Mr. Chairman, it is a pleasure to testify before this committee on the implications and lessons from the recent failure of the ironically named Superior Bank, located in the suburbs of my home city of Chicago. What is important is not so much that Superior failed – bank failures have been infrequent in recent years and inefficient or unlucky banks should be permitted to exit the industry in order to maximize the industry’s contribution to the economy – but the exceedingly large magnitude of its loss to the FDIC. This loss is estimated in the press to be somewhere between $500 million and $1 billion, or 20 to 45 percent of the bank’s assets at the date of its resolution. Recent changes in the federal deposit insurance system have greatly reduced the government and taxpayer’s liability for losses to the FDIC from bank failures by requiring near automatic and immediate increases in insurance premiums to replenish the fund whenever the FDIC’s reserves fall below 1.25 percent of insured deposits. In this way, the system is effectively privately funded. Nonetheless, because bank failures are widely perceived to be more disruptive than the failure of most other firms, and the larger the loss (negative net worth), the greater the potential for disruption, bank failures are still a public concern and a public policy issue.
In response to the large number of bank and S&L failures in the 1980s and early 1990s at a high cost not only to the surviving institutions but, at the time, also to taxpayers, Congress enacted the FDIC Improvement Act (FDICIA) in 1991 to reduce both the number and, in particular, the cost of bank failures through prompt corrective action (PCA) and least cost resolution (LCR) by the regulators.
PCA specifies sanctions that first may and then must be imposed by the regulators as a bank’s financial condition deteriorates in order to turn the bank around before it becomes insolvent with possible losses to the FDIC. The sanctions are triggered by declines in bank capital ratios. But PCA is intended to compliment, not to replace, the regulators’ other supervisory techniques that rely on other signals of a bank’s financial condition. Indeed, PCA was introduced not because regulators tended to react too quickly to developing bank problems, but too slowly (to forbear). Thus, regulators are not required or even encouraged to delay corrective action until the capital tripwires are breached.
Because of confidentiality, I do not know with certainty many of the details of the Superior failure and, in particular, the roles of the OTS and FDIC. However, the public information available casts suspicion on both the promptness of the OTS’s actions and the strength of the corrective actions when taken. Nor is a 20 to 45 percent loss rate what the drafters of FDICIA or, I suspect, Congress had in mind when they designed LCR. Indeed, this loss rate promises to be greater than the average loss rate on banks of comparable size in the bad pre-FDICIA days. ,
To put the Superior failure in perspective, while it is the largest FDIC insured institution to fail since mid-1993, it is a relatively small bank. Its losses, large as they may be, are no threat to either the FDIC or the local or national economies. Moreover, the loss rate for the next two largest institutions that failed in this period were even greater. The estimated loss rate on the 1999 failure of the $1.1 billion First National Bank of Keystone (West Virginia) is near 75 percent and that on the 1998 failure of the $320 million, again ironically named, Best Bank (Boulder, Colorado) is near 55 percent (see attached tables). This suggests that something is not working the way it was intended. Although all three of these banks may be viewed as outliers and not representative in their operations of the large majority of banks – Best Bank was primarily an internet bank, Keystone relied to a unduly large extent on insured brokered deposits to fund very risky mortgage residuals, and Superior focused on transforming its high credit risk subprime mortgage loans into even higher credit and interest risk interest only residuals – one has to wonder, if the supervisors cannot do better when times are good and failures few, how would they do, if things are not changed, when times are bad and bank failures more frequent. On the other hand, it may be argued that, at such times, bank problems are likely to be more generic and supervisors more able to deal with them. Nevertheless, an important contribution of these hearings is to identify lessons from the recent costly failures that may reduce the probabilities of a repeat performance.
It appears that in Superior, and possibly even more so in the other two failures, a number of red flags were flying high that should have triggered either a rapid response or continuing careful scrutiny. Although each flag was not flying for each bank, these red flags would include, but not be limited to:
None of these flags either by itself or even in combination with others guarantees trouble. But because the cost of spotting them is low, they are worth following up on to see whether the fish really smells.
We would know a great deal more about what the regulators did or did not do and who knew what when with respect to these flags in Superior, if we knew:
As noted earlier, the available public evidence suggests either very late realization of the seriousness of the situation by the OTS, not very forceful corrective actions by the OTS, and/or not very rapid nor strong response by Superior. Moreover, the speed of regulatory action was particularly slow after Superior’s reported equity capital ratio on call reports at yearend 2000 declined below the 2 percent threshold for critically undercapitalized status that triggers receivership, conservatorship, or a recapitalization plan within 90 days.
A number of additional questions arise. In retrospect it is clear that Superior’s reported capital was overstated by, among other things, underreserving for loan losses well before yearend 2000 and even before the reevaluation of the "toxic waste" residuals. Why were adjustments not made earlier? Why did the FDIC sign off on the proposed recapitalization plan at the end of the 90 day period, when the negative net worth at that time was likely to be much larger than the reported proposed recapitalization amount? Hopefully, we will know more about these events after these hearings than we knew before them and we can develop more refined and accurate prescriptions for future regulatory action. But, based on the public information to date, I recommend the following proposals for serious consideration:
But none of these suggestions will be effective unless the supervisors have not only the ability but also the will to comply fully with the underlying objectives and spirit of PCA and LCR. At times, the actions of all four federal bank regulatory agencies suggest a lack of commitment. It may be desirable, therefore, to encourage additional sensitivity training for regulators to increase their commitment to these important objectives. Regulators should be judged adversely not by the number of bank failures, but by the cost of the failures.
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