The regulators use formal actions to  address more severe deficiencies. Since the first quarter of 2007, the DIF balance  has decreased by about $57 billion. 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. 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. 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. 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. 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. 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. This option would add an additional risk element to the PCA  capital measures beyond the already existing risk-weighted asset  component. 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. Including another PCA trigger could also produce advantages and  disadvantages for regulators and banks. Conclusions

Before the current financial crisis, PCA was largely untested because the  financial condition of banks generally had been strong since PCA was  enacted. In turn,  PCA has not achieved a principal goal of preventing widespread losses to  the DIF when banks fail. 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. 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 written comments, FDIC, the Federal Reserve and OCC agreed with our  recommendation to consider options to make PCA more effective. 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. Specifically, we reviewed material loss reviews and other evaluation  reports available on 136 institutions that failed in 2008, 2009, and 2010. 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 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.
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.