views on the effectiveness of PCA in minimizing losses to 
the DIF. 

Analysis of Indicators, Enforcement Data, and Case Studies of 
Deteriorating Banks: 

To assess the utility of various financial indicators in predicting 
bank distress, we developed a model of leading indicators of bank 
failure based on financial ratios researchers had identified in the 
1990s that predicted bank failures in previous stress periods. 
Specifically, we used these financial ratios, regulatory ratings, and 
an indicator we developed of sector loan concentration to forecast 
bank failure within 1 to 2 years (for failed banks and peers from 2006 
through the third quarter of 2010). We used this model to assess the 
predictive power of indicators other than bank capital. Additional 
information concerning the methodology for this analysis can be found 
in appendix III. To perform this work, we relied on data from FDIC and 
SNL Financial. We assessed the reliability of data used in our 
analysis and found the data sufficiently reliable for our purposes. 

To assess the regulatory enforcement actions associated with banks 
that had deteriorated, we examined the type and timing of regulatory 
actions for failed banks with various outcomes, and analyzed the 
extent to which regulatory indicators provided warning of likely bank 
deterioration or failure. To conduct this work, we requested 
enforcement data from FDIC, the Federal Reserve, OCC, and OTS. Upon 
receipt of this information, we determined that the enforcement data 
provided could not be relied upon for our specific analysis without 
additional verification. In particular, the enforcement data the 
Federal Reserve, OCC, and OTS provided could not be used alone to make 
distinctions among different types of enforcement actions that may or 
may not have been relevant to safety and soundness issues of banks 
that were deteriorating financially. While enforcement data provided 
by FDIC did make such distinctions, we did not rely exclusively on the 
enforcement data provided by the regulators. We determined that it was 
necessary to systematically pull relevant enforcement data on failed 
banks from material loss reviews and other evaluation reports prepared 
by the inspectors general (IG) of the banking regulators and 
corroborated this information with the enforcement data provided by 
regulators. Specifically, we reviewed material loss reviews and other 
evaluation reports available on 136 institutions that failed in 2008, 
2009, and 2010. From these reports, we systematically identified the 
first enforcement action relevant to the regulator's efforts to 
address deteriorating conditions in a 2-year period before failure. 

Further, we conducted case studies to explore supervisory, managerial, 
financial, and other characteristics commonly present in troubled or 
failed banks and illustrate the sequence of steps between the onset of 
trouble and a bank's closure. Specifically, we conducted case studies 
of eight banks to highlight examples of oversight steps taken by each 
of the regulators and various outcomes. For this work, we selected a 
nongeneralizable sample of banks that is diverse with respect to 
geography, asset size, franchise value, primary regulator, date of 
failure, sequence of enforcement actions, outcome (failure or a return 
to financial stability), and losses to the DIF. The case studies also 
allowed us to observe the off-site monitoring tools employed by 
regulators and examine whether these tools provided effective warnings 
of likely bank deterioration or failure. 

Identifying Options That Could Improve PCA: 

To identify options that could help improve the effectiveness of PCA 
in minimizing losses to the DIF, we gathered ideas from a range of 
informed stakeholders from the regulatory, research, and industry 
sectors through a series of surveys. We discuss the process used to 
identify stakeholders later in this appendix. We also conducted a 
literature review and interviewed agency officials and industry 
groups, and we incorporated the results into the survey process. 

Delphi Survey Method: 

To gather options from informed stakeholders that could help improve 
the effectiveness of PCA, we employed a modified version of the Delphi 
method, which follows a structured process for collecting and 
distilling knowledge from a group through a series of questionnaires. 
For our purposes, we employed two iterative Web-based surveys. 

Our first survey consisted of open-ended questions that asked 
respondents to provide their views on the positive aspects and 
shortcomings of the PCA framework, changes to the PCA framework that 
could make it more effective in minimizing losses to the DIF, and 
trade-offs associated with suggested changes to the framework. We 
conducted the first survey between November and December 2010. We 
distributed a link for the survey to 44 individuals by e-mail and also 
subsequently e-mailed and telephoned nonrespondents to encourage a 
higher response rate. We received completed surveys from 28 
respondents (64 percent). Of the 28 completed responses, 17 were from 
regulators and supervisors, 9 were from researchers and consultants, 
and 2 were from industry participants. Of the 16 nonrespondents, 1 was 
an industry participant, 1 was a regulator and supervisor, and 14 were 
researchers and consultants. On the basis of the 28 completed surveys, 
we performed a content analysis of the open-ended responses for all 
questions on the survey. We categorized the responses on the positive 
aspects and shortcomings into five categories each. We jointly 
analyzed the responses to the two questions asking about changes to or 
alternatives beyond the PCA framework and ultimately categorized the 
responses into 12 broad options. 

To help ensure that our list of options for the second survey was 
thorough, we also reviewed literature on PCA and conducted interviews. 
We performed a literature search of studies (dating from January 2000 
through October 2010) from major electronic databases, such as 
ProQuest and EconLit. We included studies that focused on PCA or 
reducing losses to the DIF in the U.S. financial system. We only 
included studies that came from one of the following sources: peer-
reviewed journals; federal regulatory agencies, GAO, Congressional 
Research Service, IGs; conference proceedings; advocacy and think tank 
organizations; or research institute, government, or think tank 
working paper series. We then reviewed the resultant studies to 
identify options that could improve the effectiveness of the PCA 
framework. In addition, we synthesized options that federal 
regulators, IGs, industry groups, and academics suggested during 
interviews. Overall, the literature review and interviews did not 
identify any broad options beyond those identified in the content 
analysis of the first survey. However, we used specific examples for 
the options--specifically the option to include another trigger for 
PCA--from the literature review and interviews to supplement those 
gathered through the first Delphi survey. We also used the literature 
review and interviews to learn about trade-offs associated with 
options to change the PCA framework. 

We conducted the second survey from February 2011 through March 2011. 
In our second survey, we asked recipients their opinion on the 
positive aspects and shortcomings of PCA identified in our analysis of 
the first survey. We also asked recipients to rate the potential 
impact and feasibility of the options to change the PCA framework and 
rank the three top options. We sent this survey to the same 44 
individuals, and we sent out reminder Email messages and subsequently 
e-mailed and telephoned nonrespondents to encourage a higher response 
rate. We received completed surveys from 29 for a response rate of 66 
percent. Of the 29 completed responses, 15 were from regulators and 
supervisors, 11 were from researchers and consultants, and 3 were from 
industry participants. Of the 15 nonrespondents, 3 were regulators and 
supervisors and 12 were researchers and consultants. Because of the 
number of nonrespondents who were from the research sector, the data 
collected from these surveys may not fully represent the views of this 
group. 

Selecting Survey Recipients: 

We used a three-step process to determine which individuals would be 
invited to participate in our Delphi surveys. First, we identified the 
relevant sectors or groups of banking supervision stakeholders. We 
identified three sectors of stakeholders: 

1. regulators and supervisors, 

2. researchers and consultants, and: 

3. industry participants. 

Next, we identified individuals within each of these sectors, through 
formal organizations when possible, including federal regulatory 
agencies, state regulatory associations, and industry groups. Our 
decisions to identify individuals were informed by the following 
criteria: 

* professional credentials, 

* authorship of research on PCA, 

* testimony at relevant congressional hearings, 

* membership in the Shadow Financial Regulatory Committee, and: 

* recommendations we received during initial interviews with industry 
groups and researchers. 

When possible, we also consulted with organizations to confirm that we 
had identified the appropriate staff or member to include in our list 
of informed stakeholders. 

To help ensure that our selection was thorough, we asked respondents 
in our first survey to recommend additional groups or individuals who 
they felt should be included. Additional groups or individuals 
identified through this process were invited to complete both surveys 
based on the criteria described above. See appendix IV for a list of 
survey respondents. 

Although we believe that this sample was sufficient for the purposes 
of identifying options that may improve PCA and for getting a sense of 
the relative impact and feasibility of these options, the survey was 
not a census of all informed stakeholders and was not given to a 
random, generalizable sample of stakeholders. Therefore, the results 
represent only the views of the individuals who responded and are not 
representative of or generalizable to all informed stakeholders or all 
three sectors identified above. In addition, the practical 
difficulties of conducting any survey may introduce errors, commonly 
referred to as nonsampling errors. For example, difficulties in 
interpreting a particular question, differences in sources of 
information available to respondents, or differences when analyzing 
data can introduce unwanted variability into the survey results. We 
took steps in developing the surveys, collecting the data, and 
analyzing them to minimize such nonsampling errors. For example, we 
conducted a series of pretests with several survey recipients prior to 
distributing both surveys. The goals of the pretests were to help 
ensure that (1) the questions were clear and unambiguous and (2) 
terminology was used correctly. We made changes to the content and 
format of both surveys as necessary based on the pretests. 

[End of section] 

Appendix II: The Resolution Process Also Can Help Minimize Losses to 
the Deposit Insurance Fund: 

Beyond PCA, the selection of the bank closure method serves as an 
additional process for minimizing losses to the DIF. According to 
section 13 of the Federal Deposit Insurance Act (FDIA), the resolution 
method FDIC selects must be the alternative that is least costly to 
the insurance fund, except in cases involving systemic risk where FDIC 
may take other action for the purpose of winding up the insured 
depository institution for which the FDIC has been appointed receiver 
as necessary to avoid or mitigate such effects.[Footnote 55] To select 
the least costly method, FDIC compares the estimated cost of 
liquidation--basically, the amount of insured deposits FDIC must pay 
minus the net realizable value of a bank's assets--with the amounts 
that potential acquirers bid for the bank's assets and deposits. The 
most common resolution method for failing banks is the purchase and 
assumption transaction, in which a healthy bank purchases certain 
assets and assumes certain liabilities of a failed bank. FDIC sells 
banks through a purchase and assumption transaction unless another 
approach is less costly to the DIF. 

According to FDIC, their ability to influence the cost of bank 
failures to the DIF is limited, but FDIC said certain resolution 
methods helped minimize losses. FDIC's Division of Resolutions and 
Receiverships (DRR) told us that the cost of a bank failure to the DIF 
is embedded in the financial position of the failed bank. According to 
FDIC DRR, factors (beyond the resolution process) that affect the cost 
of a bank failure are both internal and external to the failed bank. 
For instance, the stability of the bank's funding sources--that is, 
the degree to which the bank has a stable base of customers rather 
than "brokered" or bulk deposits from out-of-state institutional 
investors--is a key internal factor. The quality of the bank's assets 
(for example, the proportion of its loans that carry a high risk of 
default) is a second, key internal factor. External factors such as 
wider economic conditions and the risk appetite of potential buyers 
also affect the cost of a bank failure. 

[End of section] 

FDIC DRR officials told us that although the cost of a bank failure is 
largely fixed by the time of failure, the manner of resolution can 
affect losses to the DIF "in the margin." In an effort to minimize 
these losses, FDIC DRR customized purchase and assumption 
transactions, which it used to sell 254 of the 270 banks that failed 
after undergoing the PCA process, to the needs of the market. In a 
purchase and assumption transaction, a healthy bank purchases certain 
assets and assumes certain liabilities of a failed bank. The specific 
composition of the transaction depends on the assets and liabilities 
held by the failed bank as well as wider market conditions. FDIC may 
offer to sell acquirers (1) the whole failed bank; (2) the whole 
failed bank with a shared-loss agreement, an arrangement whereby FDIC, 
with the intent of limiting losses to the deposit insurance fund, 
agrees to share with the acquirer the losses on those assets; (3) less 
than whole bank with a shared-loss agreement; or (4) a clean transfer 
(cash, securities, and insured deposits). FDIC DRR resolved the 
remaining 16 of the 270 banks that failed after being subject to PCA 
through direct payout, a scenario in which FDIC pays depositors 
directly and places the assets of the failed bank in a receivership. 

Beyond tailoring purchase and assumption transactions to the needs of 
the market, FDIC DRR pursued strategies based on the rationale that 
the long-term intrinsic value of the assets of failed banks exceeded 
their depressed market value. Examples are the FDIC structured 
transaction program, in which FDIC acts as a receiver and partners 
with a private-sector institution to dispose of assets from failed 
banks. According to FDIC DRR, this program enables FDIC to take 
advantage of private-sector knowledge while recouping future cash 
flows from the failed bank. FDIC also sought to increase the value of 
distressed assets through a loan modification program. In this 
program, FDIC works with failed banks to modify rather than foreclose 
on residential mortgages. This reduces the number of borrowers who 
face foreclosure and rehabilitates inactive mortgages into performing 
loans. 

FDIC DRR told us that it used shared-loss agreements to increase the 
value of distressed assets and protect the DIF. When market values 
were falling, in 2008, FDIC DRR's valuations of failed banks were too 
high to attract bidders. As its backlog of banks grew, FDIC DRR 
adopted a loss-share approach in which it sold a pool of problem 
assets to an acquirer under an agreement that FDIC would share a 
portion of the losses. This structure allowed FDIC to reduce the 
immediate cash outlays for the transaction. Figure 15 illustrates the 
increase in shared-loss agreements from 2007 through the third quarter 
of 2010. According to FDIC, these shared-loss agreements enabled FDIC 
to transfer failed banks to a private-sector acquirer, an outcome that 
cost the fund less than liquidation of the failed bank. 

Figure 15: Trends in Use of Shared-loss Agreements, First Quarter 2006-
Third Quarter 2010: 

[Refer to PDF for image: vertical bar graph] 

Year: 2007; 
Percentage of bank resolutions that include a loss-share agreement: 
33.3%. 

Year: 2008; 
Percentage of bank resolutions that include a loss-share agreement: 
76.7%. 

Year: 2009; 
Percentage of bank resolutions that include a loss-share agreement: 
70.2%. 

Year: 2010; 
Percentage of bank resolutions that include a loss-share agreement: 
60.6%. 

Source: GAO analysis of FDIC data. 

[End of figure] 

FDIC DRR told us that as the economy improved in 2010, it received 
bids for failed banks that included no loss-share agreement. For 
shared-loss agreements that FDIC did offer in this time period, it 
shifted more risk to bidders. Because the losses to the DIF from these 
shared-loss agreements will be realized over longer time horizons (for 
example, 8-10 years), it is too early to thoroughly evaluate the 
relative merits of the shared-loss agreements against other resolution 
methods. 

[End of section] 

Appendix III: Econometric Analysis of Leading Indicators of Bank 
Failure and Determinants of Losses to the Deposit Insurance Fund: 

This appendix describes the methodological approach we took to 
identify potential leading indicators of bank failure, generate a peer 
group for the population of failed banks, and evaluate the statistical 
and practical significance of potential leading indicators during the 
current period of bank distress. The appendix also describes the 
methodology and results for assessing potential determinants of losses 
to the DIF and impact of PCA. 

Methodological Approach: 

In order to construct a logistic (logit) regression model of bank 
failure prediction, we identified leading indicators from a previous 
period of bank failures based principally on two studies.[Footnote 56] 
We selected the following five financial ratios: equity 
capital/assets, earnings/assets, nonperforming loans (sum of past due 
loans, nonaccrual loans, and real estate owned)/assets, 
securities/liabilities, and "jumbo" ($100,000 plus) certificates of 
deposit/liabilities. The rationale for each of these indicators is 
described in table 6 below. 

Table 6: Select Leading Indicators of Bank Failure: 

Indicator: Capital; 
Definition: Equity capital divided by assets; 
Explanation: Measure of the net worth or solvency of the institution. 

Indicator: Earnings; 
Definition: Net income divided by assets; 
Explanation: Measure of the profitability of the institution. 

Indicator: Nonperforming loans; 
Definition: The sum of past due loans, nonaccrual loans, and real 
estate owned divided by assets; 
Explanation: Measures the quality of loans (asset quality) held by the 
institution, which may include losses not yet reflected in capital. 

Indicator: Securities; 
Definition: Securities divided by liabilities; 
Explanation: Measures the capacity of the institution to sell assets 
quickly to meet obligations. 

Indicator: Unstable funding; 
Definition: Large ($100,000 plus) certificates of deposit divided by 
liabilities; 
Explanation: Measures the reliance of the institution on certain high-
cost and volatile funding sources. 

Source: GAO analysis of academic studies. 

Note: We relied on two widely cited studies. See Cole and Gunther, 
"Separating the Likelihood and Timing of Bank Failure," and Cole and 
Gunther, "Predicting Bank Failure: A Comparison of On-and Off-site 
Monitoring Systems." 

[End of table] 

We found that the equity capital measure from the literature evolved 
in a way that was quite similar to certain regulatory capital measures 
(see figure 16) for banks that ultimately failed. The correlation 
between the aggregate equity capital measure and the leverage ratio 
was 0.99; the correlation with the tier 1 capital to risk-weighted 
assets ratio was 0.97. 

Figure 16: Equity Capital and Regulatory Capital at Failed Banks, 
First Quarter 2006-Second Quarter 2009: 

[Refer to PDF for image: multiple line graph] 

2006, Q1; 
Equity capital: 11.08%; 
Leverage ratio: 11.21%; 
Tier 1 capital to risk-weighted assets: 14.87%. 

2006, Q2; 
Equity capital: 11.39%; 
Leverage ratio: 11.86%; 
Tier 1 capital to risk-weighted assets: 15.69%. 

2006, Q3; 
Equity capital: 11.3%; 
Leverage ratio: 11.79%; 
Tier 1 capital to risk-weighted assets: 14.73%. 

2006, Q4; 
Equity capital: 11.35%; 
Leverage ratio: 11.58%; 
Tier 1 capital to risk-weighted assets: 15.01%. 

2007, Q1; 
Equity capital: 11.38%; 
Leverage ratio: 11.39%; 
Tier 1 capital to risk-weighted assets: 14.62%. 

2007, Q2; 
Equity capital: 10.86%; 
Leverage ratio: 10.56%; 
Tier 1 capital to risk-weighted assets: 12.96%. 

2007, Q3; 
Equity capital: 10.64%; 
Leverage ratio: 10.23%; 
Tier 1 capital to risk-weighted assets: 12.26%. 

2007, Q4; 
Equity capital: 10.09%; 
Leverage ratio: 9.49%; 
Tier 1 capital to risk-weighted assets: 11.36%. 

2008, Q1; 
Equity capital: 9.66%; 
Leverage ratio: 9.07%; 
Tier 1 capital to risk-weighted assets: 10.89%. 

2008, Q2; 
Equity capital: 8.95%; 
Leverage ratio: 8.45%; 
Tier 1 capital to risk-weighted assets: 10.25%. 

2008, Q3; 
Equity capital: 8.39%; 
Leverage ratio: 7.87%; 
Tier 1 capital to risk-weighted assets: 9.66%. 

2008, Q4; 
Equity capital: 6.89%; 
Leverage ratio: 6.35%; 
Tier 1 capital to risk-weighted assets: 8.05%. 

2009, Q1; 
Equity capital: 6.14%; 
Leverage ratio: 5.54%; 
Tier 1 capital to risk-weighted assets: 7.03%. 

2009, Q2; 
Equity capital: 5.61%; 
Leverage ratio: 4.33%; 
Tier 1 capital to risk-weighted assets: 5.75%. 

Source: GAO analysis of FDIC and SNL Financial data. 

[End of figure] 

Given the attention to commercial real estate concentrations during 
this crisis, we developed a more generic measure of loan concentration 
as a potential leading indicator. The Bank for International 
Settlements and Deutsche Bundesbank have described how a Herfindahl-
Hirschman Index (HHI) could be used to measure loan concentration. 
[Footnote 57] We adopted a version based on sectors defined below. 
This is an imperfect measure of concentration because it does not 
account for the correlations between the various sectors and with the 
overall economy. However, an HHI is a useful and straightforward 
indicator of credit concentration. All else being equal, it should be 
associated with greater risk and there may therefore be associated 
with a greater likelihood of failure. We define two possible HHIs 
based on two different sector definitions (identical except for one 
distinction--in HHI 1 multifamily residential real estate is included 
with one-four family residential real estate, and in HHI 2 it is 
included with commercial real estate): 

* HHI 1: Sector shares are defined as acquisition, development, and 
construction loans (ADC) plus nonfarm nonresidential real estate 
(commercial real estate, or CRE, narrowly defined), residential real 
estate (including one-four family and multifamily [five or more] real 
estate), consumer loans, loans to farms plus agricultural production 
loans, commercial and industrial (C&I) loans, and other (a residual). 

* HHI 2: Sector shares are defined as ADC loans plus nonfarm 
nonresidential real estate (CRE narrowly defined) plus multifamily 
residential real estate loans (these three sectors are similar to the 
broad definition of CRE used in the joint CRE concentration guidance 
that the federal banking regulators issued), one-four family 
residential real estate loans, consumer loans, loans to farms plus 
agricultural production loans, C&I loans, and other (a residual). 
[Footnote 58] 

We identified failed banks and dates of failure based on FDIC data. To 
properly assess the predictive power of potential leading indicators 
during the present bank crisis, we developed a control group of 
healthy banks. We used the Uniform Bank Performance Report to identify 
banks in the same general peer group and then selected two in the same 
state for each failed bank. For each failed thrift, we selected two 
thrifts from the same state as peers. 

Econometric Results: 

We estimated a variety of four-and eight-quarter ahead forecasting 
models via logit using Huber-White robust standard errors. 
Technically, our estimates were based on five-and nine-quarter ahead 
forecasts because the Call Report data are released well after the 
dated quarter. For example, we used fourth-quarter 2006 data, 
available sometime during the first quarter of 2007, to determine if a 
bank failed in the second, third, or fourth quarter of 2007 or the 
first quarter of 2008. 

We adopt in-sample measures of model and variable performance but no 
traditional test of out of sample forecasting ability (e.g., 
estimating the model through 2009 and measuring forecast accuracy in 
2010). However, the logistic regressions can be thought of (with the 
exception of the concentration index) as an out-of-sample test of the 
models and variables as they were estimated in the aforementioned 
assessments of earlier waves of bank failures published 1995 and 1998. 
[Footnote 59] 

We first estimated a model with the five leading indicators identified 
previously, at four-and eight-quarter forecasting horizons. As evident 
in tables 7 and 8 below, these five indicators remain highly 
significant predictors of bank failure. 

Table 7: Logit Model of Bank Failure with Standard Financial Ratios, 
Four-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -36.4539; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -46.8159; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 27.9025; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -0.9936; 
p-value: 0.0400. 

Indicator: Unstable funding; 
Coefficient: 1.0405; 
p-value: 0.0103. 

Indicator: McFadden's r-squared; 
Coefficient: 0.47; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 8: Logit Model of Bank Failure with Standard Financial Ratios, 
Eight-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -8.0321; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -68.0782; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 42.3400; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -1.5070; 
p-value: < 0.0001. 

Indicator: Unstable funding; 
Coefficient: 1.2953; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.22; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Next we estimated two models at a four-quarter horizon with our two 
measures of sector loan concentration in addition to the five 
indicators. As evident in tables 9 and 10 below, both concentration 
indices are significant predictors of bank failure, though the p-value 
of the coefficient estimate for HHI 2 is much smaller. 

Table 9: Logit Model of Bank Failure with HHI 1, Four-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -36.6820; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -47.0561; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 27.6294; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -0.8334; 
p-value: 0.0820. 

Indicator: Unstable funding; 
Coefficient: 1.0163; 
p-value: 0.0111. 

Indicator: HHI 1; 
Coefficient: 0.0001; 
p-value: 0.0124. 

Indicator: McFadden's r-squared; 
Coefficient: 0.47; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 10: Logit Model of Bank Failure with HHI 2, Four-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -37.2551; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -47.0610; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 27.4433; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -0.7846; 
p-value: 0.0916. 

Indicator: Unstable funding; 
Coefficient: 0.8846; 
p-value: 0.0276. 

Indicator: HHI 2; 
Coefficient: 0.0002; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.47; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

We estimated marginal effects of one-standard deviation changes based 
on the coefficients in table 10. The magnitude or practical 
significance of these indicators is also notable, with a one-standard 
deviation increase in the indicator changing the probability of 
failure over the next year (from about 2.8 percent at the means of the 
independent variables) in the next four quarters as follows:[Footnote 
60] 

* capital: down 2.7 percentage points, 

* earnings: down 0.7 percentage points, 

* nonperforming loans: up 5.0 percentage points, 

* securities: down 0.5 percentage points, 

* unstable funding: up 0.3 percentage points, 

* concentration index: up 0.9 percentage points. 

It is possible that the concentration index is predictive of failure 
because many failed banks had loan concentrations in sectors that 
experienced downturns, not because the institutions were less 
diversified overall. Concentration in the CRE sector in particular 
could explain the predictive power of the concentration index because 
of the recent downturn in CRE. As evident in tables 11 and 12 below, 
while CRE is predictive of bank failure, HHI 2 remains predictive 
after controlling for CRE concentration, though the coefficient is 
smaller and less significant than the model in table 10. 

Table 11: Logit Model of Bank Failure with CRE, Four-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -39.0898; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -46.7415; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 26.5067; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -1.0568; 
p-value: 0.0351. 

Indicator: Unstable funding; 
Coefficient: 0.3991; 
p-value: 0.3722. 

Indicator: CRE; 
Coefficient: 0.0133; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.47; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 12: Logit Model of Bank Failure with CRE and HHI 2, Four-Quarter 
Horizon: 

Indicator: Capital; 
Coefficient: -39.0078; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -46.9419; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 26.5317; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -0.8993; 
p-value: 0.0672. 

Indicator: Unstable funding; 
Coefficient: 0.4153; 
p-value: 0.3486. 

Indicator: CRE; 
Coefficient: 0.0099; 
p-value: 0.0001. 

Indicator: HHI 2; 
Coefficient: 0.0001; 
p-value: 0.0013. 

Indicator: McFadden's r-squared; 
Coefficient: 0.48; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Next we estimated a model with HHI 2 at the eight-quarter horizon. As 
evident in table 13, the concentration index remained a statistically 
significant predictor at the longer horizon. 

Table 13: Logit Model of Bank Failure with HHI 2, Eight-Quarter 
Horizon: 

Indicator: Capital; 
Coefficient: -9.4549; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -69.9422; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 42.5927; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -1.1304; 
p-value: 0.0003. 

Indicator: Unstable funding; 
Coefficient: 0.9810; 
p-value: 0.0001. 

Indicator: HHI 2; 
Coefficient: 0.0002; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.24; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Next we estimated a model with only CAMELS ratings at four-and eight- 
quarter horizons, along with a model combining CAMELS ratings with the 
model in table 10 (five indicators plus HHI 2) also at four-and eight- 
quarter horizons. As evident in tables 14-17, CAMELS ratings on their 
own are predictive of bank failure within four and eight quarters. As 
a composite index meant to capture the underlying CAMELS component 
factors (capital, asset quality, management, earnings, liquidity, and 
sensitivity to market risk) CAMELS are similar to a predictive 
regression model based on financial indicators that represent some of 
those categories--in the sense that they both take into account more 
than just capital. However, CAMELS ratings have less explanatory power 
by themselves, as measured by McFadden's r-squared, 0.26 versus 0.47 
for the logit with the financial ratios and concentration index. 
Furthermore, CAMELS ratings and the financial ratios we have chosen 
each contain unique information that can be helpful in anticipating 
bank distress. CAMELS ratings remain a highly statistically 
significant predictor of bank failure when added to a regression with 
capital, earnings, nonperforming loans, securities, unstable funding, 
and the concentration index, though unsurprisingly the coefficient is 
somewhat less significant than on its own. Thus CAMELS ratings contain 
information that is not fully accounted for by the financial 
indicators we have identified and included in the regression, and vice 
versa. 

Table 14: Logit Model of Bank Failure with CAMELS, Four-Quarter 
Horizon: 

Indicator: CAMELS rating; 
Coefficient: 1.5649; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.26; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 15: Logit Model of Bank Failure with CAMELS, Eight-Quarter 
Horizon: 

Indicator: CAMELS rating; 
Coefficient: 1.0279; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.08; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 16: Logit Model of Bank Failure with CAMELS and Financial 
Indicators, Four-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -34.2274; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -44.3722; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 23.2022; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -0.7588; 
p-value: 0.1072. 

Indicator: Unstable funding; 
Coefficient: 1.0172; 
p-value: 0.0101. 

Indicator: HHI 2; 
Coefficient: 0.0002; 
p-value: < 0.0001. 

Indicator: CAMELS rating; 
Coefficient: 0.4250; 
p-value: < 0.0001. 

Indicator: McFadden's r-squared; 
Coefficient: 0.48; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Table 17: Logit Model of Bank Failure with CAMELS and Financial 
Indicators, Eight-Quarter Horizon: 

Indicator: Capital; 
Coefficient: -10.6895; 
p-value: < 0.0001. 

Indicator: Earnings; 
Coefficient: -57.7312; 
p-value: < 0.0001. 

Indicator: Nonperforming loans; 
Coefficient: 40.5932; 
p-value: < 0.0001. 

Indicator: Securities; 
Coefficient: -1.1024; 
p-value: 0.0005. 

Indicator: Unstable funding; 
Coefficient: 0.9770; 
p-value: 0.0001. 

Indicator: HHI 2; 
Coefficient: 0.0002; 
p-value: < 0.0001. 

Indicator: CAMELS rating; 
Coefficient: 0.2834; 
p-value: 0.0002. 

Indicator: McFadden's r-squared; 
Coefficient: 0.25; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

Finally, we estimated marginal effect of a one-rating increase 
(deterioration) in the CAMELS rating based on the coefficients in 
table 15. The magnitude or practical significance of the CAMELS rating 
is also notable, with a one-rating increase changing the probability 
of failure over the next year from about 2.8 percent to 4.2 percent. 
[Footnote 61] 

Analysis of DIF Losses: 

We estimated a variety of econometric models to assess the impact of 
PCA on the DIF. Our model includes all bank failures from first 
quarter 2007 to third quarter 2010. In order to derive a better 
estimate of PCA's impact than comparing mean or median losses, we 
controlled for other factors that might affect losses to the DIF and 
therefore account for some systematic differences between banks that 
underwent the PCA process before failure and those that did not. We 
attempted to control for factors related to the quality of the bank's 
balance sheet (and therefore expected value to potential buyers) and 
the size of FDIC's deposit liabilities.[Footnote 62] 

Table 18: Potential Factors Affecting DIF Losses: 

Control variable: Deposits; 
Definition: Several measures of deposits divided by assets; 
Explanation: Measures FDIC liabilities. 

Control variable: Securities; 
Definition: Securities divided by assets; 
Explanation: Securities are generally more liquid and therefore easier 
to value. 

Control variable: Nonperforming loans or assets; 
Definition: Nonperforming loans are the sum of past due loans, 
nonaccrual loans, and real estate owned divided by assets; 
nonperforming assets also include nonloan assets that are repossessed 
or in nonaccrual status; 
Explanation: Measures the quality of loans or assets that may have 
limited value outside the depository institution, and therefore low 
resale value. 

Source: GAO. 

[End of table] 

We report on the results of several models we estimated via ordinary 
least-squares (OLS) below. All models reported below were estimated 
with White standard errors. Prompt corrective action is a dummy 
variable equal to "1" if the failed institution underwent the PCA 
process, "0" otherwise. 

While PCA was not statistically significant in any of the 
specifications we ran, it was consistently negative in the 1-3 
percentage point range.[Footnote 63] Because institutions that 
underwent PCA had on average almost $1 billion in assets, a small 
effect that did not meet conventional standards for statistical 
significance might in some circumstances be of practical or economic 
significance.[Footnote 64] 

Mean losses for PCA versus non-PCA banks are 28 percent of assets 
versus 25.6 percent of assets (the difference was not statistically 
significant) before controlling for other factors. After controlling 
for other factors, banks that underwent the PCA process had 1-3 
percentage point lower losses as a percentage of assets, though the 
difference remained statistically insignificant. In total, controlling 
for balance sheet quality resulted in a roughly 3-5 point change in 
DIF losses and suggests a more positive role for PCA in reducing 
losses to the DIF. In addition, the balance sheet factors are all 
highly statistically significant. 

As shown in table 19, in the model with deposits measured as the total 
deposits of the bank (which may exceed the liabilities of the FDIC), 
the coefficient on PCA was roughly negative 3--banks that underwent 
PCA had DIF losses that were roughly 3 percentage points less as a 
percentage of assets--but not statistically significant. 

Table 19: Model of DIF Losses with Nonperforming Loans and Total 
Deposits, First Quarter 2007-Third Quarter 2010: 

Variable: Securities; 
Coefficient: -0.1626; 
p-value: 0.0615. 

Variable: Nonperforming loans; 
Coefficient: 0.3628; 
p-value: 0.0001. 

Variable: Deposits; 
Coefficient: 0.3909; 
p-value: < 0.0001. 

Variable: PCA; 
Coefficient: -3.1609; 
p-value: 0.2397. 

Variable: R-squared; 
Coefficient: 0.21; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

As shown in table 20, in the model with deposits measured as the small 
deposits of the bank (which may understate the liabilities of the 
FDIC), the coefficient on PCA was roughly negative 1--banks that 
underwent PCA had DIF losses that were roughly 1 percentage point less 
as a percentage of assets--but not statistically significant. 

Table 20: Model of DIF Losses with Nonperforming Loans and Small 
Deposits, First Quarter 2007-Third Quarter 2010: 

Variable: Securities; 
Coefficient: -0.2096; 
p-value: 0.0105. 

Variable: Nonperforming loans; 
Coefficient: 0.4653; 
p-value: < 0.0001. 

Variable: Small deposits; 
Coefficient: 0.2707; 
p-value: < 0.0001. 

Variable: PCA; 
Coefficient: -1.1196; 
p-value: 0.6596. 

Variable: R-squared; 
Coefficient: 0.23; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

As shown in table 21, in the model with deposits measured as the small 
deposits of the bank and nonperforming assets substituted for 
nonperforming loans, in table 20, the coefficient on PCA was also 
roughly negative 1--banks that underwent PCA had DIF losses that were 
roughly 1 percentage point less as a percentage of assets--but not 
statistically significant. 

Table 21: Model of DIF Losses with Nonperforming Assets and Small 
Deposits, First Quarter 2007-Third Quarter 2010: 

Variable: Securities; 
Coefficient: -0.2170; 
p-value: 0.0077. 

Variable: Nonperforming assets; 
Coefficient: 0.4426; 
p-value: < 0.0001. 

Variable: Small deposits; 
Coefficient: 0.2726; 
p-value: < 0.0001. 

Variable: PCA; 
Coefficient: -1.1627; 
p-value: 0.6480. 

Variable: R-squared; 
Coefficient: 0.23; 
p-value: Not applicable. 

Source: GAO analysis of data from FDIC and SNL Financial. 

[End of table] 

[End of section] 

Appendix IV: PCA Survey Respondents: 

We asked 44 informed stakeholders from the regulatory, research, and 
industry sectors to complete our first and second surveys about prompt 
corrective action. For more information on our survey and selection 
methodologies, see appendix I. The following table lists the 
individuals from whom we received completed responses to the first, 
second, or both surveys. 

Table 22: Survey Respondents: 

Name: Braswell, Rob; 
Primary organization: Georgia Department of Banking and Finance. 

Name: Clarke, Scott; 
Primary organization: Illinois Department of Financial and 
Professional Regulations. 

Name: Cole, Chris; 
Primary organization: Independent Community Bankers of America. 

Name: Corcoran, Kevin; 
Primary organization: OTS. 

Name: Douglas, John; 
Primary organization: Davis Polk and Wardwell LLC. 

Name: Duffie, Darrell; 
Primary organization: Stanford University. 

Name: Eisenbeis, Robert A.; 
Primary organization: Cumberland Advisors. 

Name: Ellis, Diane; 
Primary organization: FDIC, Financial Risk Management and Research, 
Division of Insurance and Research. 

Name: Evanoff, Douglas D.; 
Primary organization: Federal Reserve Bank of Chicago. 

Name: Gerrish, Jeff; 
Primary organization: Gerrish McCreary Smith Consultants and Attorneys. 

Name: Grace, Ray; 
Primary organization: North Carolina Commissioner of Banks. 

Name: Hancock, Diana; 
Primary organization: Federal Reserve, Division of Research and 
Statistics. 

Name: Ivie, Stan; 
Primary organization: FDIC, Division of Supervision and Consumer 
Protection. 

Name: Kane, Edward J.; 
Primary organization: Boston College. 

Name: Kaufman, George; 
Primary organization: Loyola University, Graduate School of Business. 

Name: Kelly, Jennifer; 
Primary organization: OCC, Division of Midsize/Community Bank 
Supervision. 

Name: Lemieux, Cathy; 
Primary organization: Federal Reserve Bank of Chicago. 

Name: Leuz, Christian; 
Primary organization: University of Chicago. 

Name: Levonian, Mark; 
Primary organization: OCC. 

Name: Litan, Robert E.; 
Primary organization: Brookings Institution. 

Name: Loving, Bill; 
Primary organization: Pendleton Bank. 

Name: Nieto, Maria; 
Primary organization: Bank of Spain. 

Name: Oakes, Nancy; 
Primary organization: Federal Reserve, Enforcement. 

Name: Quigley, Lori; 
Primary organization: OTS. 

Name: Scott, Kenneth E.; 
Primary organization: Stanford University. 

Name: Spoth, Christopher J.; 
Primary organization: FDIC, Division of Supervision and Consumer 
Protection. 

Name: Stevens, Michael; 
Primary organization: Conference of State Bank Supervisors. 

Name: Sweeney, Maureen; 
Primary organization: FDIC, Division of Insurance and Research. 

Name: Tenhundfeld, Mark; 
Primary organization: America Bankers Association. 

Name: Thompson, Sandra L.; 
Primary organization: FDIC, Division of Supervision and Consumer 
Protection. 

Name: Wall, Larry; 
Primary organization: Federal Reserve Bank of Atlanta. 

Name: Watkins, Rick; 
Primary organization: Federal Reserve, Supervisory Issues and Special 
Situations. 

Source: GAO. 

[End of table] 

[End of section] 

Appendix V: Responses to Questions from GAO's Second Delphi Survey on 
the Prompt Corrective Action Framework: 

We distributed a survey to 44 individuals from the regulatory, 
research, and industry sectors to determine their views on the PCA 
framework and options for modifying the PCA framework to minimize 
losses to the DIF. We received completed responses from 29 of 44 
individuals, for a response rate of 66 percent. Tables 23-28 and 
figures 17-18 below show responses to questions from the survey. For 
more information about our methodology for designing and distributing 
the survey, see appendix I. 

Section 1: PCA Positive Elements and Shortcomings: 

Table 23: Stakeholder Views on Potential Positive Elements of the PCA 
Framework: 

Stakeholder views: Establishes consistent capital standards and 
corresponding restrictions and requirements; 
Positive element of PCA: 24; 
Not a positive element of PCA: 3; 
No opinion: 1; 
Total: 28. 

Stakeholder views: Gives institutions an incentive to avoid or resolve 
capital deficiencies; 
Positive element of PCA: 27; 
Not a positive element of PCA: 1; 
No opinion: 0; 
Total: 28. 

Stakeholder views: Makes institutions less likely to fail; 
Positive element of PCA: 16; 
Not a positive element of PCA: 10; 
No opinion: 2; 
Total: 28. 

Stakeholder views: Helps reduce regulatory forbearance; 
Positive element of PCA: 16; 
Not a positive element of PCA: 9; 
No opinion: 3; 
Total: 28. 

Stakeholder views: Helps close institutions before insolvency (i.e., 
before they develop negative net worth); 
Positive element of PCA: 23; 
Not a positive element of PCA: 3; 
No opinion: 2; 
Total: 28. 

Source: GAO. 

Note: Totals may not add to 29 because respondents did not all answer 
every question. 

[End of table] 

Table 24: Stakeholder Views on Potential Shortcomings of the PCA 
Framework: 

Stakeholder views: Capital is a lagging indicator; 
Shortcoming of PCA: 22; 
Not a shortcoming of PCA: 6; 
No opinion: 0; 
Total: 28. 

Stakeholder views: The measurement of capital is subjective (e.g., 
loan loss reserves may be insufficient, financial reporting may be 
inaccurate, etc.); 
Shortcoming of PCA: 23; 
Not a shortcoming of PCA: 5; 
No opinion: 0; 
Total: 28. 

Stakeholder views: The focus of PCA is too narrow (e.g., it is based 
only on capital; 
it applies only to institutions, not holding companies, etc.); 
Shortcoming of PCA: 22; 
Not a shortcoming of PCA: 5; 
No opinion: 1; 
Total: 28. 

Stakeholder views: PCA restrictions and requirements have limited 
flexibility; 
Shortcoming of PCA: 13; 
Not a shortcoming of PCA: 15; 
No opinion: 0; 
Total: 28. 

Stakeholder views: During times of severe economic stress, PCA's 
effectiveness is more limited; 
Shortcoming of PCA: 22; 
Not a shortcoming of PCA: 2; 
No opinion: 4; 
Total: 28. 

Source: GAO. 

Note: Totals may not add to 29 because all respondents did not answer 
every question. 

[End of table] 

Section 2: Rating Options to Modify the PCA Framework: 

Table 25: Stakeholder Views on Potential Impact of Each Option to Make 
the PCA Framework More Effective in Minimizing Losses to the DIF: 

Stakeholder views: Change accounting rules used to measure capital 
levels (e.g., make greater use of market values to assess assets, 
change rules for loan loss reserves, etc.); 
Would diminish effectiveness: 7; 
No impact: 1; 
Would improve effectiveness: 14; 
Unsure: 7; 
Total: 29. 

Stakeholder views: Eliminate the PCA framework; 
Would diminish effectiveness: 22; 
No impact: 2; 
Would improve effectiveness: 2; 
Unsure: 3; 
Total: 29. 

Stakeholder views: Encourage greater uniformity across regulators 
(e.g., more consistency in capital definitions across state regulators 
and in closure authority across federal regulators, etc.); 
Would diminish effectiveness: 2; 
No impact: 5; 
Would improve effectiveness: 21; 
Unsure: 1; 
Total: 29. 

Stakeholder views: Enhance restrictions and requirements at the 
holding company level; 
Would diminish effectiveness: 1; 
No impact: 5; 
Would improve effectiveness: 18; 
Unsure: 5; 
Total: 29. 

Stakeholder views: Include another trigger for PCA (i.e., another 
measure of bank soundness or performance); 
Would diminish effectiveness: 1; 
No impact: 2; 
Would improve effectiveness: 18; 
Unsure: 8; 
Total: 29. 

Stakeholder views: Incorporate an institution's risk profile (e.g., 
concentration exposure, etc.) into the PCA capital category thresholds; 
Would diminish effectiveness: 2; 
No impact: 2; 
Would improve effectiveness: 21; 
Unsure: 4; 
Total: 29. 

Stakeholder views: Make no changes to the PCA framework; 
Would diminish effectiveness: 13; 
No impact: 13; 
Would improve effectiveness: 0; 
Unsure: 3; 
Total: 29. 

Stakeholder views: Make PCA restrictions and requirements less 
prescriptive (e.g., more flexibility in timelines, more discretion in 
application of restrictions, etc.); 
Would diminish effectiveness: 15; 
No impact: 2; 
Would improve effectiveness: 8; 
Unsure: 4; 
Total: 29. 

Stakeholder views: Raise all capital category thresholds; 
Would diminish effectiveness: 4; 
No impact: 3; 
Would improve effectiveness: 17; 
Unsure: 5; 
Total: 29. 

Stakeholder views: Raise capital category thresholds for larger 
institutions; 
Would diminish effectiveness: 2; 
No impact: 6; 
Would improve effectiveness: 15; 
Unsure: 5; 
Total: 28. 

Stakeholder views: Raise the critically undercapitalized threshold; 
Would diminish effectiveness: 3; 
No impact: 5; 
Would improve effectiveness: 20; 
Unsure: 1; 
Total: 29. 

Stakeholder views: Strengthen PCA restrictions and requirements (e.g., 
shorter time frames, earlier use of restrictions available under the 
significantly undercapitalized category, etc.); 
Would diminish effectiveness: 8; 
No impact: 1; 
Would improve effectiveness: 15; 
Unsure: 5; 
Total: 29. 

Source: GAO. 

Note: Totals may not add to 29 because respondents did not all answer 
every question. 

[End of table] 

Table 26: Stakeholder Views on Potential Feasibility for Federal 
Regulators to Implement Each Option: 

Stakeholder views: Change accounting rules used to measure capital 
levels (e.g., make greater use of market values to assess assets, 
change rules for loan loss reserves, etc.); 
Feasible: 13; 
Not Feasible: 6; 
Unsure: 10; 
Total: 29. 

Stakeholder views: Eliminate the PCA framework; 
Feasible: 5; 
Not Feasible: 14; 
Unsure: 10; 
Total: 29. 

Stakeholder views: Encourage greater uniformity across regulators 
(e.g., more consistency in capital definitions across state regulators 
and in closure authority across federal regulators, etc.); 
Feasible: 16; 
Not Feasible: 2; 
Unsure: 11; 
Total: 29. 

Stakeholder views: Enhance restrictions and requirements at the 
holding company level; 
Feasible: 19; 
Not Feasible: 2; 
Unsure: 8; 
Total: 29. 

Stakeholder views: Include another trigger for PCA (i.e., another 
measure of bank soundness or performance); 
Feasible: 20; 
Not Feasible: 3; 
Unsure: 6; 
Total: 29. 

Stakeholder views: Incorporate an institution's risk profile (e.g., 
concentration exposure, etc.) into the PCA capital category thresholds; 
Feasible: 22; 
Not Feasible: 1; 
Unsure: 6; 
Total: 29. 

Stakeholder views: Make PCA restrictions and requirements less 
prescriptive (e.g., more flexibility in timelines, more discretion in 
application of restrictions, etc.); 
Feasible: 16; 
Not Feasible: 4; 
Unsure: 9; 
Total: 29. 

Stakeholder views: Raise all capital category thresholds; 
Feasible: 17; 
Not Feasible: 6; 
Unsure: 6; 
Total: 29. 

Stakeholder views: Raise capital category thresholds for larger 
institutions; 
Feasible: 18; 
Not Feasible: 1; 
Unsure: 9; 
Total: 28. 

Stakeholder views: Raise the critically undercapitalized threshold; 
Feasible: 20; 
Not Feasible: 4; 
Unsure: 5; 
Total: 29. 

Stakeholder views: Strengthen PCA restrictions and requirements (e.g., 
shorter time frames, earlier use of restrictions available under the 
significantly undercapitalized category, etc.); 
Feasible: 16; 
Not Feasible: 6; 
Unsure: 7; 
Total: 29. 

Source: GAO. 

Note: Totals may not add to 29 because respondents did not all answer 
every question. 

[End of table] 

Section 3: Rank Ordering of Options to Modify the PCA Framework: 

Table 27: Stakeholder Ranking of 12 Potential Options to Modify PCA: 

Potential options: Change accounting rules used to measure capital 
levels (e.g., make greater use of market values to assess assets, 
change rules for loan loss reserves, etc.); 
Most effective option: 3; 
Second most effective option: 3; 
Third most effective option: 1; 
Total number of respondents selecting option among top three most 
effective: 7. 

Potential options: Eliminate the PCA framework; 
Most effective option: 1; 
Second most effective option: 0; 
Third most effective option: 1; 
Total number of respondents selecting option among top three most 
effective: 2. 

Potential options: Encourage greater uniformity across regulators 
(e.g., more consistency in capital definitions across state regulators 
and in closure authority across federal regulators, etc.); 
Most effective option: 0; 
Second most effective option: 3; 
Third most effective option: 5; 
Total number of respondents selecting option among top three most 
effective: 8. 

Potential options: Enhance restrictions and requirements at the 
holding company level; 
Most effective option: 3; 
Second most effective option: 2; 
Third most effective option: 3; 
Total number of respondents selecting option among top three most 
effective: 8. 

Potential options: Include another trigger for PCA (i.e., another 
measure of bank soundness or performance); 
Most effective option: 3; 
Second most effective option: 4; 
Third most effective option: 5; 
Total number of respondents selecting option among top three most 
effective: 12. 

Potential options: Incorporate an institution's risk profile (e.g., 
concentration exposure, etc.) into the PCA capital category thresholds; 
Most effective option: 5; 
Second most effective option: 6; 
Third most effective option: 1; 
Total number of respondents selecting option among top three most 
effective: 12. 

Potential options: Make no changes to PCA framework; 
Most effective option: 0; 
Second most effective option: 0; 
Third most effective option: 0; 
Total number of respondents selecting option among top three most 
effective: 0. 

Potential options: Make PCA restrictions and requirements less 
prescriptive (e.g., more flexibility in timelines, more discretion in 
application of restrictions, etc.); 
Most effective option: 4; 
Second most effective option: 1; 
Third most effective option: 1; 
Total number of respondents selecting option among top three most 
effective: 6. 

Potential options: Raise all capital category thresholds; 
Most effective option: 7; 
Second most effective option: 2; 
Third most effective option: 1; 
Total number of respondents selecting option among top three most 
effective: 10. 

Potential options: Raise capital category thresholds for larger 
institutions; 
Most effective option: 0; 
Second most effective option: 3; 
Third most effective option: 2; 
Total number of respondents selecting option among top three most 
effective: 5. 

Potential options: Raise the critically undercapitalized threshold; 
Most effective option: 2; 
Second most effective option: 3; 
Third most effective option: 3; 
Total number of respondents selecting option among top three most 
effective: 8. 

Potential options: Strengthen PCA restrictions and requirements (e.g., 
shorter timeframes, earlier use of restrictions available under the 
significantly undercapitalized category, etc.); 
Most effective option: 0; 
Second most effective option: 1; 
Third most effective option: 2; 
Total number of respondents selecting option among top three most 
effective: 3. 

Potential options: Total; 
Most effective option: 28; 
Second most effective option: 28; 
Third most effective option: 25. 

Source: GAO. 

Note: Totals may not add to 29 because respondents did not all answer 
every question. 

[End of table] 

Table 28: Stakeholder Views on the Potential Impact of Potential 
Additional PCA Triggers: 

Potential additional triggers: Asset concentration trigger; 
Would diminish effectiveness of PCA: 4; 
No impact: 1; 
Would improve effectiveness of PCA: 20; 
Unsure: 4; 
Total: 29. 

Potential additional triggers: Asset quality trigger (e.g., 
nonperforming assets, etc.); 
Would diminish effectiveness of PCA: 1; 
No impact: 0; 
Would improve effectiveness of PCA: 26; 
Unsure: 1; 
Total: 28. 

Potential additional triggers: Contingent capital trigger; 
Would diminish effectiveness of PCA: 3; 
No impact: 3; 
Would improve effectiveness of PCA: 10; 
Unsure: 13; 
Total: 29. 

Potential additional triggers: Forward-looking trigger (e.g., stress 
test results, etc.); 
Would diminish effectiveness of PCA: 2; 
No impact: 1; 
Would improve effectiveness of PCA: 13; 
Unsure: 12; 
Total: 28. 

Potential additional triggers: Liquidity trigger; 
Would diminish effectiveness of PCA: 4; 
No impact: 2; 
Would improve effectiveness of PCA: 19; 
Unsure: 4; 
Total: 29. 

Potential additional triggers: Sources of funding trigger (e.g., level 
of brokered deposits, mismatch between short-term funding and long-
term lending, etc.); 
Would diminish effectiveness of PCA: 6; 
No impact: 2; 
Would improve effectiveness of PCA: 16; 
Unsure: 5; 
Total: 29. 

Potential additional triggers: Subordinated debt spreads trigger; 
Would diminish effectiveness of PCA: 1; 
No impact: 2; 
Would improve effectiveness of PCA: 14; 
Unsure: 12; 
Total: 29. 

Potential additional triggers: Supervisory-driven trigger (e.g., 
CAMELS ratings, etc.); 
Would diminish effectiveness of PCA: 5; 
No impact: 3; 
Would improve effectiveness of PCA: 14; 
Unsure: 7; 
Total: 29. 

Source: GAO. 

Note: Totals may not add to 29 because respondents did not all answer 
every question. 

[End of table] 

Figure 17: Stakeholder Views on Potential Additional PCA Trigger That 
Would Have the Most Positive Impact on PCA Effectiveness: 

[Refer to PDF for image: vertical bar graph] 

PCA trigger: Asset concentration; 
Number of stakeholders: 6. 

PCA trigger: Asset quality; 
Number of stakeholders: 4. 

PCA trigger: Contingent capital; 
Number of stakeholders: 2. 

PCA trigger: Forward-looking; 
Number of stakeholders: 3. 

PCA trigger: Liquidity; 
Number of stakeholders: 2. 

PCA trigger: Subordinated debt spreads; 
Number of stakeholders: 4. 

PCA trigger: Supervisory-driven; 
Number of stakeholders: 2. 

PCA trigger: Other; 
Number of stakeholders: 4. 

Source: GAO analysis of FDIC data. 

Note: Total may not add to 29 because respondents did not all answer 
every question. 

[End of figure] 

Figure 18: Stakeholder Overall Opinion of the PCA Framework: 

[Refer to PDF for image: vertical bar graph] 

Opinion: Should not be changed; 
Number of stakeholders: 1. 

Opinion: Should be modified with one or more of the listed options; 
Number of stakeholders: 23. 

Opinion: Should be modified with an option that was not included on 
this survey; 
Number of stakeholders: 0. 

Opinion: Should be supplemented by a different framework; 
Number of stakeholders: 2. 

Opinion: Should be completely replaced by a different framework; 
Number of stakeholders: 2. 

Opinion: Should be eliminated and not replaced; 
Number of stakeholders: 1. 

Opinion: Should be eliminated and not replaced; 
Number of stakeholders: 1. 

Opinion: Should be eliminated and not replaced; 
Number of stakeholders: 1. 

Opinion: Should be eliminated and not replaced; 
Number of stakeholders: 1. 

Source: GAO analysis of FDIC data. 

Note: Total may not add to 29 because respondents did not all answer 
every question. 

[End of figure] 

[End of section] 

Appendix VI: Comments from the Federal Deposit Insurance Corporation: 

FDIC: 
Federal Deposit Insurance Corporation: 
Division of Risk Management Supervision: 
550 17th Street NW: 
Washington, D.C. 20429-9990:	 

June 10, 2011: 

Orice Williams Brown: 
Managing Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
411 G Street N.W., Room 2A16: 
Washington, D.C. 20548: 

Dear Ms. Brown: 

The Federal Deposit Insurance Corporation (FDIC) reviewed the GAO 
report Banking Regulation: Modified Prompt Corrective Action Framework 
Would Improve Effectiveness (Report) (GA0-11-612). The Report stated 
that while Prompt Corrective Action (PCA) is a mechanism for 
addressing financial deterioration, it has not prevented widespread 
losses to the Deposit Insurance Fund (DIF). The FDIC agrees with the 
Report's recommendation that enhancements to PCA triggers should be 
considered. 

The existing PCA capital triggers, along with the accompanying capital 
definitions, form the core of the federal banking agencies' (agencies) 
regulatory capital framework for depository institutions. The 
consensus of lessons-learned studies undertaken after the recent 
financial crisis is capital requirements need to be strengthened. The 
FDIC anticipates the agencies will seek comment later this year on a 
Notice of Proposed Rulemaking (NPR) to implement the Basel 111 
standards recently published by the Basel Committee on Banking 
Supervision. That proposal should address whether the PCA capital 
triggers should be strengthened. Accordingly, the FDIC and other 
agencies will consider jointly the GAO's recommendation of possible 
modifications to the capital tripwires in the context of the comments 
received on that rulemaking. 

The Report recommends the agencies consider adding tripwires other 
than capital to the PCA framework. We would emphasize the FDIC's 
supervisory and enforcement framework is not based solely on 
institutions' capital levels. However, for purposes of PCA's automatic 
enforcement tripwires, a focus on capital levels has advantages, 
particularly in a banking environment as diverse as that of the United 
States. Capital requirements are a universally applicable construct 
for banks of all sizes that directly affect their ability to absorb 
losses. 

Other triggers mentioned in the Report, such as those measuring 
concentrations, liquidity, management, or overall risk profile, appear 
to have greater risk of unintended consequences for the structure of 
the banking industry, its activities or its stability in times of 
stress. We believe any such additions to the PCA tripwires should be 
preceded by substantial further study and consideration of the 
possible unintended consequences of these changes. We believe the wide 
diversity of views about potential changes to the triggers, expressed 
in the Report by respondents of the GAO's survey of stakeholders, 
reflects the practical difficulties and uncertain results of 
substantial changes to the triggers. 

The Report questioned the ability of PCA to help turn around troubled 
financial institutions, which would thereby reduce losses to the DIF. 
It is difficult to assess what the magnitude of losses to the DIF 
would have been during the worst financial and real-estate crisis 
since the Great Depression had the PCA framework not been in place. 
The FDIC believes the PCA framework had considerable value in 
providing a timely, objective framework for addressing problems that 
are evidenced by realized or impending capital deterioration. The very 
public and objective nature of its tripwires, which are fully known by 
banks and market participants, provide a disciplining effect that 
bolsters the efforts of supervisors in obtaining corrective action in 
addressing deteriorating bank conditions. In short, we believe the 
conceptual framework of PCA is well-founded. 

In the FDIC's experience, PCA, as currently structured, has been a 
valuable addition to enforcement tools available to the federal 
banking agencies. We do not view the PCA framework alone as the 
primary driver of a problem bank turnaround, but as a backstop to the 
enforcement framework when capital ratios (a lagging indicator, as 
noted in the Report) deteriorate. Most of the PCA provisions require 
an institution to retain capital, restore capital, or sell additional 
capital, thus attempting to limit the loss to the deposit insurance 
fund. The regulators use a variety of other enforcement powers to 
directly address the practices and conditions that contributed to the 
institutions' problems. We note that for the state nonmember banks the 
FDIC supervises, we took many formal supervisory directives, PCA and 
otherwise, in response to the problems we identified. 

The Report stated the supervisory response to problems in the U.S. 
banking industry was in many cases not sufficiently forceful or 
timely. The FDIC takes such issues very seriously and strived to 
improve its supervisory processes in response to identified lessons 
learned, such as those contained in Material Loss Reviews. The Report 
acknowledged the regulators incorporated lessons learned into their 
supervisory and enforcement programs during the crisis that improved 
the accuracy of CAMELS ratings and the timeliness of enforcement 
actions. 

It is also important to note that many of the GAO's findings with 
respect to PCA's effectiveness, as well as peripheral findings 
throughout the Report regarding the regulators' supervisory and 
enforcement programs, are heavily influenced by the timing of the 
evaluation period. The industry experienced an unprecedented, 
precipitous decline beginning in 2008 that continued well into 2010. 
Although the severity of deterioration has abated, the industry has 
not yet recovered. As of March 31, 888 insured depository institutions 
reside on the FDIC's Problem Bank List. However, most of these 
institutions will survive and are expected to remain above the
Undercapitalized PCA thresholds. As such, the results of this Report 
did not measure the effectiveness of PCA or other supervisory tools 
through the entirety of the current cycle. 

Implementing changes to PCA or other aspects of the supervisory 
framework based on this incomplete chapter in history would increase 
the risk of imposing unintended consequences on both the industry and 
the regulatory framework. In light of the foregoing, we believe 
caution and substantial further study is warranted before concluding 
that far-reaching changes in, or additions to, the PCA triggers are 
appropriate. 

Thank you for the opportunity to review the Report. 

Sincerely, 

Signed by: 

Sandra L. Thompson: 
Director: 

[End of section] 

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

Board of Governors of the Federal Reserve System: 
Division of Banking Supervision and Regulation: 
Washington, D.C. 20551: 

June 8, 2011: 

Ms. A. Nicole Clowers: 
Acting Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Ms. Clowers: 

The Federal Reserve Board (FRB) has reviewed your draft report 
entitled Bank Regulation, Modified Prompt Corrective Action Framework 
Would Improve Effectiveness. This response summarizes the FRB's 
overall reaction to the draft report. Additional technical comments 
have been provided separately by FRB staff to your staff. 

In the draft report. the GAO observes that although the Prompt 
Corrective Action (PCA) framework provided a mechanism to address 
financial deterioration in banks. PCA did not prevent widespread 
losses to the Deposit insurance Fund (DIF). The draft report notes 
that it has been well understood since the 1990s that the 
effectiveness of PCA is limited because of its reliance on capital, 
which can lag behind other indicators of hank health. By the time a 
hank falls into the undercapitalized or lower PCA capital categories 
it may not be able to recover regardless of the regulatory action 
imposed. Along that line, the draft report concludes that most banks 
that underwent PCA during the GAO's sample period of 2006 through the 
third quarter of 2010 either failed or remained troubled. Moreover, 
the report concludes that the lagging character of PCA triggers limit 
regulators' ability to promptly address bank problems, and the report 
offers three suggestions for regulators to consider to make PCA more 
effective. 

The FRB agrees the PCA capital triggers are not timely indicators of 
problems or weaknesses and typically are activated only after 
weaknesses are manifested through capital erosion and, therefore, PCA 
is not effective in preventing cost to DIF. Nonetheless, the FRB still 
views PCA as a useful supervisory tool that empowers bank regulators 
to take actions on significantly nonviable banks in a consistent 
manner and provides a mechanism for ensuring such banks are closed or 
otherwise resolved within prompt timelines (i.e., an orderly 
resolution process), which contributes to a healthy banking system and 
serves to limit cost to the DIF in the long run. 

Although, as the report concludes. most banks that underwent PCA 
either failed or remained troubled during the-GAO's sample period (a 
period of intense decline in banking conditions), that is largely 
attributed to limited access to capital more than to the 
ineffectiveness of PCA. As conditions stabilized later in the cycle 
and through the current period, an increasing number of troubled 
institutions have been successful at raising capital or merging with 
other banks. The FRB believes that the requirements of PCA on troubled 
banks are useful in containing risk and can lead to correction of 
troubled institutions as long as opportunities for capital raises or 
merger are available. For troubled banks that arc unable to raise 
capital, or otherwise resolve problems, PCA serves to limit cost to 
the DIP through a timely and orderly resolution process. Without PCA, 
failures and resolutions could he less orderly and, consequently, more 
costly. 

A point covered in the GAO's survey questions but not elaborated on in 
the report is whether a change in accounting rules used to measure 
capital levels should be considered. The FRB views this as one of the 
more promising options identified in the report to improve the 
effectiveness of PCA. The survey question may be aimed at changing the 
accounting rules to recognize credit losses earlier which would 
improve the effectiveness of PCA during declining credit cycles. The 
Financial .Accounting Standards Board and the International Accounting
Standards Board have been working on impairment accounting to move 
from an incurred loss to an expected loss model. The FRB, along with 
the other banking agencies, supports this effort and is actively 
monitoring this effort. 

As the draft report states, most stakeholders, including the FRB, 
agreed that PCA should he modified and made more effective. The GAO 
survey results suggest incorporating an institution's risk profile, 
increasing minimum PCA capital ratios for each capital category, and 
including another trigger for PCA, such as an asset quality or 
concentration trigger; as broad options for making PCA more effective. 
Although it is early in the process, most of the existing capital 
trigger levels will likely need revision to reflect regulatory capital 
requirement changes resulting from the Dodd-Frank Act and Basel Ill 
rules, and work has begun to determine what changes should be 
developed. That said. there are challenges in making revisions, and 
some revisions suggested in the report could have undesirable 
consequences. such as potentially over-restricting bank lending. The 
FRB generally agrees with the advantages and disadvantages on each of 
the three suggestions noted in the report and will keep these issues 
in mind as work progresses. 

In addition to recommendations to modify PCA, the FRB will consider 
all the recommendations it the report as part of an ongoing process to 
modify and update supervisory processes. As the report mentions, early 
warning signs in earnings, asset quality, liquidity, and concentration 
levels, as well as risk management deficiencies that could contribute 
to unsafe and unsound banking conditions are already monitored as part 
of the FRB's (and other banking agencies) supervisory processes. 
Offsite surveillance and statistical models used by the FRB as well as 
onsite supervisory activities have been the FRB's most useful tools in 
identifying early warnings signs of developing or potential financial 
distress. Despite that, the FRB recognizes that over the past few 
years of this banking cycle, early warning signs did not always result 
in appropriate and timely supervisory actions. The FRB Office of the 
Inspector General concluded in Material Loss Reviews on a number of 
banks that failed from 2008 through 2010 that there were opportunities 
for the FRB to take more forceful supervisory actions to address 
safety and soundness examination findings early on. Cognizant of the 
need for more prompt remediation of supervisory concerns, FRB staff 
has developed an examination issues tracking process that identifies 
and centrally monitors supervisory issues for each affected 
institution. Depending on the degree of concerns and responsiveness of 
bank management, institutions with uncorrected deficiencies or repeat 
deficiencies are subject to increasing supervisory actions until 
deficiencies are corrected. FRB staff believes effective 
implementation of this process will minimize uncorrected safety and 
soundness weaknesses, which should lead to fewer significantly 
troubled banks and should ultimately minimize future losses to the DIF. 

Contrary to a generalized finding in the GAO's draft report, the FRB 
does not find that it has been inconsistent in the use of supervisory 
enforcement actions and PCA for banks under its supervision. The FRB 
has a policy and practice of placing formal supervisory actions on its 
supervised banks that exhibit significant supervisory concerns. 
Moreover, the FRB has been diligent in following specific requirements 
of PCA for any bank that is less than adequately capitalized as 
defined under PCA. 

We appreciate the professionalism of the GAO review team that prepared 
the report. Thank you for the opportunity to comment. 

Sincerely, 

Signed by: 

Patrick Parkinson: 
Director: 

[End of section] 

Appendix VIII: Comments from the Office of the Comptroller of the 
Currency: 

Comptroller of the Currency: 
Administrator of National Banks: 
Washington, DC 20219: 

June 6, 2011: 

Ms. A. Nicole Clowers: 
Acting Director, Financial Markets and Community Investment: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Ms. Clowers: 

We have received and reviewed your draft report titled "Bank 
Regulation: Modified Prompt Corrective Action Framework Would Improve 
Effectiveness?' Your report was mandated by Section 202(g) of the Dodd-
Frank Wall Street Reform and Consumer Protection Act to study the 
federal regulators' use of prompt corrective action (PCA) and report 
your findings to the Financial Stability Oversight Council (FSOC). 

You found that: (1) PCA did not-prevent widespread losses to the 
deposit insurance fund; (2) other indicators provide early warning of 
deterioration, and although regulators identified conditions early, 
responses were inconsistent; and (3) while most stakeholders favored 
modifying PCA, their preferred options involve some tradeoffs. 

You recommend that the federal banking regulators consider: (1) 
additional triggers that would require early and forceful regulatory 
actions tied to specific unsafe banking practices; (2) incorporating 
an institution's risk profile into the PCA capital category 
thresholds; and (3) raising all the PCA capital category thresholds. 
You also recommend that regulators work through the FSOC to make 
recommendations to Congress on how PCA should be modified. 

We agree to consider the actions you recommend. The banking regulators 
are continuously engaged in dialog about early warning indicators and 
early intervention, though, as your report points out, a uniform 
approach is not always the result. The OCC, for example, takes formal 
enforcement action earlier than the other agencies--when a bank's 
safety and soundness composite rating drops to a three. Consistent 
with your second consideration above, the OCC imposes higher minimum 
capital standards for national banks whose risk profile warrants it. 
We also recognize that future enhancements to regulatory capital 
requirements will interplay with PCA capital category thresholds and 
may effectively raise them. 

We expect the dialog with the other federal banking agencies to 
continue as we continue to avail ourselves of the flexibility to use 
the above mentioned tools. Should We find that a statutory change is 
needed to PCA to increase its effectiveness, we agree to inform the 
FSOC of our views on this issue. 

We appreciate the opportunity to comment on the draft report. 

Sincerely, 

Signed by: 

John Walsh: 
Acting Comptroller of the Currency: 

[End of section] 

Appendix IX: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

A. Nicole Clowers, (202) 512-8678 or Clowersa@gao.gov Thomas J. 
McCool, (202) 512-2642 or Mccoolt@gao.gov: 

Staff Acknowledgments: 

In addition to the contacts above, Kay Kuhlman (Assistant Director), 
JoAnna Berry, Gary Chupka, Bill Cordrey, Andrea Dawson, Michael 
Hoffman, Barry Kirby, Joanie Lofgren, Grant Mallie, Marc Molino, Tim 
Mooney, Steven Putansu, Ellen Ramachandran, Linda Rego, Barbara 
Roesmann, and Andrew Stavinsky made key contributions to this report. 

[End of section] 

Footnotes: 

[1] The DIF was created in 2006, when the Federal Deposit Insurance 
Reform Act of 2005 provided for the merging of the Bank Insurance Fund 
and the Saving Association Insurance Fund. Pub. L. No. 109-171, title 
II, subtitle B, § 2102, 120 Stat. 4 (2006). The Federal Deposit 
Insurance Corporation (FDIC) administers the DIF, the goal of which is 
to (1) insure the deposits and protect the depositors of DIF-insured 
institutions, and (2) upon appointment of FDIC as receiver, resolve 
failed DIF-insured institutions at the least possible cost to the DIF 
(unless a systemic risk determination is made). The DIF is primarily 
funded from deposit insurance assessments. 

[2] Pub. L. No. 102-242, 105 Stat. 2236 (1991); Ch. 967, §§ 1,2, 64 
Stat. 873 (1950). 

[3] 12 U.S.C. § 1831o. 

[4] 12 U.S.C. § 1831p-1. 

[5] See GAO, Troubled Asset Relief Program: Additional Actions Needed 
to Better Ensure Integrity, Accountability, and Transparency, 
[hyperlink, http://www.gao.gov/products/GAO-09-161] (Washington D.C.: 
Dec. 2, 2008). 

[6] See GAO, Federal Deposit Insurance Act: Regulators' Use of 
Systemic Risk Exception Raises Moral Hazard Concerns and Opportunities 
Exist to Clarify the Provision, [hyperlink, 
http://www.gao.gov/products/GAO-10-100] (Washington, D.C.: Apr. 15, 
2010). 

[7] 12 U.S.C. § 5382(g). The Financial Stability Oversight Council 
(FSOC) was created by the Dodd-Frank Act to provide comprehensive 
monitoring to ensure the stability of the nation's financial system 
and has responsibilities to facilitate coordination among the member 
agencies, recommend stricter standards if necessary, and make 
recommendations to Congress in closing specific regulatory gaps. 
Voting members include, among others, the Secretary of the Treasury, 
who serves as the Chairperson of FSOC; the Chairman of the Board of 
Governors of the Federal Reserve System; the Comptroller of the 
Currency; and the Chairperson of FDIC. 12 U.S.C. § 5321. 

[8] This report uses the phrase "banks that underwent the PCA process" 
to describe banks that fell into one of the three lowest PCA capital 
thresholds--undercapitalized, significantly undercapitalized, or 
critically undercapitalized--during any quarter in our period of 
analysis. 

[9] We reported in March 2011 that FDIC maintained effective internal 
control over financial statements for the DIF. GAO, Financial Audit: 
Federal Deposit Insurance Corporation Funds' 2010 and 2009 Financial 
Statements, [hyperlink, http://www.gao.gov/products/GAO-11-412] 
(Washington, D.C.: Mar. 18, 2011). 

[10] Section 313 of the Dodd-Frank Act abolishes OTS and section 312 
distributes its regulatory functions among the Federal Reserve, FDIC, 
and OCC. OTS will cease to exist 90 days after the transfer date, 
which is July 21, 2011, unless it is extended to another date that is 
within 18 months of July 21, 2010. See 12 U.S.C. §§ 5411-13. 

[11] In October 2008, the standard maximum insurance amount of 
$100,000 was temporarily raised to $250,000, effective through 
December 31, 2013. See 12 U.S.C. § 5241. Section 335(a)(1) of the Dodd-
Frank Act, signed into law on July 21, 2010, made this increase 
permanent. See 12 U.S.C. 1821(a)(1)(E). 

[12] 12 U.S.C. § 1818. 

[13] 12 U.S.C. § 1831o(c). 

[14] Section 38 allows an exception to the 90-day closure rule if both 
the primary regulator and FDIC concur and document why some other 
action would better achieve the purpose of section 38--resolving the 
problems of institutions at the least possible long-term cost to the 
DIF. 

[15] A bank can be reclassified or downgraded to critically 
undercapitalized only based on its failure to maintain a tangible 
equity to total assets ratio of at least 2 percent. 

[16] See GAO, Deposit Insurance: Assessment of Regulators' Use of 
Prompt Corrective Action Provisions and FDIC's New Deposit Insurance 
System, [hyperlink, http://www.gao.gov/products/GAO-07-242] 
(Washington, D.C.: Feb. 15, 2007). 

[17] Capital levels, reported by institutions through Call and Thrift 
Financial Reports, may drop precipitously from previously reported 
levels, including conditions prompting liquidity issues, necessitating 
the closing of a bank without an opportunity to pursue PCA measures 
prior to failure. 

[18] Many of these banks were merged into an acquiring bank without 
financial assistance from the government, although some were merged 
with governmental assistance or were dissolved through a voluntary 
liquidation that did not result in a new institution. These 46 
dissolved banks are now classified as inactive by FDIC, although 
components of these banks may operate under the certification number 
of an acquiring bank. We did not count as dissolved 253 banks that 
continued to operate under their original unique certification number 
and were classified as active by FDIC, regardless of whether another 
entity had gained a large or controlling stake in their operations. 

[19] Expressed as means, the average loss was 28.0 percent of assets 
for banks that underwent the PCA process; for banks that did not, the 
average loss was 25.6 percent. This report frequently uses medians 
when calculating averages so that the results are less sensitive to 
values at the extremes of the sample. For example, median losses 
divide banks into equal groups, half with losses above that amount, 
and half with losses below it. 

[20] Statistical significance refers to the likelihood of an observed 
difference being due to chance. We controlled for factors affecting 
the quality of the balance sheet and the size of deposit liabilities. 
Banks with more securities had lower losses, and banks with more 
nonperforming loans and deposits had higher losses. See appendix III 
for more information. 

[21] Expressed as means, the average size of the 25 banks that did not 
undergo the PCA process before failure was $14.8 billion, versus $956 
million for those banks that first underwent the PCA process. If we 
exclude Washington Mutual Bank, or WaMu--the nation's largest savings 
and loan association before its failure--the mean size of banks that 
did not undergo the PCA process before failure drops from $14.8 
billion to $2.6 billion. 

[22] In this report, we use the term "forbearance" to refer to 
granting banks temporary relief from compliance with regulatory 
requirements. 

[23] See 12 C.F.R. § 337.6. 

[24] For example, some large institutions did not fail but received 
other assistance authorized under systemic risk determinations related 
to (1) the banking system as a whole through the Temporary Liquidity 
Guarantee Facility; and (2) Citigroup and its insured institution 
subsidiaries. See GAO-10-100 for further information on the use of 
systemic risk determinations. 

[25] Joe Peek and Eric Rosengren, "The Use of Capital Ratios to 
Trigger Interventions in Problem Banks: Too Little, Too Late," New 
England Economic Review, September/October issue (1996). 

[26] David S. Jones and Kathleen Kuester King, "The Implementation of 
Prompt Corrective Action: An Assessment," Journal of Banking and 
Finance, vol.19 (1995). 

[27] GAO, Bank Supervision: Prompt and Forceful Regulatory Actions 
Needed, [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69] 
(Washington, D.C.: April 1991). 

[28] A composite indicator is an indicator that integrates information 
from a number of distinct indicators. 

[29] We relied on two widely cited studies. See Rebel A. Cole and 
Jeffrey W. Gunther, "Separating the Likelihood and Timing of Bank 
Failure," Journal of Banking and Finance, vol.19 (1995) and Rebel A. 
Cole and Jeffrey W. Gunther, "Predicting Bank Failure: A Comparison of 
On-and Off-site Monitoring Systems," Journal of Financial Services 
Research, vol.13, no.2 (1998). 

[30] In contrast to statistical significance, which refers to the 
likelihood of an observed difference being due to chance, practical 
significance refers to the magnitude of an observed difference. 

[31] See Basel Committee on Banking Supervision, Basel III: 
International Framework for Liquidity Risk Measurement, Standards, and 
Monitoring. December 2010. Basel, Switzerland. 

[32] We measure sector loan concentration as a Herfindahl-Hirschman 
Index (HHI) where the "market shares" are the proportion of loans in 
each sector. See appendix III for more information. 

[33] John O'Keefe and James A. Wilcox, "How Has Bank Supervision 
Performed and How Might It Be Improved?" Paper presented at Federal 
Reserve Bank of Boston's 54TH Economic Conference "After the Fall: Re- 
Evaluating Supervisory, Regulatory, and Monetary Policy" (2009). 

[34] FDIC's Statistical CAMELS Off-site Rating (SCOR) system was 
designed to help the agency identify institutions that have 
experienced noticeable financial deterioration. The model helps 
predict 1-and 2-rated institutions in danger of being downgraded to 3 
or worse. The Federal Reserve uses the Supervision and Regulation 
Statistical Assessment of Bank Risk model (SR-SABR) as its primary off-
site monitoring tool. 

[35] To assess the prevalence of failed banks that previously had been 
identified on the regulators' watch or review lists, we assessed 252 
banks regulated by FDIC, the Federal Reserve, and OCC that failed from 
the first quarter of 2008 through the third quarter of 2010. We 
identified when the banks were included on the regulators' watch or 
review lists within 2 years of their failure. OTS also conducts off- 
site monitoring to identify institutions that warrant further scrutiny 
that are captured in a high risk profile list. Because of some 
complications in collecting these data for the entire time period of 
our analysis, we did not include OTS institutions in this analysis. 

[36] Uniform Financial Institution Rating System, 62 Fed. Reg. 752 
(Jan. 6, 1997). 

[37] 

[38] We reviewed CAMELS ratings over a 2-year period prior to bank 
failure for 292 banks that failed from the first quarter of 2008 
through the third quarter of 2010. 

[39] Through a systematic review of material loss reviews or other 
evaluations performed on 136 institutions that failed between in 2008, 
2009, and 2010, we identified the first enforcement action relevant to 
the regulator's efforts to address deteriorating conditions in banks 
in the 2-year period before failure. 

[40] GAO, Deposit Insurance: A Strategy for Reform, [hyperlink, 
http://www.gao.gov/products/GAO/GGD-91-26] (Washington, D.C.: March 
1991), and [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69]. 

[41] A de novo bank is a newly chartered bank that has been open for 
less than 3 years. 

[42] Of the remaining six respondents, two said PCA should be 
supplemented by a different framework, two said PCA should be 
completely replaced by a different framework, one told us PCA should 
be eliminated and not replaced, and one stakeholder told us the PCA 
framework should not be changed. 

[43] Of the remaining eight, two survey respondents said incorporating 
an institution's risk profile into the PCA capital category thresholds 
would have no impact, two told us it would diminish the effectiveness 
of PCA, and four were unsure. 

[44] To categorize institutions into the five PCA capital categories, 
two capital measures (total risk-based capital ratio and Tier 1 risk- 
based capital ratio) divide the amount of capital by risk-weighted 
assets. 

[45] Of the remaining 12, 3 told us raising all capital category 
thresholds would have no impact, 4 said it would diminish PCA 
effectiveness, and 5 respondents were unsure. 

[46] See 57 Fed. Reg. 44866 (Sept. 29, 1992). 

[47] GAO, Risk-Based Capital: Bank Regulators Need to Improve 
Transparency and Overcome Impediments to Finalizing the Proposed Basel 
II Framework, [hyperlink, http://www.gao.gov/products/GAO-07-253] 
(Washington, D.C.: Feb. 15, 2007); Congressional Research Service, Who 
Regulates Whom? An Overview of U.S. Fiscal Supervision, R40249 
(Washington, D.C.: Dec. 8, 2010). 

[48] See Who Regulates Whom; [hyperlink, 
http://www.gao.gov/products/GAO-07-253]; Douglass Elliott, "A Primer 
on Bank Capital" The Brookings Institution. (Washington, D.C.: Jan. 
28, 2010). 

[49] Of the remaining 11, 1 said adding another PCA trigger would 
diminish PCA effectiveness, 2 told us it would have no impact, and 8 
were unsure. 

[50] One survey respondent did not answer this question; therefore, 
the total number of respondents in this case is 28. 

[51] Pub. L. No. 103-325, § 318, 18 Stat. 2160, 2223-2224 (1994) 
(providing for the standards to be issued either by regulation [as 
originally specified in FDICIA] or by guideline and eliminating the 
requirement to establish quantitative standards for asset quality and 
earnings). 

[52] GAO, Bank and Thrift Regulation: Implementation of FDICIA's 
Prompt Regulatory Action Provisions, GAO/GGD-97-18 (Washington, D.C.: 
Nov. 21, 1996). 

[53] [hyperlink, http://www.gao.gov/products/GAO-07-242]. 

[54] [hyperlink, http://www.gao.gov/products/GAO-07-242], [hyperlink, 
http://www.gao.gov/products/GAO/GGD-97-18], and [hyperlink, 
http://www.gao.gov/products/GAO/GGD-91-69]. 

[55] [hyperlink, http://www.gao.gov/products/GAO/GGD-91-69] and 
[hyperlink, http://www.gao.gov/products/GAO/GGD-91-26]. 

[56] 12 U.S.C. § 1823(c)(4). 

[57] Cole and Gunther, "Separating the Likelihood and Timing of Bank 
Failure," and Cole and Gunther, "Predicting Bank Failure: A Comparison 
of On-and Off-site Monitoring Systems." 

[58] Basel Committee on Banking Supervision, Studies on Credit Risk 
Concentration. Working Paper No. 15, November, 2006. Basel, 
Switzerland. Deutsche Bundesbank, Concentration Risk in Credit 
Portfolios. Monthly Report, June 2006. Frankfurt, Germany. 

[59] Office of the Comptroller of the Currency, Board of Governors of 
the Federal Reserve System, Federal Deposit Insurance Corporation, 
Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices, December, 2006. 

[60] Cole and Gunther, "Separating the Likelihood and Timing of Bank 
Failure," and Cole and Gunther, "Predicting Bank Failure: A Comparison 
of On-and Off-site Monitoring Systems." 

[61] The marginal effect is calculated at the means of the independent 
variables in the first quarter of 2008. 

[62] As above, the marginal effect is calculated at the means of the 
independent variables in the first quarter of 2008. For comparison 
purposes, a one standard deviation (0.7) increase in the CAMELS rating 
raises the probability of failure by 0.9 percentage points, to 3.7 
percent. 

[63] A similar approach that is not focused on the effect of PCA is 
Kathleen McDill, "Resolution Costs and the Business Cycle," FDIC 
Working Paper 2004-01 (2004). 

[64] While in theory DIF losses are a random variable that could take 
on positive or negative (if the FDIC turned a profit on the sale of a 
failed bank) values, the FDIC has not earned profits over its deposit 
liabilities on any bank resolution. Therefore, one might consider the 
dependent variable to be censored and a regression approach such as a 
Tobit might be appropriate. For each of the OLS regressions reported 
below we performed the regressions again as a Tobit to see if our 
results were sensitive to this specification. We did not find any 
substantive changes as the coefficient on PCA remained statistically 
insignificant and in the negative 1-3 range. 

[65] See, e.g., Deirdre N. McCloskey and Stephen T. Ziliak, "The 
Standard Error of Regressions," Journal of Economic Literature (1996). 

[End of section] 

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