After much political hand-wringing, Congress finally passed a "narrow" banking bill to recapitalize the Federal Deposit Insurance Corp. and implement a variety of other regulatory reforms.

Many of these reforms represent compromises on long-debated issues - such as "too big to fail" and risk-based deposit insurance premiums.

Other measures found their way into final legislation without adequate consideration of possible consequences. Apparently, Congress assumed that they were good ideas with which no one could quarrel.

"Early intervention" provisions of the banking bill direct the bank regulators to take prompt corrective actions against undercapitalized depository institutions.

Powerful Tool Added to Kit

Notwithstanding the warnings voiced by responsible persons in the banking industry, early intervention is a very powerful tool that is now available to the regulatory agencies. Unfortunately, early intervention continues to be a dangerous idea whose time has not come.

At first gloss, many may wonder why anyone would question the wisdom of early intervention.

After all, one supported reason why the banking industry is in such trouble is the laxity in regulation of troubled financial institutions. The banking agencies are also purportedly unwilling to intervene early enough to correct problems before they lead to an institution's failure.

The obvious solution is to force agencies to intervene earlier in marginal institutions. This supposedly would prevent failures, or at least reduce their overall costs to the federal deposit insurance funds.

A good idean in principle, it is much less appealing in reality. As others have pointed out, early intervention requirements in the final bank reform package will reduce regulatory flexibility in dealing with problem institutions. It will also reduce business alternatives for failing institutions.

Even worse, early intervention will create many instantly insolvent banks and thrifts. The costs will fall directly on the FDIC and Resolution Trust Corp. and, ultimately, the rest of us.

Recipe for Instant Insolvency

Early intervention provisions in the bank reform legislation may well prove the truth of the old saying: The road to hell is paved with good intentions. They may well do for commercial banking what the 1986 Tax Reform Act did for commercial real estate - cripple it.

Too little thought has been given to another class of persons who may have strong reasons to avoid the banking industry altogether as a result of these early intervention provisions: investors in financial institutions.

If reform legislation hopes to increase investor confidence in the banking industry, and thus attract desperately needed capital to banking institutions, the early intervention provisions could hardly be more counter-productive.

Hierarchical Classifications

To understand why, look at how early intervention will work. Depository institutions will be classified according to a five-tier capital-dependent hierarchy.

Institutions at the top of the hierarchy will be well (or adequately) capitalized. They will generally exceed or meet all relevant regulatory capital requirements.

On the other end of the hierarchy, the legislation defines broad classes of depository institutions as undercapitalized. They generally would include banks that are close to insolvency or out of compliance with all their regulatory capital requirements. Also included are institutions that are out of compliance with only one of the applicable regulatory capital standards.

At the bottom of the hierarchy, of course, would be institutions that are capital-deficient and fail to comply with all the relevant regulatory capital standards.

'Critical Capital Level'

The legislation establishes a "critical capital level" for these depository institutions. For banks below the critical level, regulatory agencies are required to take drastic actions, which may include placing a depository institution into conservatorship or receivership.

In some ways, these regulatory reforms seem eminently reasonable and necessary in today's environment. Who can quarrel with the notion that undercapitalized depository institutions - including those teetering at the brink of insolvency - require extra regulatory attention and perhaps early regulatory intervention?

Whether this notion is a good idea in practice, however, depends on two questions:

* At what point does a depository institution's capital reach "critical levels?"

* What must you do with those institutions once they reach the "critical capital" level"

It is here that the early intervention requirements may work their mischief. The banking bill states that the "critical capital level" must include depository institutions with a tangible-equity-to-total-assets ratio of less than positive 2%.

For institutions that are unlucky enough to fall into this category, the new legislation will require bank regulatory agencies to take specific actions.

Restricting Risk

Any responsible regulatory agency would want to consider some of these actions: for example, restricting excessive compensation to executives, encouraging the institution to raise additional capital, restricting "risky" activities, and replacing the institution's board of directors.

But other actions now include limitations on payment of subordinated debt. And the institution must be placed into conservatorship or receivership unless the agency affirmatively determines otherwise.

Banks and thrifts with a positive net worth of 2% may be no better off, from the regulator's perspective - and more importantly, from the investor's perspective - than banks and thrifts with no capital at all.

How will the "average" financial institutions investor perceive these changes? Unfortunately, the early intervention provisions of the bank reform legislation may, at a minimum, significantly discourage serious investors from putting capital into undercapitalized depository institutions.

At worst, they may bar the capital markets altogether to those institutions that are most in need of raising capital. This would hasten these institutions' demise and their resulting burden on the federal deposit insurance system.

Under early intervention, it will be difficult for investors to ignore the fact that a bank capitalized at a 2% level is subject to immediate regulatory seizure.

The regulatory agencies may have some discretion not to seize a particular institution, if the circumstances permit and the agencies are courageous enough to suffer the political and regulatory consequences of nonseizure. But this will be of small comfort to investors seeking to quantify and limit their level of risk.

Nor is it of any real value to risk-averse investors that there may be legal (and constitutional) bases upon which to challenge regulatory actions under these provisions.

Worse, the early intervention provisions make no allowances for the preservation of shareholder equity. And, certainly, they can provide no assurances of this preservation.

When a bank or thrift is seized, the FDIC (or the RTC) currently forces the equity holders to bear the losses through the elimination of shareholder value.

Shareholder, Beware!

Under current practice, the issue of shareholder equity in an insolvent institution is largely academic.

With early intervention, however, this academic issue assumes an entirely new dimension: The regulators will be able to seize an institution even where significant shareholder value remains.

The "equity loss" problem is exacerbated by the usual balance sheet consequences of a conservatorship or receivership. The market value of many of the seized institution's assets diminishes significantly, solely as a result of government action.

For example, a $2 billion banking institution with an equity capital base of 2% to total assets will have a $40 million equity net worth.

Under early intervention, that net worth will be subject to regulatory expropriation. This could happen if the principal regulatory agency determines that it is required to take the actions required under the early intervention provisions of the legislation.

Shave and Haircut

And when the institution is seized, the conservator or receiver may have to take a significant "haircut" on the market value of many of the assets. This haircut will come right off the top - from shareholders' equity.

Matters will be compounded by the restrictions on payment of subordinated debt that would apply to the weakest undercapitalized institutions (generally those on the lowest tier).

These restrictions will permit the bank regulatory agencies, by regulatory fiat, to deprive subordinated debtholders of the lawful benefits of the bargain they struck when they contributed capital to a depository institution. This applies even to contributions made while the institution is still solvent.

Undercapitalized institutions generally would be restricted in their ability to make "capital distributions."

Standing by themselves, some of these restrictions may be reasonable. But viewed in the larger context of early intervention, they only promise more bad news for bank investors.

Powerful Inhibitions

These provisions will have a powerful inhibiting effect on potential sources of capital for troubled depository institutions. The harm will be precisely to thos institutions most in need of outside capital.

Early intervention will place financial institutions in the remarkable, unenviable class of corporate investment that the government can take away from its owners - when it still has equity value.

For many responsible investors, either individuals or institutions, this level of risk will be flatly unacceptable.

In the laternative, the returns that investors will demand as a price for investment in a marginal financial institution may be pushed up until its capital-raising costs increase beyond the level of acceptability.

As with most other forms of investment, a risk-reward "yield curve" is used to grade investment in financial institutions: The greater the risk of a particular investment, the more substantial the reward must be for a potential invetor.

Under early intervention, the risk-reward yield curve for financial institutions investments will experience an immediate upward shift of 200 basis points.

Distasteful for Investors

Early intervention creates conditions that may strongly discourage potential sources of bank capital.

These conditions will apply even if there is no catastrophic drying up of capital as a result of early intervention. Many potential investors will view these provisions with distaste, if not alarm, and seek to redirect their capital elsewhere.

After all, there are clearly much safer and more secure uses of capital - given the returns that could be expected - than banking institutions which can be liquidated by the regulators even when they have a significant positive net worth.

Further, the regulatory discretion and delayed effective dates built into the new early intervention provisions are not likely to change the perceptions of investors who are willing to take risks only if risks are informed and quantifiable.

As a result of early intervention, we now run the risk of ending up with a class of equity-solvent depository institutions that will have no access to the capital markets in the absence of costly FDIC assistance or guarantees.

In addition, we may have created a whole new class of depository institutions - those with regulatory capital slightly over 2% - for which the investment rewards will no longer outweigh the risks.

These same institutions are already having difficulty raising capital. Thanks to the legislation, capital formation may now become impossible.

Holdings Bound for the Dump

What of current investors in bank and thrift stocks? Is it far-fetched, in today's regulatory environment, to believe that shareholders of a financial institution with tangible capital of 2.25% will seek to dump their holdings rather than take their chances with the regulators? As a result of Congress' actions, it is now up to the bank regulatory agencies to take a close, hard look at early intervention. They must determine how the purported benefits which these provisions create can be implemented without unnecessary harm to the capital markets for financial institutions.

In the one-year period before early intervention becomes effective, the FDIC and the other bank regulatory agencies must develop a regulatory system capable of persuading investors that their capital will not be taken away from them before the insolvency of a depository institution is likely.

Quick Action Gets the Prize

Given the enormous political pressures in this regulatory environment for regulatory agencies to be "prompt" in their corrective actions, this will not be an easy task.

The bank regulatory agencies must do more than justify their decisions not to intervene early in specific cases. Their decisions, in most cases, will be subject to review by the inspectors general of each of the agencies and audit by GAO.

Hence, the agencies, unfortunately, will have little political incentive not to act early.

But it would be well for them to find the will to resist precipitous aceion: The last thing we need at this time is creation of an "untouchable" caste of depository institutions.

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