Mr. Chairman, I appreciate the opportunity to appear this morning to discuss the lessons for policy-makers suggested not only by the Superior Federal Bank failure, but by recent closings of insured depositories. I am the managing partner of Federal Financial Analytics, a firm that has advised financial services companies in the U.S. and abroad for the last sixteen years. Federal Financial Analytics has no clients that are parties in the Superior or other recent bank failures before you today.
In 1993, I was an adviser to a commission chartered by Congress to examine the causes of the S&L crisis and to make recommendations about ways to prevent another one. One major commission finding that has been cited in many other books on the 1980s crisis: Congress throughout the period was not given reliable information on which to act and, in some cases, it ignored the signs of brewing trouble. As the Commission concluded, "Congress appears to have been largely unaware of the severe problems developing in the S&L industry … By the time the extent of the problem was recognized, much of the damage was done." The prompt attention the Superior Federal Bank case is receiving in this hearing and your interest in any action that the case may warrant indicates that one of the more important lessons of the 1980s will guide Congress in 2001.
The Superior failure, like several other recent ones, is neither a crisis nor even a very great event in the scheme of the nation’s banking history. It is, though, a timely reminder after a decade of unprecedented prosperity that things can go very wrong at insured depository institutions, and that vigilance is essential to correct any policy failures these bank failures reveal.
This morning, I would like to offer the following observations:
I. PCA Reform
One of the most lauded sections of the FDIC Improvement Act of 1991 (Section 131) established a set of capital-based triggers at which regulatory intervention is mandated. This section is often described as the "prompt corrective action" or PCA framework. As Members of the Banking Committee in the 107th Congress will recognize – and many will personally recall – the 1991 Act was the result of extensive debate and many compromises. One of these gave regulators numerous options in the PCA framework. Even when a bank falls below the 2% or "critical" capital threshold, regulators can keep a bank open if they have approved a capital restoration plan. The statute does not place any meaningful restrictions on the terms on which regulatory approval can be granted.
Some have argued that the PCA framework should be more prescriptive so that a primary regulator must close a bank when it fails the critical capital test. However, I am very concerned that an automatic trigger based on a single indicator of bank condition could result in the closing of some healthy banks and the ongoing operation of other, truly insolvent ones. This is because the current measures of capital adequacy on which the PCA tests are based are flawed. Indeed, under current capital standards, a bank with its entire portfolio in risk-free Treasury securities could be subject to far higher regulatory capital standards than one like Superior with a portfolio of risky subprime assets. Further, pending changes to the Basel risk-based capital standards suggest that this problem could become even worse, increasing the already wide variance between the amount of capital a bank needs as determined by the market ("economic capital") and that demanded by bank regulators.
Bank regulators disagreed over the capital condition of Superior Federal Bank as it slid towards regulatory insolvency, and this is one of the disputes now before the Committee. However, the Superior case is not an isolated one. In three other recent bank failures – Keystone, Best Bank and Pacific Thrift & Loan – questions about capital adequacy comparable to those at Superior are also relevant. All four banks engaged in complex securitization transactions that put structured assets, often called residuals, on their books. The appropriate capital treatment for residuals and for other structures in which a bank retains risk, "recourse" in regulatory parlance, remains very crude in relation to the real risks posed by these complex instruments. Further, the accounting valuation of residuals remains at best an art, putting bank regulators at the mercy of accountants whose judgment proved unreliable in each of these recent bank failures. The massive revaluation a week or so ago of servicing rights at a major non-bank mortgage servicer is yet another indication of the capital risks associated with new types of banking assets.
The current U.S. bank capital standards in large part flow from a 1988 agreement among international bank regulators usually called the Basel Accord. This Accord was an effort to align regulatory capital more closely to economic risk. It was an improvement over prior capital rules because it incorporated off-balance sheet assets into the capital framework and because it made it more difficult for banks in one country to best those in others because their home-country regulators had lax capital rules.
Even as they were put in place, however, regulators and analysts recognized that the Basel framework was, at best, only the least worst solution to the problems of the mid-1980s. First, as the ongoing debacle in Japan demonstrates, an international capital regime is only as strong as the willingness of home-country regulators to enforce it. When home-country regulators forebear by treating dud loans as good ones, no amount of nominal capital is sufficient to ensure either a level competitive playing field or, more important, a sound global banking system.
The capital accord was also flawed because the new risk "buckets" that set capital were very crude. For example, all corporate and consumer loans (other than certain mortgages) have a 100% risk weighting. This means that a secured loan to a AAA-rated corporation bears the same amount of capital as one to a high-flying dot.com or to a consumer who has gone bankrupt a time or two. When capital standards are constant regardless of risk, a regulatory incentive to take on the greatest risk for the least amount of capital is created. This incentive is often described as "arbitrage" or "gaming," and it is the incentive that drove Superior and several other now-closed banks to become very risky. The capital rules permitted them to perch atop a thin pillar of capital that initially met regulatory standards even though it fell far, far short of what the market would have required.
Another big problem in the current capital standards is that the real risk of residuals and recourse positions is not captured. Again, this creates an incentive to take on risk, since highly risky structured assets can be amassed in great volume without a capital requirement commensurate with the risk. As noted, these risks are further compounded by the complexities of these instruments, which accountants consistently demonstrate an inability to value accurately. Thus, not only are the structures themselves high risk, but the risks can and often are vastly understated on a bank’s books. Small interest-rate changes can result in huge and sudden asset devalutions that leave a bank in a dangerous condition unless ample capital has been stock-piled to protect the deposit insurance funds.
In January, 2001, the Basel regulators issued a consultative paper outlining a complete revision of the prior international risk-based capital rules. These were intended to redress the arbitraging to which the current rules have led, with the new standards aiming at a far more precise calibration of economic and regulatory capital. However, the new rules – which run to about 600 pages – raise at least as many questions as they answer. For example, the new rules include a capital charge for "operational risk," which is defined as the risk of systems or similar failures. There is, however, no widely-accepted methodology for measuring operational risk, let alone assigning capital in relation to it. If the Basel Committee moves forward with this proposal, the gap between economic and regulatory capital could become still wider. This would leave some institutions far over-capitalized in relation to their risk profile, while others would be dangerously under-capitalized.
Another major problem with the pending accord is its failure to deal well either with portfolio or line-of-business diversification. As a result, institutions with big portfolios of risky loans might not be penalized, nor would those which fail to engage in a prudent mix of businesses where risks tend naturally to hedge each other. This failure could in fact create a regulatory incentive for banks to become monoline institutions focusing on the high-risk end of the market. This could lead to more, not fewer, Superior-style failures.
The link between PCA and capital under U.S. law makes it especially urgent that the capital rules be properly calibrated to risk. In other countries, banks that fail the Basel or their own domestic capital rules may get a slap on the wrist, if their regulators even do that. However, FDICIA obligates U.S. regulators to take the steps outlined above if capital slips below stated thresholds. Thus, banks will maintain regulatory capital even if their true risk profile argues for far more — and sometimes far less — regulatory capital. In addition, the link between being "well-capitalized" and being allowed under the Gramm-Leach-Bliley Act to form a financial holding company ties U.S. banks far closer to the capital standards than is the case in other countries.
Further, the PCA framework and GLBA requirements mean that many bank examiners focus on the letter of the capital requirements, not their spirit. They impose capital sanctions in a mechanical fashion or deem banks to be well-capitalized regardless of their real risk potential. The fact that many Texas banks (e.g., First National City) were well-capitalized under the PCA framework on the day they were closed makes it clear that regulatory capital cannot be the sole criterion on which regulators base their supervisory decisions.
In my view, the PCA framework is a valuable one, as it prevents the endless forbearance that characterized both bank and thrift regulation during the 1980s. However, the serious flaws in the current and prospective capital rules argue strongly against too tight or too mechanical a link between capital and supervisory intervention. Under PCA, there has yet to be a bank failure that did not cost the FDIC money, demonstrating that reliance solely on capital as the PCA trigger provides no guarantee against losses to the deposit insurance fund, as Congress intended.
Specifically, I would suggest:
II. FDIC Enforcement Power
The Committee is rightly concerned that bank regulators work well together, and that the FDIC is informed early about any emerging problems that might result in a cost to the deposit insurance fund. However, the FDIC already has broad authority to intervene in troubled institutions that are not dependent on cooperation from its sister agencies. For example, the FDIC can terminate deposit insurance at its sole discretion, without regard to whether a primary regulator has decided to close a bank or savings association. Further, the FDIC can under current law notify a primary regulator that it believes that PCA sanctions should be invoked. Should the primary regulator fail to do so, the FDIC can intervene. In the ten-plus years since the FDIC got these powers, they have never been used. This suggests to us that differences of opinion among the regulators are isolated and that these should be resolved through greater congressional oversight and improved regulatory communication, not through any statutory change.
Indeed, giving the FDIC broader authority could well be problematic. There appears to be little reason to give the agency automatic authority to examine healthy banks, especially the large ones that are already subject to double and in some cases triple or more supervision from a variety of bank and non-bank regulatory bodies. Further, the FDIC has little experience with specialized, sophisticated institutions. While it might like to learn on the job to anticipate potential problems in such situations, its entry into such institutions would add considerable regulatory burden without any discernible benefit.
Indeed, supervision of all insured depositories might be improved if the FDIC worked with other bank regulators to take advantage of their expertise. While Superior and Keystone are the largest and most costly recent bank failures, the FDIC has had two smaller ones of its own. Best Bank of Colorado failed in 1999 due to very dubious management practices and questionable lending, while Pacific Thrift & Loan failed largely because of the same problems with residuals that toppled Superior. In both cases, the FDIC let as many as five years lag between the time at which it first spotted trouble and the time the banks were closed. Through these years, the FDIC appeared as reluctant to second-guess management and accountants as its sister agencies in the Keystone and Superior cases.
The lesson: supervising banks engaged in complex activities during trying economic times is hard work for each agency charged with doing so. When bank management is engaged in systematic fraud or desperate practice, all of the regulators face a still more daunting task. None has a recipe for total success, and each would benefit from improving communications with the others and from more general reforms to bank examination. These could include:
III. Examination Fees
It is also possible that the dependence of certain regulators on assessment fees could create problematic supervisory incentives. At present, we do not see any evidence that fees have played any role in recent supervisory decisions by the OCC and OTS. Indeed, as these agencies note, problem institutions generally cost the agencies far more in supervisory resources and, in some cases, court costs than they provide in fees. Further, both agencies experience what they call reputation risk when a horse is shot out from under them, as is evident not only from today’s hearing, but also from earlier ones in the House after Keystone’s collapse.
However, the fact that fees are not now problematic does not mean that they won’t become so in time. The consolidation in the banking industry means that the OCC and OTS are increasingly dependent on a few very large institutions for the bulk of their revenue. This is particularly true at the OTS, where one very large savings association dwarfs the rest of the industry in terms of market size and, therefore, assessment fees. Loss of such an institution to another regulator could be costly, and it is therefore possible that an agency head might be more inclined to work with such a bank than with a smaller one with less impact on the agency’s bottom line.
However, while the shape of the looming problem with assessments is clear, the cure is less so. Bringing the OTS and OCC under the appropriations process is, in my view, highly ill advised. The problem with appropriating supervisory resources is evident at OFHEO, the safety-and-soundness regulator for Fannie Mae and Freddie Mac. Due to budget and other pressures, Congress consistently appropriates less for OFHEO than the agency requests, giving it far fewer resources with which to supervise its charges than is the case at the OCC and OTS for institutions of comparable size.
The OCC has suggested that the premiums paid by national banks and federal savings associations to the FDIC be used also to pay for bank supervision, as is the case for state non-member banks. Doing so would ensure that the FDIC uses its resources wisely, while eliminating an obvious inequity between the federal and state charters. However, it is very difficult to identify precisely which portion of the FDIC’s premiums should be subtracted to compensate federally-chartered institutions. Further, doing so could reduce the resources available to absorb losses to the deposit insurance funds, increasing the prospect of rapid increases in industry-wide premiums or even, under extreme circumstances, taxpayer assistance. Finally, calibrating the amount repatriated to federal supervisors would become far more difficult when truly risk-based premiums are instituted.
In light of these concerns, I recommend that:
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