WASHINGTON - The Office of the Comptroller of the Currency should have been more aggressive in its supervision of First National Bank of Keystone, which failed last year at an estimated cost to the Bank Insurance Fund of $750 to $850 million, according to a report issued Monday by the Treasury Department.

"The supervisory history of Keystone points to a potential fundamental weakness in the OCC's examination process," the Treasury's Office of the Inspector General found.

In careful language short of an outright indictment, the report found that the agency's examiners may have placed too much emphasis on the bank's own audited financial statements, and that exam procedures may be insufficient to detect fraud.

Exams performed between 1992 and 1999 "repeatedly uncovered unsafe and unsound banking practices and regulatory violations." Yet OCC enforcement actions were "largely ineffective" in fixing the bank's problems.

"Alleged fraudulent accounting practices, uncooperative bank management, and reported high profitability may have all served to mask the bank's true financial condition from OCC examiners," according to the 51-page report. "Despite this, indicators existed throughout the period that may have dictated a more aggressive supervisory response from the OCC."

Keystone of Keystone, W.Va., was a $107 million-asset bank in 1992, but it grew to $1.1 billion by last year. The OCC declared the bank insolvent on Sept. 1 after discovering that management could not account for $515 million in loans. It appears the loans were sold, but the bank did not record the sales. Federal law enforcement agencies are investigating the failure for possible prosecutions.

Keystone's rapid growth was fueled by underwriting and then securitizing subprime loans. The decision to close the bank was made after the OCC attempted to independently verify Keystone's assets by contacting loan servicing companies. But the inspector general concluded that "earlier verification [of the loans] appeared warranted, possibly as early as 1997."

The presence of fraud may have made detection of the fake loans difficult, and earlier intervention might not have made much difference to the eventual loss to the insurance fund, the report said.

The Office of the Inspector General issued seven recommendations for improving the OCC's supervisory process.

The OCC should require examiners to perform a risk assessment of a bank's financial accounting, reporting, and controls. And a set of indicators to warn examiners that they should not trust a bank's external audited financial statements should be developed.

The report also recommended that the agency develop clearer standards on what it means for a bank to be in "full compliance," and set a maximum time limit for achieving it after an enforcement action is instituted. The agency should reassess the usefulness of repeated informal enforcement actions in the face of repeated violations of the same rule.

The report asked the OCC to examine the failure of Keystone in general, and decide whether it indicates the need for broader regulatory response to banks that engage in high-risk strategies to grow quickly. Comptroller John D. Hawke Jr. agreed with the report's conclusions and said that the OCC had formed a committee of senior deputy comptrollers to review possible corrective action by the agency. "We fully concur with the report's conclusions that the OCC has important lessons to learn from this matter," Mr. Hawke wrote in a letter to Dennis S. Schindel, an assistant inspector general at the Treasury.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.