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An oversight report Thursday called for changes to prompt corrective action, saying the process for regulating troubled banks has not prevented losses to the Deposit Insurance Fund.
June 23 -
International regulators worked hard, agreed in December to impose tough standards and then gave bankers eight years to meet them. But the reality is something much less concrete.
February 2 -
In a farewell speech Wednesday, Comptroller of the Currency John Dugan called on regulators to re-examine the prompt corrective action regime.
July 21
WASHINGTON — Bankers have found some cover in their argument that regulators are too hung up on capital.
A report last week by the Government Accountability Office sharply criticized "prompt corrective action" — a series of regulatory triggers based solely on capital levels — saying it failed to work during the financial crisis. The watchdog said the reliance on capital levels, which lags other indicators of a bank's health, did little to save troubled banks or contain their cost to the government.
"The prompt corrective action rules were maybe a good idea when they were adopted, but they haven't worked as well as the authors had hoped they would," said Sanford Brown, a managing partner at Bracewell & Giuliani LLP in Dallas. "The horse is already out of the barn and then they close the door."
But although many agree PCA needs repairs, the consensus stops there. Even regulators, for example, concur the system needs improvements, but still argue in favor of capital triggers.
Meanwhile, some observers argue PCA would be more effective if it gave the agencies more discretion, while others believe its problems come from regulators being too shy to use it.
"Even where capital was blinking red" in 2008 and 2009, "they didn't do what needed to be done," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc.
PCA, mandated among other legislative reforms in 1991, laid out recommended and required steps for regulators to take once a bank starts falling down the scale of categories from "well-capitalized" to "critically undercapitalized." The process culminates once a bank hits that "critical" level — when its tangible equity is just 2% of assets — and a countdown begins for it to find an immediate solution or be closed.
But the report said the system has been ineffective in the current prolonged wave of failures, with every failed bank that underwent PCA still causing losses to the Deposit Insurance Fund — losses that were similar to banks not entering PCA.
While signs such as asset problems or poor management emerged well before the failure, those indicators came in advance of the bank hitting the capital triggers, and the agencies were at times slow to apply pressure. GAO said regulators could develop other indicators besides capital, such as asset quality, or raise the capital triggers in each category so banks hit them faster.
"Without an additional early warning trigger, the regulators risk acting too late, thereby limiting their ability to minimize losses to the DIF," the report said.
Any fix to the warning system may ultimately be joined with the implementation of global capital reforms through the Basel committee. Under proposed Basel III requirements, all banks will have to hold 7% common equity by 2019, and face tougher requirements for what cons t itutes Tier 1 capital. The largest banks will also face a capital surcharge of between 1% to 2.5%.
In both the debate over fixing PCA, and higher capital levels at systemically-important firms, many in the industry argue capital is not a cure-all.
"The fixation on capital is myopic. You have to look at much more than capital if you are going to effectively supervise banks and prevent failure," said John Douglas, a former general counsel at the Federal Deposit Insurance Corp. and now a partner at Davis Polk & Wardwell. "This current furor over getting more capital in the banks is simply PCA on steroids. If a 5% capital ratio is not enough, maybe it should be 7% or 10% or 20%. That's one line of thinking. The other line is that there are other things we should be looking at - that those things are better predictors of a bank's health."
Petrou said that as so many new capital reforms move forward — such as the Basel III standards and a Dodd-Frank Act provision written by Sen. Susan Collins establishing an industry-wide capital floor — it makes sense to reform PCA as well.
"It's an embedded issue. Whether it's the Collins amendment rule or others, we have a lot of new rules riding atop a very old PCA framework," she said. "PCA was designed in 1991. The capital triggers predate" Basel II and Basel III "and efforts to change the capital structure."
Some say PCA's shortcomings are because many banks fail not from capital shortfalls, but liquidity problems.
"For hundreds of shops that had to close, PCA is very minor," said Stuart Stein, a partner at Hogan Lovells. "PCA is only focused on one particular piece: when an institution is severely undercapitalized. But it may have plenty of liquidity left to still operate. … As a practical matter, most banks are closed because of a lack of liquidity instead of a lack of capital."
Regulators agree with the need for improvements to PCA, but only to a point.
Sandra Thompson, the FDIC's director of risk management supervision, said in a letter to GAO that while "enhancements to PCA triggers should be considered," that should come in the form of strengthening the capital triggers, and other indicators "appear to have greater risk of unintended consequences" if used in PCA. The agencies should address the PCA capital triggers when they implement new Basel III reforms, Thompson said.
"Capital requirements are a universally applicable construct for banks of all sizes that directly affect their ability to absorb losses," she said.
Similarly, Patrick Parkison, the Federal Reserve Board's director of banking supervision, said in a letter that while the capital triggers are lagging and "PCA is not effective in preventing cost to the DIF," the warning system still has its benefits.
"The FRB still views PCA as a useful supervisory tool that empowers bank regulators to take actions on significantly nonviable banks in a consistent manner and provides a mechanism for ensuring such banks are closed or otherwise resolved within prompt timelines," he said.
Parkinson and others said one reason why PCA did not help more banks recover was because finding capital was difficult during the crisis.
"I don't think PCA ever envisioned a nationwide recession like we had," said Randy Dennis, the president of DD&F Consulting Group in Little Rock. "There was nobody to right the ship, to put money in the bank to restore capital. And the economy has not allowed" banks "to do anything earnings-wise to right the ship."
Dennis said one option for regulators is to conduct more regular monitoring between examinations so that a bank's capital decline is discovered earlier in the process.
"The volatility of the exams, and the way the economy is in certain parts of the country, take away any advantages you have," he said.
But Brown said PCA has demonstrated other weaknesses that have hurt institutions, rather than help them. For example, under the process, when an institution falls below "well-capitalized," it faces tough restrictions on its ability to take brokered deposits. But he said PCA should give regulators more discretion to allow brokered funds to improve a troubled bank's liquidity.
"That's one that causes in my experience more problems than it solves," Brown said. "It creates a potential liquidity crisis."
Other said the whole idea behind PCA was to discourage regulators from being too lenient with banks.
"The whole purpose was to take away the discretion of the regulators to exercise forbearance with respect to undercapitalized banks because that was viewed as one of the primary reasons the thrift and banking crisis of the 1980s got so bad," said Arthur Wilmarth, a professor at George Washington University.
