The government continues to impose new rules designed to avoid a repeat of the financial crisis. Yet we still haven't repaired the flaws of an earlier policy that followed the previous savings and loan debacle in the 1980s and '90s. That policy, known as “prompt corrective action,” ultimately did nothing to prevent the 2008 meltdown.
Unfortunately, even though the Government Accountability Office has recommended overhauling PCA, regulators have halted any changes. The position of the government is that new regulations such as those mandated in the 2010 Dodd-Frank Act and under the Basel Committee accords should be given time to take effect before PCA is revisited. But further delay means a necessary revamp could come too late.
PCA was a key component of the Federal Deposit Insurance Corporation Improvement Act of 1991. It created five buckets of relative capital strength, mandating that regulators must intervene with remedial measures on a bank's management once an institution's capital had reached the lowest PCA thresholds, either to prevent it from becoming insolvent or to limit the effect on the Deposit Insurance Fund should it fail. PCA requires that bank regulators impose rehabilitative measures on banks well before they become insolvent, and to resolve weak institutions within 90 days of reaching critically undercapitalized status. By closing banks while they still have positive capital, PCA was supposed to limit Deposit Insurance Fund losses.
But PCA did not live up to expectations in the first big crisis since its creation. Since 2008, more than 400 banks have failed and cost nearly $50 billion in Deposit Insurance Fund losses. Numerous forensic studies of the financial crisis have concluded that PCA not only failed to rehabilitate troubled banks in the real estate crash, it also resulted in a higher average failed-bank loss rate compared with pre-PCA-era bank failures.
Congress should reform PCA sooner rather than later. A relatively simple way to do that is to make PCA triggers more forward-looking. Right now, the ratios used to determine when regulators intervene can reveal that a bank's capital is depleted after the point when there is enough time for the institution to right itself. During the financial crisis, some banks failed just as their PCA orders were being issued publicly.
But despite the obvious need for reform, the Financial Stability Oversight Council has taken exception to the GAO's findings, saying the performance of recent Dodd-Frank and Basel III reforms need time to be evaluated. If we take the FSOC's recommendation seriously, we must wait to evaluate PCA performance until after the next financial crisis.
While it is true that post-crisis reforms have modified PCA, none of the changes has addressed PCA's primary weakness. All current PCA intervention thresholds are driven by regulatory definitions of bank capital that are lagging indicators of a bank's true solvency position. By the time troubled banks trip PCA early-warning thresholds, many are already insolvent.
Far simpler PCA monitoring ratios are available that accurately reflect changing bank solvency conditions in a timely manner.
Among the most promising proposed reforms is to replace PCA capital ratios with a bank's nonperforming-asset coverage ratio. The nonperforming asset coverage ratio assumes that a certain percentage of a bank's past due loans, leases and repossessed real estate will generate losses in a liquidation. It compares a simple estimate of nonperforming asset losses with a simple measure of the bank's capacity to absorb these losses, and expresses the difference as a positive (or negative) percentage of bank assets. The nonperforming asset coverage ratio is a “rule of thumb” that has long been used by bank regulators across the globe to get quick estimate of a bank's solvency position. It is closely related to the “Texas ratio” solvency measure favored by some bank analysts.
Academic research has shown that the nonperforming-asset coverage ratio identifies failing institutions long before the regulatory capital ratios used in PCA. Moreover, simulation studies suggest that a PCA bank closure rule triggered by a minimum nonperforming-asset coverage ratio will significantly reduce Deposit Insurance Fund losses. For example, one academic study suggests that, in the prior financial crisis, if institutions had been closed within 90 days after their nonperforming-asset coverage ratios fell below 2%, Deposit Insurance Fund losses would have been reduced by more than 25%.
There is ample evidence from multiple credible sources that shows that the current complex system of prompt corrective action rules has not worked. The current rules can be dramatically simplified while improving PCA performance. If the goals of PCA are in the public's interest, there is a strong case for reform. If there is no public support for PCA reform, the regulation should be abolished because the current rule clearly does not work.
Paul H. Kupiec is a resident scholar at the American Enterprise Institute. He has also been a director of the Center for Financial Research at the Federal Deposit Insurance Corp. and chairman of the research task force of the Basel Committee on Banking Supervision.
Corrected February 11, 2016 at 2:30PM: This was adapted from a longer policy paper about prompt corrective action.