Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
December 7, 1990
How to Close Troubled Banks
The Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA) commissioned a joint
task force of government agencies to prepare
recommendations for reforming the deposit insur-
ance system. Banking industry observers eagerly
await the results of this study, scheduled for re-
lease early next year. Major reforms are needed
to prevent a recurrence of the problems recently
suffered by the thrift industry.
Deposit insurance reform is not, however, the
only element of bank regulation that demands
attention. Another is the process of closing trou-
bled banks. It is simple to suggest that bank
supervisors treat an insolvent bank like any other
bankrupt firm, and close it immediately upon
insolvency. In reality, supervisory practice and
industry accounting standards have prevented
timely closure.
In this Letter, I describe current procedures for
resolving problems at troubled banks, and sug-
gest that a tightening of procedures can go a long
way toward promptly closing insolvent banks.
Supervisory practice
The current procedure for resolving bank
insolvencies relies to a great extent on the
discretion of bank supervisors at the Office
of the Comptroller of the Currency, the Federal
Deposit Insurance Corporation (FDIC), the Fed-
eral Reserve System, and state banking com-
missions. Perhaps the best way to describe this
process is one of progressive discipline and
orderly resolution.
A crucial component of the process is the
regularly scheduled bank examination. The
supervising agency examines banks, and
the examiners pass judgment on both general
and specific aspects of a bank's condition. The
primary evaluation criterion is the bank's com-
posite CAMEL rating, a confidential figure cur-
rently disclosed only to bank management.
Examiners derive this rating from assessments
of the Capital adequacy of the bank, its Asset
quality, the strength of its Management, its
Earnings, and its Liquidity.
Supervisors consider banks with composite
CAMEL ratings of 1or 2 to be in good con-
dition, and generally allow them to operate
without restriction. A rating of 3 indicates that
a bank is weaker than desired and deficient
in some areas covered by the rating process.
CAMEL ratings of 4 or 5 indicate that a bank
suffers significant problems and may be a
candidate for insolvency.
Although the CAMEL rating includes an
assessment of bank capital, there is some inter-
play between required capital ratios and the
composite CAMEL rating. Capital represents the
funds invested in the bank by its owners. These
funds act as a buffer to shield the bank from
losses in asset values. Capital ratios are these
invested funds relative to the total assets of
the bank.
All banks must satisfy a system of minimum
capital requirements, which includes the inter-
national risk-based capital standards. Above
these minimum levels, however, regulators may
exercise some discretion regarding how much
capital a bank should hold. Regulators may thus
permit banks with strong composite CAMEL rat-
ings to hold less capital than banks with lower
CAMEL ratings.
In addition to the CAMEL rating, bank examiners
consider the quality of a bank's loan portfolio by
examining individual loans. During this process,
they may categorize loans as "substandard" or
"doubtful" depending on the expected ability of
borrowers to make scheduled interest payments
and repay principal. For loans in these catego-
ries, bank examiners may require management
to add to loan loss reserves and thus provide for
potential future loan losses. Bankers generally
take these loan loss provisions from the current
net income ofthe bank or, if income were not
sufficient, directly from bank capital.
Examiners may require a bank to "charge off"
loans that are particularly bad and face little
chance of repayment. That is, they require the
bank to recognize the losses. The bank wouldFRBSF
charge the losses against its loan loss reserves,
or against capital if reserves were insufficient.
Progressive discipline
A bank whose CAMEL rating declines or whose
capital position deteriorates is increasingly likely
to face restrictions on its activities. in general, the
restrictions become more severe the worse off the
bank. The supervising agent chooses the appro-
priate restrictions on a case-by-case basis.
One example of an early restriction is a demand
to report more frequently on the condition of the
bank. Supervisors may reduce the interval be-
tween examinations, artCl may require bank man-
agement to provide specific information relevant
to the perceived problem areas. These require-
ments improve the flow of information about the
troubled bank, and may enable supervisors to
intervene quickly should problems worsen.
Supervisors will give a "capital call" to a bank
they consider to have insufficient capital. The
bank must then submit a plan describing how it
will raise new funds to meet capital standards.
Supervisors prescribe an amount of time for the
bank to raise needed funds and, thus, to satisfy
capital requirements.
If a bank were unable to raise additional
capital, or if its condition were to deteriorate
further, supervisors could impose increasingly
severe limitations on its management's latitude.
These limitations appear in documents such as
"memoranda of understanding;' "written agree-
ments;' and "cease and desist orders." Among
other things, these directives may restrict the
amount of dividends the bank can pay, reduce
its freedom to attract new insured liabilities, or
induce it to tighten loan standards. The intent
of these restrictions is to curtail the risk-taking
behavior ofthe bank, and thus to protect the
deposit insurance fund from further potential
losses.
Orderly resolution
As the capital, and therefore the net worth, of
a bank approaches zero, supervisors may deter-
mine that the bank is no longer "viable:' They
may then subject the bank to more direct inter-
vention. In the typical procedure, supervisors
appoint a conservator (usually the FDIC) to re-
place the bank's management and assume the
daily operations ofthe bank. Supervisors can
officially declare a bank with zero net worth
to be bankrupt, and appoint a receiver (again,
usually the FDIC) to dispose of it.
Since the imposition of conservatorship or
receivership is an extreme step, supervisors
must presume that the bank is too far gone to
have any reasonable prospect for recovery. The
goal of the conservator or receiver, therefore, is
to provide an orderly "resolution" of the bank.
A frequently used resolution procedure is a "pur-
chase and assumption" (P&A) transaction, in
which a solvent bank purchases the loans and
other assets of the failing bank and assumes its
deposit liabilities. The FDiC must provide in-
ducements to attract purchasers in cases where
failed banks have negative market-value net
worth. The majority of the FDIC's transactions
during the past several years have been such
"assisted" transactions. Other types of assisted
transactions include "bridge banks" and
"modified payoffs:'
Alternatively, bank supervisors may decide that
a P&A transaction is not feasible and may instead
choose to liquidate the bank. That is, they dis-
solve the bank and sell its assets with the inten-
tion of recovering as much of the original asset
value as possible. The supervisors use the funds
from this sale to payoff insured depositors. In
general, the deposit insurer would make up any
shortfall of assets relative to insured liabilities.
Problems with current practice
Supervisors intend the techniques described
above to minimize the disruptive effects of a
bank insolvency and, at the same time, minimize
the costs to the deposit insurer from the closure.
To limit the exposure of the insurer, supervisors
should base progressive intervention and orderly
resolution on a bank's market-value net worth.
in this way, the deposit insurer can minimize
the losses inherent in assisted transactions or
liquidations.
in practice, the intervention process has
deviated from this ideal in a number of ways.
First, there are lags in recognizing and identify-
ing problem loans. Economic conditions may
change abruptly, leading to rapid deterioration in
the credit quality of a bank's loan portfolio. Since
bank exams normally take place at most only
once a year, problems can develop before bank
supervisors have a chance to tag them for
supervisory action.
Second, regulations set bank capital require-
ments on a book-value basis, not on a current
or market-value basis. However, book-valuecapital ratios may not accurately reflect the cur-
rent, potential burden imposed on the deposit
insurer by troubled banks. Such inaccuracies
may permit institutions to continue operating
despite market-value insolvency. Although prob-
lems may exist in implementing market-value
accounting for banks, a sole reliance on book-
value capital standards may not adequately
shield the insurance fund from loss.
Finally, a discretionary intervention process
leaves open the possibility that supervisory
incentives will mitigate against closing troubled
institutions. For example, economist Edward
Kane has suggested that perverse regulatory
incentives contributed to the thrift crisis because
closing already insolvent S&Ls would only high-
light the regulators' failure to act earlier. To Kane,
and others, regulatory discretion means regula-
tory forbearance.
Some observers counter this argument by sug-
gesting that concerns about systemic risk in the
financial markets requires supervisory flexibility
in responding to troubled institutions. Moreover,
they claim that bank supervisory and regulatory
practices are based on the presumption that
supervisors will not forbear. Despite these argu-
ments, a supervisory policy based on discretion
opens the door to possible forbearance.
Evolution, not revolution
Because current procedures for intervening in
and resolving troubled banks have not success-
fully sheltered the deposit insurance fund from
losses, some critics have suggested a complete
overhaul of the banking system. Less extreme
measures, however, may achieve the same result.
First, supervisors could initiate progressive
disciplinary procedures at higher capital levels.
Such intervention would reduce the adverse ef-
fects on the insurance fund of lags in recognizing
and identifying the problems in bank portfolios.
More capital would then exist to buffer the fund
against losses. In addition, higher capital require-
ments would reduce the incentive for banks to
take extra risk in the first place.
Second, although it may not be practical for
banks to increase the frequency of reporting,
they can improve the content of data provided.
The goal here is to provide the information ne-
cessary to identify problematic assets before
they become actual problems. In this context,
supervisors could require banks to make market-
value adjustments to the book values of their
assets and liabilities, including adjustments for
losses resulting from changes in interest rates.
For example, long-term, fixed-rate assets (such as
fixed-rate mortgages or long-term bonds) suffer
losses in value when market interest rates rise.
These interest rate increases reduce the market
value of the bank. Data reported to supervisors
should reflect the reduction. In this way, it may
be possible to identify those banks most likely
to be affected by a regional economic downturn
or real estate slump.
In addition to identifying the market values of
assets and liabilities, supervisors could require
true market-value capital standards. Market-
value capital ratios provide a better measure of
the net worth of banks. Moreover, a bank would
be less able to disguise its true net worth from
supervisors when market-value capital ratios
trigger intervention and resolution procedures.
Finally, while bank supervisors do not willingly
keep insolvent banks open, reform efforts should
probably include curtailing the scope of regula-
tory discretion to prevent any moves toward
forbearance. Reform could provide for an auto-
matic triggering of progressive intervention by,
for example, a drop in capital or a declining
CAMEL rating. Similarly, new regulations could
allow supervisors to place any bank that fell be-
low some minimum market-value capital ratio
(preferpble greater than zero) into immediate
conservatorship. Reform efforts also should
probably limit regulatory discretion to making
standards tighter rather than looser.
The changes outlined above are not as radical
as some other proposals for reforming the bank-
ing system. As suggested, incremental changes
to the current supervisory structure and practices
may be quite effective in preserving the integrity
of the deposit insurance fund.
Jonathan A. Neuberger
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
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How to close troubled banks

http://www.frbsf.org/publications/economics/letter/1990/el90-49.pdf

How to close troubled banks

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Research Papers in Economics