Although regulators often  identified these risky practices early on in each crisis, the regulatory  process was not always effective in correcting the underlying problems  before the banks became undercapitalized and failed. They found that generally, examiners  had identified the underlying issues that eventually led to the failures but  did not press management hard enough to deal with those issues. Past Crises Revealed Limitations in Existing Tools for Monitoring and Addressing Emerging Risks

			PCA Reliance on Capital Triggers Limited Its Effectiveness

As discussed earlier, in the aftermath of the thrift and commercial bank  crises regulators were criticized for failing to take timely and forceful  action to address the causes of thrift and bank failures and prevent losses  to taxpayers and the deposit insurance fund. However, in prior crises, regulators did not always assign management  component ratings that were reflective of weaknesses in management,  and staff from one regulator said that there was a tendency to use the  rating more as a point in-time snapshot of a bank’s condition, rather than  a reflection of long-term risk factors that may cause losses several years  later. Bank Supervision Did Not Consider the Impact of Risks from the Broader Financial System on Banks

The financial crisis also highlighted the need for regulators to consider the  impact of risks in the broader financial system on individual banks. Regulators Have Taken Steps Intended to Improve Their Ability to Identify and Respond to Emerging Risks

Federal banking regulators have taken steps to incorporate the lessons  learned from the 2007-2009 financial crisis and improve their ability to  identify and respond to emerging risks. As such, they have been working to include more  forward-looking elements into examinations, such as bank-performed  stress test processes and results, and to reflect such forward-looking  information in the CAMELS ratings and other risk assessment tools. We and others have begun to review some of  these regulatory initiatives, but further work is needed to fully evaluate  their effectiveness in improving regulators’ ability to identify and respond  to emerging risks in a timely manner. Framework for Monitoring Regulatory Efforts Could Identify Issues Requiring Additional Attention

Ongoing monitoring of banking regulators’ efforts to identify and respond  to emerging threats to the banking system can provide a starting point for  identifying opportunities for more targeted and frequent assessments of  these efforts. Bank Financial Condition

The framework includes financial indicators that reflect bank condition  and performance that can provide insight into emerging risks at banks  (and bank holding companies, in the case of the largest SIFIs), such as  credit risk, liquidity risk, and market risk. In monitoring regulatory responses to emerging risks, it is important to  identify the full range of tools regulators might employ to address such  risks, the goals of these tools, and their potential tradeoffs. Once the crisis began, and banks began suffering losses, the level of  informal and formal enforcement actions surged as did the number of  problem banks and failed banks. The 2013 OCC peer review noted that delays in the issuance of guidance  or regulation to address emerging risks can be demoralizing for  examiners who may perceive that agency management has not acted on  their risk identification and warnings.guidance or regulation, users of the framework would monitor quantitative  and qualitative sources for trend information on the identified problem  area for evidence that risk was increasing, flagging potentially harmful  delays in regulatory action for further follow up. Lessons learned from past banking-related crises identified the need for  federal banking regulators to respond proactively to problems developing  in the banking system. This report (1)  examines regulatory lessons learned from the 1980s thrift and  commercial bank crises and the 2007-2009 financial crisis, focusing on  the efforts of federal banking regulators to identify and address emerging  risks to the solvency of insured banks before the onset of these crises;  and (2) offers a strategy that we and other oversight bodies, such as  inspectors general (IGs) and the international auditing community  (hereafter, oversight bodies) can use to provide continuous future  oversight of regulatory responses to emerging risks. To identify regulatory lessons learned from the crises we reviewed and  analyzed studies by GAO, federal banking regulator IGs, the federal  banking regulators, and academics. To incorporate the regulatory lessons learned into a strategy that  oversight bodies and others can use to monitor regulatory responses to  emerging risks, we established a framework for monitoring (1) known  emerging risks to the safety and soundness of the banking system, and  (2) regulatory responses to these risks, including detecting trends in  regulatory responses that might signal a weakening of regulatory  oversight.
Why GAO Did This Study

Weakness in federal oversight was one of many factors that contributed to the size of federal losses and the number of bank failures in banking-related crises over the past 35 years—including the 1980s thrift and commercial bank crises and the 2007–2009 financial crisis. Resolving the failures of banks and thrifts due to these crises resulted in estimated costs to federal bank and thrift insurance funds over $165 billion, as well as other federal government costs, such as taxpayer-funded assistance during the financial crises.
Ongoing monitoring of banking regulators' efforts to identify and respond to emerging threats to the banking system can provide a starting point for identifying opportunities for more targeted and frequent assessments of these efforts. This report (1) discusses regulatory lessons learned from these past crises and (2) offers a framework that GAO and other oversight bodies, such as inspectors general, can use to provide continuous future oversight of regulatory responses to emerging risks.
To do this work, GAO reviewed its prior studies and those of federal banking regulators, the regulators' inspectors general, and academics that evaluated regulators' efforts to identify and respond to risks that led to bank failures in past crises. In developing an oversight framework, GAO reviewed frameworks for monitoring domestic and global financial systems to identify key areas in which risks to banks can arise. GAO interviewed regulators to identify supervisory actions that can be used to respond to emerging risks.

What GAO Found

Past banking-related crises highlight a number of regulatory lessons learned. These include the importance of
Early and forceful action. GAO's past work on failed banks found that regulators frequently identified weak management practices that involved the banks in higher-risk activities early on in each crisis, before banks began experiencing declines in capital. However, regulators were not always effective in directing bank management to address underlying problems before bank capital began to decline and it was often too late to avoid failure. For example, examiners did not always press bank management to address problems promptly or issue timely enforcement actions.
Forward-looking assessments of risk. The crises revealed limitations in key supervisory tools for monitoring and addressing emerging risks. During examinations, examiners did not always incorporate forward-looking information when assigning supervisory ratings based on banks' exposure to risk. For example, ratings did not consistently reflect factors such as poor risk-management practices that while not causing losses in the short term, caused losses in the long term.
Considering risks from the broader financial system. The 2007–2009 financial crisis demonstrated that risks to bank safety and soundness could not be assessed by looking only at the performance and activities of individual banks or groups of banks. Rather, regulators must look across the financial system to identify emerging risks.
In response to these lessons learned, regulators said they have taken a number of steps intended to improve their ability to identify and respond to emerging risks—including instituting more granular tracking of bank compliance with examination recommendations to address emerging problems in a timely manner; incorporating more forward-looking elements into supervisory tools; and participating in systemic risk-monitoring efforts as members of Financial Stability Oversight Council. GAO and others have begun to review some of these initiatives.
GAO has incorporated the regulatory lessons learned into a two-part framework for monitoring regulators' efforts to identify and respond to emerging risks to the banking system. First, the framework incorporates quantitative information in the form of financial indicators that can help users of the framework track and analyze emerging risks and qualitative sources of information on emerging risks—such as regulatory reports and industry and academic studies. Second, the framework monitors regulatory responses to emerging risks, such as agency guidance, with the goal of flagging issues for further review when questions arise about the effectiveness of these responses. Users—oversight bodies such as inspectors general—can analyze regulatory actions taken to address emerging risks and gain insights into regulators' ability to take forceful actions to address problematic behavior at banks. Such ongoing monitoring can provide a starting point for identifying opportunities for more targeted and frequent assessments of these efforts. GAO plans to implement this framework in its future work.