oversight

Bank Insurance Fund: Additional Reserves and Reforms Needed to Strengthen the Fund

Published by the Government Accountability Office on 1990-09-11.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                  1Juited States   General   Accounting   Office

GAO               Report to the Congress




                  BANK INSURANCE
                  FUND
                  Additional Reserves
                  and Reforms Needed
                  to Strengthen the Fund



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                                                                    142182




GAO /AFMD-W-100
*      United States
GA!0   General Accounting Office
       Washington, D.C. 20548

       Comptroller General
       of the United States

       B-l 14831

       September 11, 1990

       To the President of the Senateand the
       Speaker of the Houseof Representatives

       This report presents the results of our audit of the Bank Insurance Fund’s financial
       statements for the years ended December31,1989 and 1988. The Bank Insurance Fund is the
       insurer of deposits for the banking industry.
       The Bank Insurance Fund was formerly reported as the Federal Deposit Insurance
       Corporation (FDIC).Public Law 101-73,the Financial Institutions Reform, Recovery, and
       Enforcement Act of 1989 (FIRREA) created the Bank Insurance Fund as well as the Federal
       Savings and Loan Insurance Corporation Resolution Fund, which assumedmost of the assets,
       debts, obligations, and other liabilities of the dissolved Federal Savings and Loan Insurance
       Corporation, and the Savings Association Insurance Fund, a new fund for savings and loan
       associations.FIRRJSA transferred the assetsand liabilities of FDICto the Bank Insurance Fund
       and expanded FDIC’Soperations to include the administration of the three funds. FIRREA
       requires that FDIC maintain each fund separately and that we audit them annually. We will
       report separately on the financial condition of these funds.

       We found that the Fund is too thinly capitalized to deal with the potential for bank failures
       in the event of a recession.Such an event could exhaust the Fund and require a taxpayer
       bailout. Our report discussesthe serious problems facing the banking industry, the Fund’s
       ability to deal with the exposure it faces in the 1990s and our recommendationsfor needed
       reforms to strengthen the Fund.

       We are sending copies of this report to the Chairman of the Board of Directors, Federal
       Deposit Insurance Corporation; the Director of the Office of Managementand Budget; the
       Secretary of the Treasury; the Chairman of the Board of Governors of the Federal Reserve
       System; the Comptroller of the Currency; and the Chairmen of the SenateCommittee on
       Banking, Housing and Urban Affairs and the HouseCommittee on Banking, Finance and
       Urban Affairs.
       This report was prepared under the direction of Robert W. Gramling, Director, Corporate
       Financial Audits, who may be reached on (202) 276-9406 if you or your staff have any
       questions.




       dharles A. Bowsher
       Comptroller General
       of the United States
Executive Summq                                                                             .




                   This report presents GAO’S opinion on the Bank Insurance Fund’s
Purpose            December31, 1989 and 1988 financial statements as required by the
                   Financial Institutions Reform, Recovery, and Enforcement Act of 1989
                   (FIRREA). It includes other information and observations of importance to
                   the Congress,the administration, and the taxpayers in considering the
                   serious problems facing the banking industry and the Fund’s ability to
                   deal with the exposure it faces in the 1990s.

                   The Bank Insurance Fund insures deposits in about 13,200 commercial
Background         and savings banks and is administered by the Federal Deposit Insurance
                   Corporation (FDIC). Prior to 1989, the insurance entity reported as FDIC.
                   It was renamed the Bank Insurance Fund by FIRREA. FDIC operations also
                   include examining state-chartered banks that are not membersof the
                   Federal ReserveSystem, conducting liquidation activities for insured
                   banks that have failed, and providing and monitoring assistanceto
                   failed banks.
                   As the Fund’s administrator, FDIC provides financial assistanceto banks
                   in danger of failing. For failed banks, FDIC is appointed receiver, pays
                   the insured claims of the failed banks’ depositors or banks acquiring
                   those claims, and liquidates the remaining assetsof failed banks not
                   assumedby acquiring banks. The Fund’s operations are funded through
                   assessmentsfrom insured banks and certain other activities.

                   Not since it was born in the Great Depressionhas the federal system of
Results in Brief   deposit insurance for commercial banks faced such a period of danger as
                   it doestoday. The Bank Insurance Fund has resourcesto handle antici-
                   pated bank failures in 1990. However, a worst casescenario suggests
                   that over the next few years, low levels of reservescoupled with a
                   recessioncould lead to a level of bank failures that would exhaust the
                   Fund and require taxpayer assistance.
                   The leading causeof problems within the industry is the increasingly
                   risky nature of its loan portfolio, especially the growing levels of
                   nonperforming loans. Meanwhile, as of December31, 1989, the ratio of
                   the Fund balance to insured deposits stood at .7 percent, the lowest level
                   ever. GAO’S analysis shows that becauseof the likelihood of high levels
                   of lossesfrom future anticipated bank failures, the minimum Fund ratio
                   of reservesto deposits of 1.26 percent, set by FIRREA, is not likely to be
                   met by 1996. Even if this target could be met, Fund reservesmay still
                   prove inadequate to cover lossesin the event of a recession.


                   Page 2                                    GAO/AFMD-90-100Bank Insurance Fund
    Executive   Summary




    The Bank Insurance Fund ended 1989 with a net loss of $862 million,
    reducing its balance to $13.2 billion. GAO identified a total of 36 banks in
    such severefinancial condition that, without someform of recapitaliza-
    tion, they are likely to fail or require assistancewithin the next year.
    The failure of these banks would result in an estimated cost to the Fund
    of between $4 billion and $6 billion.

    GAO also identified a significant number of other banks that are at risk
    of failure within the next few years. A recessionwould exacerbatetheir
    problems and could lead to their failing, as well as the failure of other
    banks, threatening to deplete the Bank Insurance Fund.

    GAO'S analysis raises other   concerns,including
l   a potential liquidity problem for the Fund resulting from its $8 billion
    contingent liability for troubled assetsheld by acquirers of failed banks,
    someundetermined portions of which FDIC will be required to purchase
    in the future, and
l   the inability of the supervisory and examination processesto provide
    the early warning system neededto deal with troubled banks, specifi-
    cally (1) the inadequacy of regulator on-site examination coverage,
    (2) unrealistic asset appraisals resulting in overstated recoverable
    values, and (3) overly optimistic financial accounting and reporting by
    banks.

    In GAO'S opinion, the Fund’s December31, 1989 and 1988, financial
    statements are fairly presented in accordancewith generally accepted
    accounting principles. The estimated costsof $4 billion to $6 billion from
    the banks GAO believes are likely to fail in the near future unless recapi-
    talized do not meet the degreeof certainty for loss recognition estab-
    lished by accounting principles. Accordingly, these estimated costs are
    excluded from the Fund’s financial statements, GAO believes these
    accounting principles may unduly delay recognizing lossesthat could
    substantially reduce the Fund balance.




    Page3                                      GAO/AFMD-90.1OOBankIncwranceFund
                           Executive Summmy




GAO's Analysis

Financial Performance of   The performance of the commercial banking industry worsened in 1989
Commercial Banks Is        compared to 1988. The risks associatedwith the industry’s loan port-
                           folio and declines in certain regional economieshave led to significant
Declining                  growth in nonperforming assets,particularly real estate loans in the
                           Northeast. Also, large commercial banks are continuing to experience
                           losseson their portfolios of loans to less developed countries. These neg-
                           ative trends, which have been increasing the risk to the find over the
                           past few years, together with the potential for bank losseson loans
                           involving highly leveraged transactions, could lead to bank failures in
                           the 1990s and significant costs to the Bank Insurance Fund. (See
                           chapter 2.)


Many Banks in Danger of    While the number of banks on FLIIC’S problem list has declined from
Failing                    about 1,600 in 1987 to 1,100 in 1989, the number of problem institu-
                           tions, along with the level of exposure they represent to the Fund, is still
                           alarmingly high. GAO’S financial analysis of the 200 problem banks with
                           assetsover $100 million at December31,1989, as well as the nation’s
                           100 largest banks, disclosed36 institutions in such severefinancial con-
                           dition that without someform of recapitalization, they are likely to fail
                           or require regulatory assistancewithin the next year.
                           These 36 banks are located principally in the Northeast and Southwest
                           and have assetstotaling $46.1 billion. Basedon loss rates FDIC has his-
                           torically experienced on bank failures, GAO estimates that the failure of
                           these banks would result in a total cost to the Fund of $4 billion to
                           $6 billion. It is not possible to predict with certainty that each of these
                           banks will fail in the near future. However, GAO believes it is highly
                           likely that most of them will fail within a year.
                           GAO also identified a significant number of other banks that although
                           less troubled than the 36, are also at risk to fail within the next few
                           years, particularly if their regional economiescontinue to deteriorate. If
                           many of these troubled banks were to fall, the Fund could be signifi-
                           cantly impaired. A recessioncould exacerbatethis problem and result in
                           even more bank failures, which could deplete the Fund.




                           Page 4                                     GAO/AFMD-90.100Bank Inaurmce Fund
                             EmcudveSummary




Separate Asset Pools Are a   In assisting failed banks, FDICenters into agreementswith acquirers that
Liquidity Concern for the    in somecasesrequire FDICto later purchase the failed banks’ troubled
                             assetsfrom the separate assetpools which the acquirers are allowed to
Fund                         establish. As of December31,1989, the Fund was contingently liable for
                             about $8 billion of troubled assetsthat acquirers may pass back to FDIC.
                             If such transactions are not carefully monitored, they may pose a
                             liquidity problem for the Fund or overextend its resources.
                             In addition, unrealistically high appraisal values for these assetscould
                             mask lossesthat may be incurred when they are sold. FDICguidelines
                             require that assetsheld in separate assetpools be recorded and adjusted
                             basedon appraised values. GAO found indications that somerecorded
                             values for these assetshad overstated recoverable values due to unreal-
                             istic assumptions used by the appraisers. (Seechapter 4.)


Reliance on Bank Financial   Regulators’ efforts to strengthen both on-site and off-site monitoring
Reports May Hinder Early     systems are hindered by unreliable information in the quarterly reports
                             of financial condition that banks prepare for the regulators. GAO found
Warning of Problem Banks     instanceswhere the banks’ reports did not reflect their true financial
                             condition; their accuracy seemedto be dependent on whether there had
                             been a recent on-site examination by the bank regulators. GAO believes
                             that the effectiveness of off-site monitoring as an early warning of
                             potential bank problems may be limited by reliance on banks’ reports.
                             (Seechapter 3.)


Fund ReservesToo Low         The Bank Insurance Fund ended 1989 with a net loss of $862 million,
                             reducing the fund balance to $13.2 billion. The ratio of the Fund balance
                             to insured deposits stood at .7 percent-the lowest level ever-of its
                             reservesto insured deposits. FIRREA established assessmentrates that
                             FDICmay charge to increasethe Fund’s reservesand set a minimum 1.26
                             percent ratio of reservesto insured deposits to be achieved by 1996. It is
                             unlikely that the Fund will reach this minimum ratio without using
                             annual assessmentrates higher than those currently authorized by
                             FIRREA. (Seechapter 4.)



Fund ReserveLevel and        GAO identified two issuesfor further study. First, Bank Insurance Fund
Accounting Principles        reservesset at 1.26 percent of insured deposits may not be sufficient to
                             carry the Bank Insurance Fund through a recession.The risk levels asso-
Need Further Study           ciated with the industry’s loan portfolio have increasedover the past



                             Page5                                     GAO/AFMD-90-1OO?.hnkIneuranceFund
                                                                                            ,
                    Executive   Summary




                    decade.Becauselevels of bank equity capital have not changedcorre-
                    spondingly, the increasedportfolio risk is not cushionedby additional
                    capital. Therefore, the traditional level of Bank Insurance Fund reserves
                    may not be sufficient now. (Seechapter 2.)

                    The level of deposit insurance reservesnecessaryto reasonably protect
                    the taxpayer against lossesfrom bank failures in a recessionrequires
                    further study. It should be included in the deposit insurance reform
                    study required by FIRREA. GAO recognizesthat achieving a more adequate
                    Fund balance solely through premium assessmentsmay not be feasible.
                    Therefore, the study should include other meansof reducing the Fund’s
                    exposure, such as increasing capital levels in banks. (Seechapter 4.)
                    Second,study is required to determine the extent to which the applica-
                    tion of generally acceptedaccounting principles is hindering early
                    warning of the financial condition of troubled banks. Becausethe princi-
                    ples allow managementtoo much discretion, they may be unduly
                    delaying the recognition of lossesin the financial statements. Addition-
                    ally, basing an estimate of loss on the traditional fair value concept may
                    not be appropriate. The traditional concept determines values in a
                    market where the seller is under no compulsion to sell and has time to
                    negotiate a sale. Assets in troubled banks and nonperforming assetsin
                    any bank may have to be disposedof in a market when conditions may
                    require that the assetsbe disposedof in the near future. Both of these
                    concernswith the application of generally acceptedaccounting princi-
                    ples impact banks’ capital, the accurate determination of which is crit-
                    ical if the government’s interests as insurer are to be protected. GAO is
                    raising these questions to encouragethe accounting profession, regula-
                    tors, and others to begin to further define the problems and develop the
                    changesthat may be neededto minimize lossesto the Bank Insurance
                    Fund. These issuesand other accounting, reporting, auditing, and
                    internal control issuesfacing the banking industry are discussedin this
                    report. (Seechapter 6 and appendix II.)

                    To addressthe concernsand uncertainties currently facing the Bank
Recommendations     Insurance Fund, GAO is recommendingthat
                  . the Congressamend FIRREA to authorize the FDIC Chairman to raise the
                    assessmentrates beyond those currently provided so that the Fund can
                    achieve the minimum reserve ratio of 1.26 percent designated in FIRREA
                    by 1996;



                    Page6                                     GAO/AFMDM-1OOBankInsuranceFund
                      Executive   Summary




                  l the Secretary of the Treasury determine in the Department’s study of
                    deposit insurance reform required by FIRREX (1) the reasonablenessof
                    the minimum and maximum reserve ratios designatedby FIRREA, (2) a
                    reserve ratio target that would protect taxpayers by maintaining the
                    Fund in the event of a recession,(3) meansin addition to premium
                    assessments,such as increasedcapital levels in banks, that would
                    reduce the Fund’s potential liabilities;
                  . the Chairman of the Federal Deposit Insurance Corporation, the
                    Chairman of the Board of Governors of the Federal ReserveSystem, and
                    the Comptroller of the Currency perform on-site full scopeexaminations
                    of problem banks and large banks on an annual basis; and
                  l the Chairman of the Federal Deposit Insurance Corporation (1) revise its
                    appraisal guidelines for determining and recording the book value of
                    assetsowned or held in separate assetbanks so they reflect more real-
                    istic values by taking into account both historical experience and cur-
                    rent conditions and (2) monitor the use of separate assetpools to ensure
                    the Bank Insurance Fund has cash resourcesto meet its commitments.


                      The Federal Deposit Insurance Corporation and the Board of Governors
Agency Comments       of the Federal ReserveSystem generally concurred with GAO'S findings
                      and recommendations.In fact, FDIC’SBoard of Directors recently issued
                      a proposal to implement additional assessmentrate increasesallowed by
                      FIRREA in 1991 basedon its revised projections of the Fund’s 1990 opera-
                      tions and the impact of these operations on the Fund balance. GAO
                      believes this increase is necessaryin light of the Fund’s current condi-
                      tion and outlook and commendsFDIC'S recent action.

                      The Office of the Comptroller of the Currency stated that the report
                      was, for the most part, factually accurate. However, the Office ques-
                      tioned the recommendation for annual on-site, full scopeexaminations
                      of problem banks and large banks. The Department of the Treasury did
                      not specifically addressGAO'S recommendation on factors to include in
                      its study on deposit insurance reform. Treasury stated that the report
                      should be a useful contribution to a better understanding of the Bank
                      Insurance Fund. (Seechapters 2,3, and 4 for agency comments and
                      GAO's evaluation.)




                      Page7
Contents


Executive Summary                                                                               2

Chapter 1                                                                                      12
Introduction             The Federal Deposit Insurance Corporation                             13
                         Objectives,Scope,and Methodology                                      14
                         Report Organization                                                   16

Chapter 2                                                                                      16
Increased Risks in       Commercial Banks’ Performance in 1989                                 16
                         Changesin Commercial Bank Loan Portfolios                             18
Commercial Banking       Problems in Real Estate                                               20
Industry Not Matched     LDC Problems Persist                                                  21
by Increases in Equity   Uncertain Risks Associated With Highly Leveraged                      23
                             Transactions
Capital                  Conclusions                                                           26
                         Agency Commentsand Our Evaluation                                     26

Chapter 3                                                                                      27
Problem Banks Expose     Problem Banks Declining but Still at High Level                       27
                         Certain Problem Banks Threaten the Fund’s Soundness                   29
the Bank Insurance       Quality of Bank Call Report Data Not Always Reliable                  32
F’und to Significant     Monitoring of Banks Varies Among the Regulators                       33
Risks                    Regulator Judgment DecidesWhen Banks Fail                             37
                         Discussionof GAO’s Opinion on the Fund’s 1989 Financial               39
                             Statements
                         Conclusions                                                           40
                         Recommendation                                                        41
                         Agency Commentsand Our Evaluation                                     41

Chapter 4                                                                                      44
Reported Performance     FIRREA Authorizes AssessmentIncreasesto Reach
                            Minimum ReserveRatio
                                                                                               45
and Condition of the     FDIC Projections of Attaining the Minimum ReserveRatio                45
Bank Insurance Fund         May Be Overly Optimistic
                         GAO Projections of Attaining the Minimum ReserveRatio                 46
                         Separate Asset Pools Present Liquidity and Asset                      60
                            Valuation Exposures to the Fund
               Y
                         Conclusions                                                           63
                         Recommendations                                                       64
                         Agency Commentsand Our Evaluation                                     64


                         Page 8                                 GAO/AFMD-90-100Bank Insurance Fund
 .
                     Contenta




Chapter 5                                                                                  67
Accounting and       Banks’ Reported Financial Condition Before Failure                    68
                          Dramatically Different Than After Failure
Reporting Issues     Financial Reporting Issuesfor Further Study                           69
Facing the Banking   Internal Control WeaknessesContinue                                   60
Industry
Appendixes           Appendix I: Reports on the Financial Statements of the                64
                        Bank Insurance Fund for the Years Ended
                        December31,1989 and 1988
                     Appendix II: GAO’s March 7, 1990, Letter to the Secretary             93
                        of the Treasury
                     Appendix III: CommentsFrom the Federal Deposit                       111
                        Insurance Corporation
                     Appendix IV: CommentsFrom the Board of Governors of                  114
                        the Federal ReserveSystem
                     Appendix V: CommentsFrom the Office of the                           118
                        Comptroller of the Currency
                     Appendix VI: CommentsFrom the Department of the                      123
                        Treasury

Tables               Table 2.1: Banking Industry Equity Capital for 1985                    17
                         Through 1989
                     Table 2.2: Composition of Commercial Banking Loan and                  19
                         LeasePortfolios From 1986 Through 1989
                     Table 2.3: Commercial Banks’ Noncurrent Real Estate                    21
                         Loans for 1988 and 1989
                     Table 3.1: Problem Banks for Calendar Years 1987                       28
                         Through 1989
                     Table 3.2: Key Banking Industry Financial Indicators as                31
                         of December3 1,1989
                     Table 4.1: FDIC Projections of the Bank Insurance Fund                 46
                         ReserveRatio for 1990 Through 1996
                     Table 4.2: GAO Projection of the Bank Insurance Fund                   47
                         ReserveRatio for 1990 Through 1996 - Scenario 1
                     Table 4.3: GAO Projection of the Bank Insurance Fund                   47
                         ReserveRatio for 1990 Through 1996 - Scenario 2
                     Table 4.4: GAO Projection of the Bank Insurance Fund                   48
                         ReserveRatio for 1990 Through 1996 - Scenario3




                     Page 9                                  GAO/~90.100    Bank Insurance Fund
Abbreviations

CAEL      capital adequacy, assetquality, earnings, and liquidity
CAMEL     capital adequacy, assetquality, management,earnings, and
              liquidity
ECR       estimated cash recovery
FDIC      Federal Deposit Insurance Corporation
FIRREA    Financial Institutions Reform, Recovery, and Enforcement Act
              of 1989
FRB       Federal ReserveBoard
FSLIC     Federal Savings and Loan Insurance Corporation
GAO       General Accounting Office
HLT       highly leveraged transaction
LDC       less developed countries
NCNB      North Carolina National Bank
          Office of the Comptroller of the Currency
OREO      other real estate owned
RTC       Resolution Trust Corporation
SFAS      Statement of Financial Accounting Standards


Page 10                                 GAO/AFMD-90-100Bank Insurance Fund
Page 11   GAO/AFMD-90400 Bank Inmnme F’und
Chapter 1

Introduction                                                                                                  ,


               During the 198Os,banks failed at record rates. From 1934,the year the
               Federal Deposit Insurance Corporation (FDIC)was created, through
               1979, a period of 46 years, 568 Fmc-insuredbanks failed. In the 10 years
               from 1980 through 1989, 1,086 FDIC-insuredbanks, including 630 in the
               last 3 years, failed or received assistancefrom F&C. These failures and
               assistancetransactions have had an adverseeffect on the Bank Insur-
               ance Fund, which was formerly reported as FDIC. Our 1988 audit’
               reported that the insurance fund incurred its first net loss since its
               inception-$4.2 billion-in 1988, This loss reduced the insurance fund
               balance from $18.3 billion at the end of 1987 to $14.1 billion at the end
               of 1988. The ratio of the fund balance to insured deposits was reduced
               to what then was its lowest level ever-about .83 percent as of
               December31,1988.
               The banking industry and the Bank Insurance Fund continue to be vul-
               nerable to the exposurescausedby persistent problems in real estate
               lending and loans to less developed countries and uncertainties associ-
               ated with loans involving highly leveraged transactions. Furthermore, in
               1989 industry earnings fell from the previous year’s $24.8 billion to
               $16.3 billion, and the Fund reported a net loss for the secondconsecu-
               tive year. The Bank Insurance Fund’s 1989 net loss was $852 million,
               reducing the fund balance to $13.2 billion. As a result of this loss and
               growth in the industry’s insurable deposit base,the ratio of the Fund
               balance to insured deposits fell to a record low of .7 percent at
               December31,1989. Just 4 years earlier, the Fund reported an $18 bil-
               lion balance and a 1.19 percent ratio of the Fund balance to insured
               deposits.

               These adversetrends have fostered heightened concernsin both the
               Congressand the general public as to whether the banking industry will
               mirror the financial disaster in the savings and loan industry-and ulti-
               mately require a taxpayer bailout. While the conditions in the banking
               industry parallel someof those in the savings and loan industry, they
               are in many respectsdifferent. Someof the problems that contributed to
               the savings and loan debacle are not present in the banking industry.
               This report addressesthe condition of the Bank Insurance Fund and the
               exposuresit faces, but it doesnot attempt to compare these to the sav-
               ings and loan industry. This report discussesFDIC’S role as the insurer of
               banks and its responsibility for reporting on the condition of the Bank
               Insurance Fund.

               ‘Financial Audit: Federal Deposit Insurance Cwpo ration’s 1988 and 1987 Financial Statements
               @AO/AFMD-89-63 , April 28,1989).



               Page 12                                                 GAO/AFMD-90-100Bank Insurance Fund
      .

  .                             chapter 1
                                Wroduction




The Federal Deposit   FDICwas created by the Banking Act of 1933 to stabilize or promote the
                      stability of banks by providing deposit insurance to protect bank deposi-
Insurance Corporation tors. It was authorized to promulgate and enforce rules and regulations
                                relating to the supervision of insured banks and to perform other regu-
                                latory and supervisory duties consistent with its responsibilities as
                                insurer. On August 9,1989, with the enactment of the Financial Institu-
                                tions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), FDIC was
                                designated sole federal insurer of all banks and savings associations.As
                                such, FDIC is responsible for reporting on the condition of the Bank
                                Insurance Fund, the SavingsAssociation Insurance Fund and the Fed-
                                eral Savings and Loan Insurance Corporation Resolution Fund. These
                                three funds are accounted for and reported separately by FDIC. The Bank
                                Insurance Fund covers federally insured commercial banks, state
                                chartered savings banks, and any federal savings bank chartered pur-
                                suant to section 6(o) of the Home Owners’ Loan Act. The SavingsAssoci-
                                ation Insurance Fund is the insurance fund for federally insured savings
                                associations.The Federal Savings and Loan Insurance Corporation Reso-
                                lution Fund is the fund established by FIRREA to managethe assetsand
                                liabilities related to transactions entered into before January 1,1989, by
                                the now defunct Federal Savings and Loan Insurance Corporation. We
                                will report separately on the condition of the other funds.
                                FDICis the insurer of all banks; however, it doesnot have primary regu-
                                latory responsibility for all banks. The Federal ReserveBoard (FRB)
                                examines state-chartered banks that are membersof the Federal
                                ReserveSystem and bank holding companies,while the Office of the
                                Comptroller of the Currency (CMX)examines national banks. FDIC’S oper-
                                ations include examining state-chartered banks that are not membersof
                                the Federal ReserveSystem, conducting liquidation activities for insured
                                banks that have failed, and providing and monitoring assistanceto
                                failing banks.

                                FDIC’S role as the insurer of banks is to protect depositors in the nation’s
                                banks, help maintain confidence in the banking system, and promote
                                safe and sound banking practices. FDIC supervisesapproximately 7,600
                                state-chartered nonmember banks and insures deposits up to $100,000
                                in approximately 13,200 commercial and savings banks. In addition, FDIC
                                supervises approximately 470 state-chartered savings banks. occ super-
                                vises approximately 4,260 national banks, and FRB supervisesapproxi-
                                mately 1,060 state-chartered member banks.
                                As the insurer of bank deposits, FDIC has established financial programs
                                for both failing and failed banks. Financial assistanceto failing banks is


                               Page lg                                    GAO/APMD~1oO Bank Insurance F’und
                            Chapter  1
                            lntroductlon




                            designedto rehabilitate an insured bank. Assistancemay be granted
                            directly to the bank or to a company that controls or will control it.
                            Assistancemay also be granted to facilitate the merger of a bank. When
                            banks fail, FDIC is appointed receiver, directly pays insured claims to
                            depositors or the acquiring bank, and liquidates the remaining assets
                            and liabilities not assumedby the acquiring bank.

                            Although FDIC doesnot receive any appropriated funds to administer the
                            Bank Insurance Fund, FDIC is subject to congressionaloversight. The
                            Bank Insurance Funds operations are funded through assessmentsfrom
                            insured banks and the Fund’s internal operations, such as investments
                            and recoveries from salesof assetsacquired in assisting troubled
                            institutions.

                            The objectives of our audit were to (1) render an opinion on the presen-
Objectives, Scope,and       tation of the Bank Insurance Fund’s financial statements in accordance
Methodology                 with generally acceptedaccounting principles for the years ended
                            December31,1989 and 1988, and (2) report on FDIC’S    internal control
                            structure and on its compliance with applicable laws and regulations
                            related to the Bank Insurance Fund. In addressingthese objectives, we
                        . evaluated the financial condition of the banking industry and the ade-
                          quacy of the Bank Insurance Fund to meet its current and near-term
                          identifiable needsthrough 1990;
                        l analyzed financial information on the banking industry and on specific
                          banks the regulators identified as troubled institutions to determine the
                          potential near-term exposure to the Bank Insurance Fund;
                        . analyzed the impact existing assistancetransactions could have on the
                          Fund’s cash position;
                        l reviewed the Fund’s sourcesof revenue to determine its ability to
                          handle the potential costs of additional failure and assistancetransac-
                          tions, as well as the potential for increased costson existing transac-
                          tions; and
                        l identified significant accounting and related reporting issuesthat we
                          believe should be studied and resolved to ensure reliable financial
                          reporting by banks.
                            The issuesare derived in part from findings of our ongoing review of the
                            adequacy of financial information that was available to the regulators
                            for 39 banks that failed during 1988 and 1989.




                            Page 14                                  GA0/AFMD.90.100 Bank Insurance Fund
 .                    Chapter 1
                      Introdudon




                      Our work was performed at FDIC headquarters in Washington, D.C.;
                      FDIC’S New York regional office; and various FDIC receivership locations
                      in Texas. We conducted our work between August 1989 and June 1990.
                      Our audit was performed in accordancewith generally acceptedgovern-
                      ment auditing standards.
                      The Federal Deposit Insurance Corporation, the Board of Governors of
                      the Federal ReserveSystem, the Office of the Comptroller of the Cur-
                      rency, and the Department of the Treasury provided official agency
                      commentson a draft of this report.

                      Chapter 2 discussesthe commercial banking industry’s financial per-
Report Organization   formance and major areas of concern related to the future condition of
                      the industry. Chapter 3 analyzes the problem bank sector of the banking
                      industry, including our concernsregarding the quality of call report data
                      that banks reported. Chapter 4 assessesthe adequacy of the Bank Insur-
                      ance Fund’s balance and liquidity position. Chapter 6 identifies
                      accounting and reporting issuesin the banking industry that require fur-
                      ther study and resolution to ensure that banks report reliable financial
                      information.
                      Appendix I contains our opinion on the 1989 and 1988 financial state-
                      ments of the Bank Insurance Fund, our reports on FDIC’S internal control
                      structure and on its compliance with laws and regulations for the Bank
                      Insurance Fund, and the Bank Insurance Fund’s financial statements for
                      the years ended December31,1989 and 1988. In accordancewith
                      auditing standards, our opinion includes an explanatory paragraph
                      expressing our concern about the significant exposure of problem banks
                      as discussedin chapter 3. Appendix II contains our March 7, 1990, letter
                      to the Secretary of the Treasury, outlining our suggestionsfor consider-
                      ation in Treasury’s study of the federal deposit insurance system. Com-
                      ments from FDIC, FRB, occ, and Treasury are included in appendixes III,
                      IV, V, and VI, respectively.




                      Page 16                                  GAO/AFMDSO-100Bank Insurance Fund
IncreasedRisks in CommercialBanking
Industry Not Matched by Increasesin
Equity Capital
                      The performance of the commercial banking industry worsened in 1989
                      compared to 1988. The growth in nonperforming assetsoutpaced the
                      growth in the industry’s equity capital,’ and industry earnings declined
                      sharply from their 1988 level. The composition of the banking industry’s
                      assetshas changedfrom commercial and industrial loans to a greater
                      reliance on real estate loans. The banking industry’s opportunities for
                      lending to commercial applicants have been reduced significantly by
                      international competition, corporations issuing debt directly in the
                      market, and other nonbank sourcesmaking financing available to these
                      applicants. Banks have becomemore actively involved in real estate
                      lending to replace the opportunities lost to lend to these commercial
                      borrowers.
                      The risks associatedwith the industry’s loan portfolio and declines in
                      certain regional economieshave led to significant growth in the
                      industry’s nonperforming assets,particularly real estate loans. In addi-
                      tion, large commercial banks are continuing to experiencelosseson their
                      portfolios of less developed countries (LDC) debt. The industry’s expo-
                      sure to highly leveraged transactions (HLTS) is also of concern.Regula-
                      tors have not tracked total industry exposure on HLTS over time and thus
                      comparable data from years prior to 1989 are not available. However,
                      the FRB measuredthe HLT exposure of the 60 largest bank holding com-
                      panies, for their bank and nonbank subsidiaries, as $126 billion as of
                      year end 1989. Comparative data are not available for 1988. The impact
                      of loans categorized as HLTS on the cost of future bank failures is
                      unknown.

                      The commercial banking industry is continuing to show significant asset
Commercial Banks’     growth in real estate loans. The industry’s equity capital, its cushion to
Performance in 1989   absorb loan losses,is growing at a rate comparable to the overall growth
                      in assets.However, the growth in real estate loans and industry
                      nonperforming loans has greatly exceededthe growth in the industry’s
                      equity capital. Also, industry earnings declined sharply in 1989, as a
                      significant number of large banks reported 1989 year-end losses.
                      According to FDIC, the commercial banking industry reported total assets
                      of $3,299 billion at December31,1989. This is an increaseof $168 bil-
                      lion (6.4 percent) over the $3,131 billion of total assetsreported at year-
                      end 1988. Real estate loans accountedfor more than half of this growth,
                      increasing $87 billion (12.8 percent) in 1989. Industry loss reserves

                      ‘Equity capital is defined as common equity and retained earnings



                      Page 16                                                 GAO/AF’MD9O-100Bank Insurance Fund
  .
                                     Chapter 2
                                     IucreeeedR&kslnCommerclelBenklng
                                     Industry Not Matched by IncreaeeaIn
                                     Ecluity CaP1-l




                                     totaled $63 billion at December31, 1989, an increaseof $6 billion (13.9
                                     percent) from the $47 billion reported in 1988. Higher reservesfor LDC
                                     and real estate loans accountedfor this increase.

                                     At year-end 1989, the industry reported $206 billion in equity capital.
                                     This is an increaseof $9 billion (4.6 percent) from the $197 billion
                                     reported at year-end 1988. The industry’s equity capital to assetsratio
                                     declined to 6.2 percent at December31, 1989, from 6.3 percent for year-
                                     end 1988. This decline indicates that the rate of industry assetgrowth
                                     was slightly higher than that of its equity capital. Table 2.1 shows the
                                     growth of equity from 1986 through 1989.
Table 2.1: Banking Industry Equity
Capltal for 1986 Through 1989        Dollars in billions
                                                                                  Percentage of total   Percentage of tote1
                                     Year-end              Total eaultv capital              assets       loans and leases
                                     1985                                  $169                   6.2                  10.3
                                     1986                                   182                   6.2                  10.3
                                     1987                                   181                   6.0                  10.1
                                     1988                                   197                   6.3                  10.2
                                     1989                                   206                   6.2                  10.0


                                     The Northeast and Southwest regions posethe greatest financial risk to
                                     the Bank Insurance Fund becausetheir loan portfolios contain a higher
                                     level of problem real estate loans. At year-end, both regions reported
                                     equity capital to assetratios of 6.6 percent, compared to ratios at year-
                                     end 1988 of 6.9 and 6.7 percent, respectively. The year-end 1989 ratios
                                     for these two regions were 10 percent below the industry’s averageof
                                     6.2 percent. These negative trends are of concern becausethe high
                                     growth in real estate loans is accompaniedby increasing default rates
                                     for these loans, while equity capital, the industry’s cushion to absorb
                                     loan losses,is growing more slowly.

                                     In 1989, the commercial banking industry reported earnings of $16.3 bil-
                                     lion, a decline of $8.6 billion (34 percent) from the $24.8 billion reported
                                     in 1988. Commercial banking industry earnings for 1989 were about the
                                     sameas in 1988 in each geographic region except for (1) the Northeast
                                     region, which reported an $11.7 billion decrease,and (2) the Southwest
                                     region, which reported a $1.6 billion increase.The decline in earnings
                                     reported by banks with more than $10 billion in assetslargely accounts
                                     for the decreasein the Northeast, In 1989, this group of banks was com-
                                     prised of 44 banks with collective assetsof $1,262 billion as compared
                                     to 40 banks with assetsof $1,162 billion in 1988. These banks reported


                                     Page 17                                          GAO/AFMD-90-100Bank Insurance F’und
                  chapter 2
                  lncreased~ksInConunerdaIBanIdng
                  Industry Not Matched by Increases ln
                  Eslnity cspitnl




                  1989 earnings of only $1.3 billion, a decreaseof 88 percent from 1988
                  earnings of $11.1 billion. For 1989,26 percent of these large banks
                  reported net losses,while only 6 percent reported net lossesin 1988.
                  Overall, 1,474 banks (11.6 percent of the industry) reported net lossesin
                  1989, compared to 1,863 banks (14.2 percent of the industry) reporting
                  net lossesin 1988. Thus, while fewer banks overall are reporting losses,
                  a greater number of the large banks experienced losses.This is a con-
                  cern becauseexperience has shown that the failure of large banks cause
                  significant impairment to the Fund balance. For example, the total cost
                  to the Bank Insurance Fund of providing assistanceto Continental Illi-
                  nois National Bank and Trust Company of Chicagowas over $1.1 billion.
                  Additionally, the cost to the Fund arising from the failure of First
                  RepublicBank Corporation, Dallas, is currently estimated to be $2.9 bil-
                  lion Most recently, the closing of 20 MCorp subsidiary banks is expected
                  to cost the Fund $2.7 billion. In contrast, the Fund has incurred esti-
                  mated costs of $2.0 billion in 1989 on failure and assistancetransactions
                  for 161 banks with assetsof less than $1 billion. The assetsof these
                  smaller institutions totaled $7.5 billion. Thus, the Fund appears better
                  able to handle the costs associatedwith smaller bank failures.

                  The banking industry’s businessstrategy has changedsignificantly over
Changesin         the past 6 years. Additional businesssourceswere neededto compen-
Commercial Bank   sate for revenue losseswhen traditional businesssources,such as cer-
Loan Portfolios   tain commercial and industrial borrowers, began obtaining financing
                  outside of the commercial banking industry. As a result, the composition
                  of the commercial banking industry’s loan and leaseportfolios has
                  changede2

                  Since 1986 the commercial banking industry has reported an increaseof
                  $408 billion (24.8 percent) in total loan and leaseportfolios. Total
                  industry loan and leaseportfolios were $1,649 billion at December3 1,
                  1986, and increasedto $2,067 billion by December31,1989. Of the
                  reported year-end 1989 loans and leases,$1,781 billion (86.6 percent)
                  were real estate loans, commercial and industrial loans, and loans to
                  individuals. In comparison, $1,326 billion (80.4 percent) of the reported
                  year-end 1986 loans and leaseswere these types of loans. Thus, from
                  1986 to 1989, the overall loan concentrations remained in these three
                  2Commercial banks’ loan and lease portfolios consist of (1) real estate loans, (2) commercial and
                  industrial loans, (3) loans to individuals, (4) agriculture/farms loans, and (6) other loans and leases.
                  Banks report loans and leases aa a single line item to the regulators. Although the leases included in a
                  bank’s loans and lease portfolio are legally leases, they have virtually all the characteristics of loans.



                  Page 18                                                     GAO/AFMD-90-100Bank Insurance Fund
  .
                                         cllaptm 2
                                         IlumamdBlaksinconunerclalBanking
                                         Industry Not Matched by Increases in
                                         Equity -Pital




                                         loan categories.However, as illustrated in table 2.2, the mix within
                                         these loan categorieschangedsignificantly.
Table 2.2: Composition of Commercial
Banking Loan and LOO80P0ti0liO8   From   Dollars in billions
1986 Through 1989                                                                                December 31,
                                         Loan8 and leases                       1985     1988        1987        1988       1989
                                         Fh3pslEMi;                             $438                  $600
                                                                                 26.6     $2591:
                                                                                             .         33.5      Y2l        $3-;
                                         CoP;ye;;al/lndustrial                   35.0
                                                                                  578     33.9
                                                                                           601         32.9
                                                                                                        590      31
                                                                                                                  600.l     30.1
                                                                                                                             618

                                         Loans to individuals                   309       336         351         378        401
                                           Percent                              18.7      18.9        19.6        19.6       19.5
                                         Ag;icw&~/Farms                          22        31
                                                                                           1.8          ITi        l?         l?

                                         Le;w$erfoped       countries            58:       t;          AT:         2          25:

                                         Other
                                           Percent                              12.2
                                                                                201       11.6
                                                                                          207          2:          181
                                                                                                                   9.4        $9;
                                         Total Loans and Leases             $1,849      $1,773      $1,742      $1,932    $2,057


                                         The changesin the industry’s portfolio mix show that commercial banks
                                         are increasingly reliant on real estate lending. This is currently a serious
                                         concern becauseof the depressedreal estate markets in various geo-
                                         graphical sectorsof this country. The changesin bank loan portfolios,
                                         together with these economicdownturns, may increasethe number of
                                         bank failures, which in turn would significantly affect the Bank Insur-
                                         ance Fund.
                                         The remaining categoriesof the industry’s loan portfolio consist of agri-
                                         culture/farm loans, LDCloans, and other loans and leases.In total, these
                                         categoriescomprised $324 billion (19.6 percent) of the $1,649 billion
                                         total loans and leasesreported at December31,1985, and $277 billion
                                         (13.4 percent) of the $2,057 billion total loans and leasesreported at
                                         December31, 1989. IJX loans totaled $54 billion (2.6 percent) of the
                                         year-end 1989 total loans and leases.Basedon the amount of total loans
                                         outstanding, LDCloans would not appear to present a significant expo-
                                         sure to the banking industry. However, becauseof the high concentra-
                                         tion of LDCloans in large banks and their high loss rate, they are a
                                         concern to the banking industry and the Bank Insurance Fund.
                                         The industry data reported above are somewhat deficient becausedata
                                         on the level of HLTS included in the various loan and leasecategoriesare
                                         not available for the full S-year period from 1985 through 1989. Higher


                                         Page 19                                           GAO/AF’MD-90-199Bank hmrance Pund
                   chapter2
                   InQwuedRiskainConwereialBanklng
                   Industry Not Matched by Increamw in
                   Esluity capital




                   levels of HLm may increasethe risk associatedwith the changein the
                   banking industry’s portfolio.

                   Significant concentrations in nonperforming real estate loans were
Problems in Real   largely responsible for the high level of bank failures in the late 1980s.
Estate             Poor lending practices combined with a significant economicdownturn
                   in the Southwest region led to most of the bank failures there. Because
                   of the cyclical nature of real estate markets and the recent history of
                   significant bank failures due to high concentrations of nonperforming
                   real estate loans, we are concernedabout the significant growth in the
                   banking industry’s level of real estate loans, particularly in the North-
                   east. The significant growth in this region’s nonperforming real estate
                   loans is similar to that which occurred in the Southwest region in the
                   1980s.
                   Bank real estate loans are comprised of (1) construction and develop-
                   ment loans, (2) loans securedby l-4 family and multifamily residential
                   properties, (3) loans securedby farmlands, and (4) loans securedby
                   nonresidential, nonfarm properties. The different types of real estate
                   loans have varying degreesof risk associatedwith them. Construction
                   and development loans are consideredthe riskiest becauseof their more
                   speculative nature. Banks with assetsgreater than $1 billion hold more
                   construction and development loans than the smaller banks. This is true,
                   in part, becauseconstruction and development loans are typically large
                   loans and smaller banks are usually unable to fund significant levels of
                   these loans due to their liquidity and capital restraints. Further, we
                   have found that insolvent banks and banks that fail irrespective of size
                   have a higher proportion of construction and development loans than
                   banks with higher capital levels.

                   Commercial banks reported a total of $762 billion in outstanding real
                   estate loans as of December31, 1989. Of these loans, $22.2 billion (2.9
                   percent) were reported as either 90 days or more past due or in nonac-
                   crual status. In comparison, at December3 1, 1988, commercial banks
                   reported noncurrent real estate loans of $16.0 billion (2.4 percent) of the
                   $675 billion in real estate loans outstanding.
                   The Southwest region continued to report the highest ratio of noncur-
                   rent real estate loans to total real estate loans outstanding, but the ratio
                   improved. In 1989, the southwest reported that $4.0 billion (7.7 percent)
                   of the region’s $51.3 billion total real estate loans outstanding were
                   either 90 days or more past due or in nonaccrual status. In comparison,


                   Page 20                                    GAO/AFMD-90-100Bank Insurance Fund
          .


                                          cbaptm 2
                                          lncreMedlu#k8incQmmerdalBulktng
                                          Indnatry Not Matched by Incmama in
                                          wtr    CrPitsl




                                          this region reported in 1988 that $4.6 billion (8.2 percent) of its $64.2
                                          billion total real estate loans outstanding were past due 90 days or more
                                          or in nonaccrual status.

                                          The Northeast, Southeast, and Central regions reported increasesin the
                                          ratio of noncurrent real estate loans to total real estate loans out-
                                          standing in 1989. The sharpest increase in the ratio of noncurrent real
                                          estate loans to total real estate loans outstanding between 1988 and
                                          1989 occurred in the Northeast. That region reported noncurrent real
                                          estate loans of $9.9 billion (3.8 percent) of its $269.3 billion in out-
                                          standing real estate loans at December31,1989. In comparison, at
                                          December31,1988, this region reported noncurrent real estate loans of
                                          $4,4 billion (1,9 percent) of its $231.7 billion in outstanding real estate
                                          loans. Table 2.3 shows the changesin noncurrent real estate for each
                                          region for 1988 and 1989.

Tablo 2.9: Commercial Sanka’ Noncurrent Real Eatate Loanr for 1999 and 1989
Dollaro in billions
Real ertato loan8                                           Northeast       Southeaclt      Central     Midwest       Southwest       west
1999                                                                                         $117.1         $42.5           f§5;.;   s14;.;
Percent noncurrent                                                              $14E            1.4           1.6
1968                                                                                                        $39.1           ly;      $12;.;
Percent noncurrent                                                              512::i       s’“?:Z           1.6


                                          The six New England states3in the Northeast region showed the most
                                          significant increase in noncurrent real estate loans in 1989. Noncurrent
                                          real estate loans represented 6.8 percent of the outstanding real estate
                                          loans for these six states, a sharp increase from the 1.7 percent reported
                                          in 1988.


LDC Problems Persist                      Increased loss provisions for LDCdebt continue to adversely affect the
                                          reported earnings of the commercial banking industry. FDIC reported
                                          that 6 of the 10 largest banks in the United States reported 1989 year-
                                          end lossesdue to increased loss provisions for LDC loans. Total US. com-
                                          mercial bank exposure to countries that FDIC, FRB, and ooc categorized as
                                          “troubled” foreign debtors was $64 billion as of December31, 1989. This
                                          is a decreaseof $14 billion (21 percent) from the $68 billion total
                                          reported at December31,1988, and a sharp decreaseof $37 billion (41

                                          3The six New Englaud states are Massachusetts, Connecticut, Maine, Vermont, Rhode Island, and
                                          New Hampshire.



                                          Page 21                                                GAO/AFMIHO-100 Bank Inmrance Fund
percent) from the $91 billion total reported at December31, 1982, the
beginning of the international debt crisis. This decreasecan be attrib-
uted to several factors, including (1) banks becoming less involved in
international lending or abandoning such lending entirely, (2) countries
seeking lending from other external financing sources,and (3) banks
charging off and increasing reserveson troubled foreign loans.

While total U.S. commercial bank exposure on troubled foreign loans has
declined, the remaining exposure is heavily concentrated in a small
number of the nation’s largest banks. Of the $64 billion exposure
reported at December31,1989, $43 billion (80 percent) is held by nine
money center banks.4At December3 1,1982, these nine money center
banks held $68 billion (64 percent) of the total U.S. LJNexposure. Thus,
even though the nine money center banks’ exposure to troubled foreign
debtors decreasedbetween 1982 and 1989, their exposure to these loans
remained relatively high. Much of the overall decline in industry expo-
sure to LDCloans was attributable to increased loss reserves.For
example, in 1989, large commercial banks set aside a total of $10 billion
for future losseson their foreign operations, which include LIX debt.
Despite increased reserves,total LDCexposure could still have a signifi-
cant impact on their operations.
FDIC, FXB,and occ reported that as of December31,1989, the nine money
center banks reported reserveson their IJX exposure ranging from 40
percent to 96 percent, with an averagereserve level of 49 percent. At
December31,1988, the nine money center banks had averageLDC
reserve levels of 36 percent.
The federal banking regulators believe that the U.S. commercial banking
system could better absorb the impact of the debt servicing problems
associatedwith developing country debt today than in 1982, when the
international debt crisis began,In a joint report, the regulators state that
(1) banks with LDCexposure have generally increasedtheir capital
levels, (2) the earnings of large multinational banks are more diversified
than in the past, and (3) the banking industry’s policies and procedures
on international lending have been strengthened. Despite these improve-
ments, federal banking regulators also report that both bank manage-
ment and the regulatory bodies will need to continually monitor the


‘The nine money center banks are Bank of America, Banker’s Trust, Citibank, Chase Manhattan
Bank, Chemical Bank, Continental Bank, First National Bank of Chicago, Manufacturer’s Hanover,
and Morgan Guaranty.



Page 22                                                GAO/AFMD-f&100 Bank Insurmce F’und
 .
                   Chapter 2
                   IncreeeadIUek6inCommerdalBanldng
                   Induetry Not Matched by Incremes in
                   muw capital




                   existing risk presented by the substantial exposure levels of the largest
                   U.S. banks to LDCdebt.
                   Last year, the administration unveiled a debt plan for highly indebted
                   countries which called for banks to both forgive someexisting LM: debt
                   and to extend new loans to developing countries. The plan received some
                   acceptanceby commercial banks; however, only the Mexico restruc-
                   turing has been completed to date. Furthermore, very little new money
                   was offered, with most banks granting interest rate or principal conces-
                   sions. Failure of the plan to provide for successfulrestructurings for
                   other debtor countries could causefurther lossesto the banks as the
                   developing countries continue to experience difficulty repaying their
                   debt.


                   In addition to the adverse impact of nonperforming real estate and LDC
Uncertain Risks    loans, there is a growing concern over the future performance of HLTS.
Associated With    Since HLTS are a type of transaction rather than a lending category, any
Highly Leveraged   loan type (for example, real estate or commercial and industrial) could
                   result in an HLT. In October 1989, FDIC, MB, and occ agreed on a common
Transactions       definition of HLTS to be utilized by all examiner personnel. According to
                   the three federal regulators, a bank or bank holding company is consid-
                   ered to be involved in a highly leveraged transaction when it extends
                   credit to or invests in a businesswhere the financing transaction
                   involves the buyout, acquisition, or recapitalization of an existing busi-
                   nessand significantly increasesthe company’s ratio of total liabilities to
                   total assets.
                   These loans experienced significant growth in the industry during the
                   late 1980swith the advent of the junk bond market in the investment
                   banking industry. Many of the junk bond offerings by investment
                   bankers were part of an overall financing packagethat also included
                   senior debt6loaned by commercial banks that qualified as HLTS. FDIC




                   ’ Senior debt typically collateralized with the first-most   superior-lien   against the assets of the
                   borrower.



                   Page 23                                                      GAO/AFMD-90-100Bank Insurmce Fund
Chapter 2
Increwed M&s ln Ckmmercial Jhnking
Indwtry Not Matched by Increaseain
pxlultv CaPltal




reported that if overall economicconditions deteriorate, loans to highly
leveraged commercial borrowers could add to credit losses.Discussions
with bank regulators revealed that although these loans have resulted in
significant lossesin the investment banking industry, HLTS in the com-
mercial banking sector are generally better collateralized than they are
in the investment banking industry.
The recent financial problems in the investment banking industry have
 raised concernsabout bridge loans and junk bond exposuresin the com-
mercial banking industry. Bridge loans are defined as temporary
 financing by a lender until permanent financing can be obtained. Bridge
loans similar to those which facilitate a securities offering in the invest-
ment banking industry are usually not made in commercial banks. Also,
commercial banks have minimal exposure to losseson junk bonds.
Unlike prior regulations for savings and loans, in most states commer-
cial banks can only invest in investment gradesbonds, By definition,
junk bonds are not investment grade and, therefore, commercial banks
generally do not invest in them. Further, regulators consider any junk
bonds in commercial banks as classified assets7for which loss reserves
are usually required to be recorded.
Generally, when commercial banks issue bridge loans associatedwith
securities offerings they are extremely short term. According to the reg-
ulators, commercial banks do not have significant amounts of out-
standing bridge loans or loan commitments in connection with
uncompleted securities offerings. Commercial banks usually provide
bridge loan financing for construction projects, as opposedto uncom-
pleted securities offerings, to facilitate financing for the time between
the maturity of the construction loan and the point at which the bor-
rower obtains permanent financing. Bridge loans in commercial banks
have the samecharacteristics as permanently financed loans, except for
the shorter term to maturity. These loans usually have the normal loan
to value ratio of the respective loan type and are fully collateralized by
the underlying asset.Investment banking industry bridge loans pose the
risk that the investment banker who provides bridge financing will be
unable to raise sufficient funds from the sale of the related securities to
repay the bridge loan. Further, this financing is generally provided
“Investment grade means that the debt or equity security is rated in one of the four highest rating
categories by at least one nationally recognized statistical rating organization.

71ngeneral, classification of an asset indicates that the asset has been impaired and that loss reserves
are necessary to accurately reflect the recoverable value of the aaset. However, assets can sometimes
be classifkd when insufficient loan file documentation makes it impossible to evaluate the asset
quality based on the available data.



Page 24                                                    GAO/AFMBBO-100Bank Iwurmce Fund
Chapter 2
Increased Risks in ConwerchI Baddng
Industry Not Matched by Increaseain
Equity Capital




without recourseto the company issuing the securities. Thus, the expo-
sure to bridge financing is significantly less in commercial banks than
the investment banking industry.

In 7 of the 10 largest banks, HLT exposure was in excessof the banks’
equity capital-ranging from 112 percent to 206 percent. Most out-
standing HLT bank loans are in the form of secured,senior debt. Thus,
the principal risk is that in the event of bankruptcy of the leveraged
company, its assets(the underlying security for the loan) would be
reduced in value to such an extent that senior debt holders would suffer
loss. The significant market discounts on junk bonds associatedwith
someof the senior debt held by banks suggestthat there is little or no
earnings margin to cover interest payments on the junk bonds. The
recent bankruptcy filings of companiesinvolved in junk bond offerings
illustrate the risk that the senior debt portion of the original financing
packagemay not be repaid. Historically, and especially as demonstrated
in bank failures, the value of underlying assetsfor loans that default
tends to be significantly reduced compared to the loan origination value.
This phenomenonhas resulted in significant lossesto banks and the
Bank Insurance Fund.

While someindustry observers suggestthat leveraged buyout transac-
tions (which by their very nature are HLTS) strengthen the subject com-
panies, others hold contrary views. Someindustry observershave stated
that in many instances managementpractices of companiesthat had
junk bond offerings may have diminished both asset and business
values. As a result of the required emphasis on debt service, manage-
 ment may be required to adopt cost cutting measuresthat reduce invest-
ments in the company’s future economicviability. These policies and
practices typically result in companiesthat are weaker than their finan-
 cial statements purport them to be. If this view is correct, in bankruptcy
there will be less protection for bank held senior debt. Also, unlike other
 loans, HLTS do not necessarily improve with seasoning.The borrowers
 are usually so highly leveraged that they are unable to reduce the prin-
cipal amount outstanding substantially over the life of the loan and thus
remain vulnerable to downturns in the industry and the economy gener-
 ally for the life of the loan. These loans usually have large balloon pay-
 ments with minimal principal reductions other than those tied to
significant assetsales.




Page 26                                   GAO/AFMD-B&100Bank Inmrance Fund
                      Chapter 2
                      IncrewedRisksInCommercial~
                      Industry Not Matihed by Increases in
                      Equity Capital




                      Overall, the condition of the banking industry deteriorated in 1989 as
Conclusions           compared to 1988. The industry’s increasedlevel of nonperforming
                      assetsadversely affected the industry’s earnings. Lossesdue to
                      increasedprovisions for LDCloans severely hampered the earnings of
                      large commercial banks in 1989 as compared with 1988. Moreover, the
                      increasing levels of nonperforming real estate loans, particularly in the
                      Northeast, and the uncertain impact of bank losseson loans involving
                      HLTS raise serious concernsas the banking industry enters the 1990s.

                      The disturbing trend in nonperforming real estate loans in the Northeast
                      region is reminiscent of problems experiencedby many Southwest banks
                      in the 1980s.Real estate loan performance problems in these banks ulti-
                      mately led to the failure of many Southwest banks in the late 1980s and
                      continue to hamper the recovery of others. Becausethese failures have
                      had a significant impact on the Bank Insurance Fund in the past 3 years,
                      we are concernedthat the high levels of nonperforming real estate
                      loans, coupled with the potential for bank losseson loans involving HLTS,
                      could lead to bank failures in the 1990sand significant costs to the Bank
                      Insurance Fund.

                      occ commented(see appendix V) that our conclusionsabout the condi-
Agency Comments and   tion of the banking industry are inaccurate becausethey are drawn, for
Our Evaluation        the most part, from analyses of industry data covering only 2 years. occ
                      believes that this is an insufficient time span from which to draw sub-
                      stantive conclusionsabout industry trends and their impact on the Bank
                      Insurance Fund.
                      Our focus on more recent events is appropriate in light of the banking
                      industry’s current environment. The purpose of our analysis of the
                      banking industry is to highlight those indicators that present exposure
                      to the industry and, ultimately, the Fund in both the short and the long
                      term. Current data comparisons are more useful in identifying current
                      industry problems that could affect the Fund than evaluating historical
                      data that are 6 to 10 years old. In the last 2 years, a period of national
                      economicgrowth, a record number of bank failures causedthe Fund to
                      suffer a net loss in both years and has resulted in the Fund balance
                      declining dramatically from $18.3 billion to $13.2 billion (27.9 percent).
                      Additionally, FDIC recently estimated that the Fund will lose $2 billion in
                       1990 and decline for the third consecutiveyear.




                      Page 26                                   GAO/AFMD-90-100Bank Insurance Pund
      .
Chapter 3

Problem Banks Exposethe Bank Insurance
Ftd to Significant Risks

                         Continued problems in real estate loans have contributed to many bank
                         failures over the past 2 years. Moreover, a significant number of banks
                         are in such severefinancial condition that without someform of capital
                         infusion, they are also likely to fail in the near future.1 In addition, other
                         banks are vulnerable to future failure if their negative performance
                         trends continue and their regional economiescontinue to deteriorate. If
                         these banks were to fail, we estimate that the cost would materially
                         impact the Bank Insurance Fund balance. Many uncertainties affect the
                         continued existenceof these banks and we cannot accurately predict
                         their future viability. However, in their present financial condition they
                         pose a significant exposure to the Fund.
                         Our estimates of the cost to the Fund in the event of these bank failures
                         may be low becausethe estimates are basedon FIX’S historical loss
                         rates, which do not provide for changesin assetcomposition that have
                         occurred over the past few years. Our estimated costsmay also be low
                         becausethe underlying financial data on which they are based come
                         from bank call reports. Our limited review of examination reports for
                         certain problem banks suggeststhat call report data may only be as reli-
                         able as the most recent bank examination. Examination policies
                         regarding problem banks vary among the regulators. FDICand FRB
                         require annual on-site, full scopeexaminations of problem banks. occ
                         monitors call reports and other related data in deciding the frequency
                         and scopeof examinations of problem banks.

                         The number of problem banks has declined from a year-end all time high
Problem Banks            of 1,676 at December31,1987, to 1,109 at December31, 1989. While
Declining but Still at   this has been a significant 30 percent drop, the number of problem
High Level               banks continues at an alarming level, and they pose a significant, on-
                         going financial threat to the health of the Bank Insurance Fund.
                         FDIC produces a quarterly problem bank list which lists institutions with
                         a uniform composite rating of 4 or 6. This composite rating is assignedto
                         a bank after a regulatory examination. It is basedon the examiner’s
                         combined ratings for each of the following factors: adequacy of capital,
                         quality of assets,performance of bank management,level and composi-
                         tion of earnings, and level of liquidity-referred to as the CAMEL rating.
                         The rating is basedupon a scale of 1 through 6. A 1 represents the



                         ‘31 USC. 714(c) precludes us from disclosing the identity of a specific open bank.



                         Page 27                                                  GAO/AFMD-SO-100
                                                                                                Bank Insurance Fund
                                          chapter 8
                                          Problem Banka Expoee the Bank Inouranm
                                          Fund ti Stgnttlwt lti&




                                          highest rating and, consequently, the lowest level of supervisory con-
                                          cern; a 6 represents the most critically deficient level of performance
                                          and, therefore, the highest degreeof supervisory concern.

                                          A 4-rated bank exhibits serious financial weaknessesand potential
                                          unsafe and unsound conditions that if not effectively addressed,could
                                          impair the bank’s future viability, pose a threat to the interests of the
                                          bank’s depositors, and a potential for disbursement of funds by the
                                          Bank Insurance Fund. While the regulators do not consider a 4-rated
                                          bank’s failure to be imminent, such a bank exhibits a higher than normal
                                          potential for failure. The regulators consider a S-rated bank to have an
                                          extremely high immediate or near-term probability of failure. These
                                          institutions exhibit weaknessesor unsafe and unsound conditions that
                                          require urgent aid from stockholders or other public or private sources
                                          of financial assistance.In the absenceof urgent and decisive corrective
                                          measures,S-rated banks will likely fail and require someform of assis-
                                          tance from the Bank Insurance Fund.
                                          As of December31, 1989,1,092 commercial banks (8.6 percent of the
                                          industry’s 12,706 commercial banks) with assetstotaling $187.8 billion
                                          (6.7 percent of the industry’s $3.3 trillion in assets)were on the problem
                                          bank list. In certain instances,the Bank Insurance Fund is the insurer of
                                          savings banks. However, industry data reported by the regulators usu-
                                          ally cover the commercial banking industry, which excludes savings
                                          banks insured by the Fund. There were 17 savings banks with assets
                                          totaling $47.6 billion included on the problem bank list as of
                                          December31, 1989. Table 3.1 shows the distribution of problem banks
                                          on the list basedon composite ratings for 3 years.

table 3.1: Problem Bank8 for Calendar Year8 1987 Through 1989
Dollars in billions
                                                                                   As of December 31,
                                                              1989                        1988                        1987
                                                         Number   Ametr            Number     Assets          Number      Assets
4-rated
.-__-- banks                                                 895     $211.8          1,124       $317.4         1,339      $336.5
f&rated
  ..-   banks -.-                                            214       23.6            282         34.8           236        21.9
Total Problem Bank8                                        1.109     $235.4          1.406       $352.2        1.575       $358.4


                                          The number of banks on the problem bank list has been significant over
                      Y                   the past several years. At December31,1987, the problem bank list
                                          included 1,676 banks. Through December31,1989,268 of these banks


                                          Page 28                                            GAO/AFIMD-90-100Bank Insurance Fund
                     chapter 8
                     Problem &mlu Expom the Bank Inourance
                     Fund to 8ignlficant Birkr




                     actually failed and 21 were assisted.Of the remaining banks, 729 were
                     deleted due to an improved financial condition or merger and 667
                     remained on the list at December31, 1989. Thus, while a bank’s pres-
                     enceon the problem bank list identifies it as an institution in severe
                     financial condition, it doesnot conclusively indicate that the bank will
                     fail. Conversely, as is discussedlater, a bank’s absencefrom the list is
                     not assurancethat the bank will not fail.
                     FDICbelieves that as the number of problem banks continues to decline,
                     the failure rate will also decline. While the number of banks on the
                     problem bank list has declined since 1987, the number of problem insti-
                     tutions along with the level of exposure they represent to the Bank
                     Insurance Fund is still alarmingly high and posesa significant risk to the
                     Fund. The Southwest region’s 610 problem banks continued to be the
                     highest number by far, more than three times the 178 problem banks
                     reported by the West,the secondhighest region. At year-end 1989, the
                     Northeast region reported 20 problem banks as compared to 19 in 1988.
                     In 1989,206 banks with assetsof $29.2 billion failed, compared to 200
                     banks with assetsof $36.6 billion that failed in 1988. Through the first
                     quarter of 1990, the bank failure rate decreasedfrom the 1989 rate. FDIC
                     reported that 37 banks with assetstotaling $2.0 billion had failed during
                     the first quarter of 1990. By comparison, FDICreported 63 bank failures
                     (including 20 MCorp subsidiary banks), with assetstotaling $18.6 bil-
                     lion, during the first quarter of 1989.

                     We conducted a financial analysis of all the banks with assetsin excess
Certain Problem      of $100 million on FLMC’Sproblem bank list at December31, 1989, using
Banks Threaten the   quarterly and annual financial information the banks reported in their
Fund’s Soundness     quarterly call report and Securities and ExchangeCommissionsubmis-
                     sions from December1986 through December1989. We analyzed banks
                     with over $100 million in assetsbecausewe believe banks with lower
                     asset levels can be resolved by the Bank Insurance Fund and not result
                     in the fund balance declining from year to year unless a recessionwere
                     to occur. As stated in chapter 2, the collective estimated cost of 161
                     smaller bank failures in 1989 was comparable to one large bank failure.
                     Our analysis included 171 of the problem banks with assetstotaling
                     $202 billion (86.8 percent of the total assetsof banks on the
                     December31, 1989, problem bank list). Additionally, we reviewed finan-
                     cial information for the 100 largest U.S. commercial banks, 5 of which
                     were included in the 171 from the problem bank list. Also, our review


                     Page 29                                  GAO/AFMIHO-100 Bank Inmrance Jhnd
Chapter 3
Problem Banka Fixposethe Bank Insurance
Fund to Significant Risks




included another 34 banks that we identified as problem banks basedon
other regulatory and public source information. In total, we reviewed
the financial condition of 300 banks.
We reviewed each of the 300 banks’ assetcomposition and performance,
equity capital level, earnings performance, and liquidity level. We also
compared these key financial indicators for each bank with the averages
of all 300 banks and with the averagesof the industry as a whole. We
used this information to determine which banks were in such severe
financial condition at December31, 1989, that they were likely to fail in
the near future without someform of recapitalization. We also used this
information to determine which banks were experiencing significant
downward trends in their performance as of December31,1989, such
that a continued deterioration in their region’s economieswould result
in the likelihood of their failure. We reviewed the condition of these
banks through March 31, 1990, to seeif conditions had changedsignifi-
cantly since December31, 1989.

Our financial analysis of the 300 banks showed 36 institutions in such
severefinancial condition at December31, 1989, that without someform
of recapitalization, they are likely to fail or require regulatory assis-
tance in the near future. These 36 banks are located principally in the
Northeast and Southwest and have assetstotaling $46.1 billion. While it
is not possible to predict with certainty that all of these banks will fail,
we believe it is highly likely that many, if not all, of them will fail. If all
of these banks fail, we estimated a cost to the Fund ranging from $4.4
billion to $6.3 billion.

Of these banks, 26 with assetstotaling $17.6 billion were listed on the
December31, 1989, problem bank list. These institutions represent 2.3
percent of the banks and 7.4 percent of the total assetsof the banks on
the problem bank list, The remaining 9 banks with assetstotaling $27.6
billion were rated 2 to 6 by the regulators.
FDICstated that the 7 banks rated 4 or 6 were not on the problem bank
list becausetheir last examination was too closeto year-end to reflect
their revised CAMEL rating in the year-end problem bank list. In addition,
they stated that 3 of these 7 banks were operating under a recapitaliza-
tion plan that the regulators believed was credible. The remaining 2
banks were rated 2 or 3. They were not examined in the last year and
thus the CAMEL rating did not change.




Page 30                                     GAO/AFMD-90-100Bank Insurance Fund
          .

   .                                          chapter a
                                              Problem Banka Expose the Bank Insurance
                                              Fund to Significant RIska




                                              The primary determinants we used in identifying the 36 banks likely to
                                              fail were the likelihood of their becoming equity insolvent based on the
                                              bank’s earnings trend and the level of nonperforming assets.Generally,
                                              these banks were already insolvent basedon equity capital or had min-
                                              imal levels of equity capital, had excessivelevels of problem assets
                                              (composedof nonperforming loans, delinquent loans, and other real
                                              estate owned/acquired through foreclosure), and had earnings trends
                                              that if continued would lead to their insolvency basedon equity capital
                                              in the near future. Table 3.2 shows that financial indicators of the 36
                                              banks’ financial condition are dramatically worse than the industry
                                              averagesand the averagesof the 300 banks we reviewed.

Table 3.2: Key Banklna industry Financial Indicators as of December 31, 1989
-Dollars in billions
                                                       Equity capital              Problem assets               Net income (loss)
                               Total asset8          Amount Percenta              Amount Percent0               Amount Percent’
Problem banks (35)                    $45.1                $.6              1.4         $4.0       8.8             S(1.6)     (3.5)
Total sampled banks (300)           1,999.g              100.1              5.0         79.1       4.0               1.7        .l

To~h~;o;;lercial       banks        3,299.0              206.0              6.2         113.8      3.4              16.3        .5
                                              aPercentage of total assets

                                              Our analyses of the 300 banks showed that a significant number of
                                              other banks were experiencing significant negative trends in certain key
                                              financial indicators at December31, 1989. Thesetrends include the rate
                                              of depletion of equity capital, negative earnings, the growth in problem
                                              assets,and low levels of bank liquidity. In addition, these banks are pri-
                                              marily located in the Northeast and Southwest-areas with depressed
                                              real estate markets. Given the banks’ financial condition, they are likely
                                              to fail in the future if these economiescontinue to deteriorate.
                                              Costs related to the 36 banks we believe are likely to fail in the near
                                              future without recapitalization and those banks we believe are likely to
                                              fail later if deteriorating economicconditions persist could significantly
                                              impair the Fund, which reported a balance of $13.2 billion as of
                                              December31, 1989. In addition, there are several other large banks that
                                              could fail if the economy experiencesa recession.Their financial condi-
                                              tion was better than the banks we identified; however, their failure
                                              could result in depletion of the Fund.
                                              Our estimates of $4.4 billion to $6.3 billion of costs to the Fund are
                                              basedon loss rates FDIC has historically experienced on bank failures.


                                              Page 31                                           GAO/AJ?MD-BOW0Bank Insurance F’und
                       Chapter 8                                                                .
                       Problem Banka Expoee the Bank Insurance
                       Fund to Significant l&h




                       However, there are certain inherent limitations in using historical expe-
                       rience to predict future events. As a result of changesin the composition
                       of assetsin banks, such as those noted in chapter 2, FDIC'S past loss rates
                       might be inaccurate indicators of future loss rates. For example, very
                       few of the bank failures have had concentrations of HLTS in their loan
                       portfolios through 1989. HLTS are relatively new and do not yet have
                       reliable historical loss rates which could be used to reasonably predict
                       their potential impact on bank losses.

                       Another factor affecting the Fund’s estimated exposure for future bank
Quality of Bank Call   failures is the quality of somequarterly call report data the banks pre-
Report Data Not        pared for the regulators. The call report consistsof a balance sheet,
Always Reliable        income statement, and various other financial information required by
                       the governing bank regulations. These reports are not audited. Other
                       than on-site examinations by the regulators, call reports and other infor-
                       mation the banks prepare at the regulators request are the principal
                       meansby which regulators assessthe financial condition of a bank. The
                       regulators use this data for off-site monitoring of banks’ financial condi-
                       tion and performance between on-site examinations in order to identify
                       adversetrends in an individual bank or the industry, in the aggregateor
                       regionally. The data are also used in helping to decide the frequency and
                       timing of on-site bank examinations and generally in planning the scope
                       of an on-site examination.

                       We used the quarterly call reports to analyze the banks’ financial condi-
                       tion. Although we did not review the overall quality of call reports, we
                       have found examples in certain problem banks that suggestcall report
                       accuracy often dependson whether there has been a recent examination
                       by the bank regulators.
                       We reviewed examination reports for 10 institutions in the Northeast
                       which were rated 4 or 6. We found that the regulators reported that
                       these institutions had understated the level of nonperforming loans in
                       their call report submissions;thus, they had established inadequate
                       levels of loss reservesand had overstated interest income and net
                       income. In addition, our ongoing study on accounting and reporting
                       issuesin banking, where we reviewed examination reports prepared
                       prior to the failure of 39 banks, found that the regulators cited inade-
                       quate reservesbeing reported in the call reports in 31 of the 39 banks.
                       The level of these understatements and their impact on the institutions’
                       financial condition varied. We found that someof the assetclassifica-
                       tions the examiners recommendedwould changethe reported financial


                       Page 32                                   GAO/~90-100     Bank Insurance F’und
                      Chapter   3
                      Problem BanL;sExpose the Bank Insurance
                      F’und to SQijniflcant Rinks




                      condition of the institutions. Thus, the information reported in call
                      reports does not always reflect the true financial condition of an institu-
                      tion. Discussionswith regulators revealed that they agreethat the
                      quality of call report information submitted by somebanks, particularly
                      problem institutions, is questionable.
                      Another indicator of the problems with the quality of call report data is
                      the timing of bank failures in relation to when and if the bank appeared
                      on FDIC’Sproblem bank list. In general, banks remain on the problem
                      bank list for several quarters or years before they either fail, are
                      merged or assisted,or their financial condition improves resulting in a
                      composite CAMEL rating less than 4. However, of the 406 banks that
                      failed in 1988 and 1989, we found that 22 failed without ever appearing
                      on the problem bank list and that 9 failed after appearing on the list for
                      only one quarter. The recent failure of the National Bank of Washington
                      is another example of a bank that failed without appearing on the
                      problem bank list. The absenceor limited presenceof these banks on the
                      problem bank list suggeststhat the regulators had not thought them to
                      be in danger of failing until the bank examiners, in conducting on-site
                      examinations, found them to be in such severely deteriorated financial
                      condition that they were immediately closed.While we did not review
                      the examination and call reports for these institutions, we are concerned
                      that the call reports apparently did not forewarn regulators about the
                      conditions which causedthese banks to fail.


Monitoring of Banks   Federal regulators attempt to ensure that all banks are examined on a
                      routine basis. However, due to staffing limitations, greater reliance is
Varies Among the      being placed on off-site monitoring. The accuracy of call report data,
Regulators            particularly for troubled or near troubled (3-rated) banks where the
                      effect of misstatement is more critical, is a concern for effective off-site
                      monitoring. Another concern is the disparity in the frequency and scope
                      of on-site examinations from regulator to regulator. Both FJXCand FRB
                      rely more on on-site examinations, while occ utilizes off-site monitoring
                      with limited scopeon-site examinations.

                      The goal of the Federal ReserveBoard, which supervisesand regulates
                      state-chartered banks that are membersof the Federal ReserveSystem
                      and bank holding companies,is to examine state-chartered banks and
                      inspect large and problem bank holding companiesannually. CCC,which
                      supervises and regulates national banks, places the responsibility for
                      the scopeand timing of examinations on field managersassignedto
                      monitor specific banks. FDIC supervisesand regulates insured state-


                      Page 93                                    GAO/AF’MD~l00 Bank Insurance Fund
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                  F’und to SIgnifhant Risk




                  chartered banks that are not membersof the Federal ReserveSystem.
                  FDIC’Sgoal is to conduct on-site examinations at least every 24 months
                  for institutions consideredhealthy, and on-site examinations at least
                  every 12 months for problem and near-problem institutions.


FDIC Monitoring   FDIC'S Division of Supervision is responsible for conducting and planning
                  bank examinations. It conducts full scopeon-site examinations of
                  problem banks for which FDIC has supervisory responsibility. These
                  examinations, sometimesreferred to as safety and soundnessexamina-
                  tions, are often more limited in scopefor banks with CAMEL ratings of
                  less than 4. A full scopeexamination consistsof a detailed review of the
                  entire bank to determine its CAMEL rating. In conjunction with safety and
                  soundnessexaminations, the Division of Supervision also conducts more
                  specific examinations for (1) performance of fiduciary responsibilities,
                  (2) adequacy of internal controls in electronic data processing,and (3)
                  compliance with consumer protection and civil rights laws and
                  regulations.

                  FDIC’S Division of Supervision doesnot conduct on-site examinations
                  basedon fixed examination cycles. It believes that the use of such cycles
                  results in somebanks receiving too much supervision and others not
                  enough. Instead, it places more emphasis on monitoring problems/risks
                  within the banking industry and individual banks through off-site moni-
                  toring procedures. However, to ensure that banks are routinely
                  examined, the Division of Supervision has an examination frequency
                  policy that requires an on-site examination be conducted at least every
                  24 months for banks with a 1 or 2 CAMEL rating and every 12 months for
                  banks with a 3,4, or 6 CAMEL rating. The examination frequency policy
                  is also flexible and counts many state examinations of banks rated 1,2,
                  and 3 the same as an FDIC examination. However, the frequency of
                  examinations is not necessarily acceleratedfor banks on the problem
                  bank list. Rather, the Division of Supervision assessesthe risk associ-
                  ated with these banks on a case-by-casebasis and decideson an appro-
                  priate response(for example, an examination within 6 months, a visit to
                  the bank quarterly, or periodic phone calls to the bank).

                  In addition to the on-site examination process,FJIIC has an off-site moni-
                  toring program known as the CAEL off-site review program. CAEL stands
                  for capital, assetquality, earnings performance, and liquidity. Under the
                  CAEL program, financial information submitted by the banks (call report
                  data) is reviewed and compared to the examination data. The CAEL pro-
                  gram is maintained in a computer databaseand updated as quarterly


                  Page 34                                   GAO/APMD-WlOO Bank Insurance Fund
 .
                 Chapter 3
                 Problem Banka Expose the Bank Insurance
                 F’und to Significant Risks




                 call reports are submitted to FDIC. The program gives examiners on-line
                 accessto the latest supervisory data and financial information and helps
                 them detect banks with deteriorating financial conditions. Thus, banks
                 are examined on-site once every 12 or 24 months, and supervisory off-
                 site review is performed on a quarterly basis.


FRB Monitoring   The FRB uses a computerized surveillance system to monitor the finan-
                 cial condition of all member banks. The surveillance system is divided
                 into two parts, one for member banks and one for bank holding compa-
                 nies. The main objective of the system is to identify financial institutions
                 that are not yet problems but exhibit deteriorating financial profiles, FRB
                 reviews and updates the system quarterly to facilitate early warning
                 and to detect emerging problems.
                 Data used in the surveillance system are obtained from the financial
                 reports of the banks and bank holding companies.Using this data, the
                 system computes six ratios for each institution and ranks it basedon a
                 comparison with its peers. The lowest ranked institutions (the bottom
                 6 percent through 10 percent) are segregatedby district on an exception
                 list. The responsible field analyst will perform an extensive evaluation
                 of all the institutions identified on the exception list and, basedon this
                 evaluation, conclude as to whether they are potential emerging
                 problems . The system also provides a detailed performance report for
                 each institution.
                 Although F'RB administers the program, its reserve banks have computer
                 accessto the data and the performance reports. Reservebank analysts
                 review the exception list to determine the validity of the initial evalua-
                 tions and annotate the list with their final evaluation or surveillance
                 notation. Generally, banks with a 3 CAMEL rating are put on a “watch”
                 list (the “watch” list indicates that a bank’s condition warrants concern
                 but is manageable).Banks with a 4 CAMEL rating require special supervi-
                 sion (increased frequency of examination) and banks rated 6 are consid-
                 ered problem banks targeted for special attention (on-site supervision
                 and constant contact with the bank). Bank holding companiesare rated
                 using the BOPEC rating system. BCPEC stands for bank subsidiaries, other
                 subsidiaries, parent company, earnings-consolidated,and capital
                 adequacy-consolidated.This system usesthe same 1 to 5 rating catego-
                 ries as the CAMEL rating system. In addition, reserve banks prepare
                 written analyses for all institutions with deteriorating financial profiles.
                 FRB staff report the reserve bank’s conclusionsto F'RB senior officials;
                 any revisions are reported back to the reserve banks. The reserve banks


                 Page 35                                    GAO/AF’MD-90-100Bank Insurance Fund
                Chapter 9
                Pmblem Bmh JZxpoaethe Bank Inauranw
                Fund to Significant IUnlrs




                then take supervisory action, such as on-site supervision or closemoni-
                toring of the bank’s condition.
                In addition to the surveillance system described above,the stock prices
                for bank holding companieswith over a $1 billion in consolidated assets
                are also monitored. Bank holding companieswith a decline of 10 percent
                or more in their stock price relative to the industry are added to the
                exception list.
                In addition to the surveillance system, the reserve banks examine state
                member banks in conjunction with state banking authorities and inspect
                large and problem bank holding companiesat least once a year. How-
                ever, certain banks require additional review. For example, multina-
                tional state member banks and all other banks with assetsgreater than
                $10 billion are subject to a full scopeexamination annually, in addition
                to limited scopeor target examinations. Limited scopeexaminations
                review all areas of activity covered by a full scopeexamination, but less
                intensively. Also, banks with a 4 or 6 CAMEL rating must be examined
                twice a year, including one full scopeexamination, until their condition
                improves.
                Between examinations, the reserve banks review all annual Securities
                and ExchangeCommissionfilings and regulatory reports to aid in the
                early detection of banks with deteriorating conditions.


OCCMonitoring   Like F'RB and FLMC, WC also usesa computerized supervisory monitoring
                system to monitor the financial condition of national community banks,
                national regional banks, and multinational banks. Generally, on-site
                examinations at occ are more limited in scopethan those done by FDIC
                and FRB, and greater reliance is placed on an off-site monitoring system
                to aid in (1) the early warning, identification, and monitoring of problem
                banks, (2) the determination of possible systematic problems within the
                financial community, and (3) the estimation of resourcesneededto
                monitor/supervise problem banks.
                o&s field offices are primarily responsible for identifying problem
                banks. Portfolio managersfrom the field are assignedspecific banks to
                review and monitor. occ believes that this system enablesthe portfolio
                managersto remain in constant contact with their banks and thus
                becomevery familiar with the banks’ operations.




                Page 36                                   GAO/AFMD-90-100Bank Ineurance Fund
 1
                     chapter 8
                     Problem Banka Expose the Bank Insurance
                     F’und to Si@fIcant   Riska




                     Portfolio managersuse the supervisory monitoring system as a primary
                     tool to carry out their responsibilities. The supervisory monitoring
                     system contains such information as the bank’s most recent call report
                     and CAMEL   rating, other relevant off-site/on-site financial data such as
                     financial statements, any enforcement actions against the bank, audit
                     reports, risk profile, and supervisory strategy.
                     The portfolio manager writes the supervisory strategy, which includes
                     critical data: how often the bank should be examined, supervisory
                     actions neededbasedon the bank’s condition and any significant
                     changesin the bank’s businessstrategies, the bank’s capital level, and
                     the percentageof classified assets.
                     occ requires a manager to update the supervisory strategy at least once
                     a year. For banks with a 4 or 6 CAMEL rating, the strategy should be
                     updated quarterly or after each on-site review. For banks rated 4 or 6,
                     district managershave more input into the supervisory strategies. Some
                     districts with banks rated 4 or 6 include 3-rated banks in this review
                     process.occ’s Special Supervision Division and Multinational Division
                     look at all S-rated banks. They review the bank’s condition and supervi-
                     sory strategy for adequacy and reasonableness.

                     The regulators stated that becauseof the large number of problem
                     banks and the limited number of bank examiners, each of the three bank
                     regulatory agencieshas developed its own system of off-site monitoring.
                     While these are useful tools in day-to-day surveillance, they may not be
                     as effective as routine, on-site examinations becausethey rely on the
                     integrity of quarterly call reports and other bank financial data.
                     Without frequent full scope,on-site examinations, particularly for
                     problem institutions and large institutions, the financial information
                     provided by the banks through call reports could present an overly opti-
                     mistic picture of their financial condition. We believe that full scope,on-
                     site examinations are the most certain means for regulators to determine
                     the true financial condition of banks.

                     While analysis of a bank’s financial condition and performance may
Regulator Judgment   show that it has little potential for viability, this doesnot mean the bank
DecidesWhen Banks    will actually fail. Depending on the type of institution, occ or a state
Fail        ”        chartering authority has the express power to close an institution. A
                     bank fails when its chartering authority declaresit to be insolvent and
                     closesthe institution. A recent CKXregulation, effective November 21,
                     1989, defines insolvency as the point at which the institution has


                     Page 87                                   GAO/AFMD-90-100Bank Insurance Fund
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exhausted its equity capital. However, state chartering authorities will
close an institution when it has becomeinsolvent on the basis of regula-
tory capital2
FDIC, occ, FRB, and state banking authorities for state-chartered banks
determine together the options available for a distressed institution. The
regulators consider their assessmentof the institution’s current finan-
cial condition and its primary causes.If they conclude that (1) the insti-
tution would be viable given someinfusion of financial assistanceand
(2) such assistancewould be more cost beneficial than closing the insti-
tution, they will attempt to provide assistance.For example, if an insti-
tution cannot meet its obligations as they comedue and if the regulators
conclude that the bank is otherwise a viable institution, FRB may
authorize the bank to borrow funds from a Federal ReserveBank to
meet its liquidity needs.Since such borrowings are payable on demand,
FRB could call them whenever the institution is no longer considered
viable. Additionally, these borrowings are collateralized by bank assets
which are equal to or in excessof 100 percent of FRB borrowings.
Granting this assistanceimplies the belief that it will enable the institu-
tion to return to viability. In somecases,however, FDIC may provide
temporary assistanceto an institution no longer consideredviable to
minimize the disruption of banking servicesin the bank’s community
and to bring about an orderly closing of the institution.

The regulators also consider other factors in determining whether a dis-
tressed institution is viable. They may request and evaluate business
plans the institution submits to determine whether the institution has a
realistic strategy to work itself out of its difficulties. In addition, if the
bank is a subsidiary of a bank holding company, the holding company’s
ability to provide capital and/or other assistanceto the distressed insti-
tution is considered.FQB will bring pressure to bear on those holding
companiesthat are able to provide such assistance.However, a recent
federal court decision related to the MCorp bank holding company in
Texas could adversely affect FRB’S ability to apply pressure to holding




2Regulatory insolvency refers to the point at which an institution has exhausted its regulatory cap-
ital. The mejor distinction between equity capital and regulatory capital is that the reserves for loan
and lease losses are included in the determination of regulatory capital.



Page86                                                     GAO/AFMD-@lb100
                                                                         Bank Insurance Fund
                        Chapter 8
                        Frablem Bank Expose the Bank Lmmrance
                        F’undto Significant R.isks




                        companies.The court ruled that FRB doesnot have authority to order a
                        holding company to transfer its funds to its troubled subsidiary banks.3
                        The size of the institution and the effects closing it would have on the
                        local economy and other parts of the nation’s banking system are also
                        consideredin determining whether to close an insolvent institution.
                        Thus, although we can use empirical data to identify banks that may
                        fail, we cannot say with certainty that the chartering authorities will or
                        should closethese institutions until the institution is insolvent basedon
                        regulatory capital.


Discussion of GAO’s     Appendix I includes the Bank Insurance Fund’s 1989 and 1988 financial
                        statements and our opinion on those statements. The Fund’s 1989 finan-
Opinion on the Fund’s   cial statements do not reflect the $4.4 billion to $6.3 billion estimated
1989 Financial          cost associatedwith the 36 institutions we believe are likely to fail in
                        the near future without someform of recapitalization. Under generally
Statements              acceptedaccounting principles, an entity must accrue an estimated loss
                        if it is probable that a liability has.been incurred and the amount of the
                        loss can be reasonably estimated. If both of the conditions are not met,
                        disclosure of the loss contingency should be made if there is a reason-
                        able possibility that a loss has occurred.

                        We believe that lossescan be reasonably estimated using FJXC’S historical
                        loss experience in assisting failed institutions. However, we were not
                        able to ascertain that it was probable that FDIC had incurred a loss from
                        the 36 banks as of December31,1989, the date of its financial
                        statements.
                        We applied several criteria in determining whether, in effect, the 36
                        banks had failed and FDIC had probably incurred a loss. The criteria
                        reflect the conditions the regulators use in deciding bank assistance
                        actions. First, we believe it is probable that the Bank Insurance Fund
                        has incurred a liability if a bank is insolvent on the basis of regulatory




                        3MCorp,Civ. No. 89-2816 (6th Cir, May 16,199O). In this case, FRB argued that MCorp’s failure to
                        provide capital to ita subsidiary banks was an “unsafe and unsound practice” under 12 U.S.C. 1818,
                        which FRB could act to restrain. The court concluded that FRB’s determination was an unreasonable
                        and impermissible interpretation of the statute since, among other thii,  the Congress had made no
                        effort in any of the Bank Holding Company Act legislation to require holding companies to inject
                        capital into subsidiary banks.



                        Page 89                                                 GAO/AFMD-90-100Bank Ineurance Fund
              Chapter 3                                                                                     .
              Problem Banh Expose the Bank I~uranca
              Fund ta Significant Rinks




              capital4 Second,we consideredwhether, as of December31,1989, any
              of the 36 banks were (1) equity insolvent basedon generally accepted
              accounting principles or in severeenough financial condition that they
              would becomeinsolvent in a year if not recapitalized, and (2) a current
              agreementor ongoing negotiations indicated that bank assistancefrom
              the Fund would be necessary.While the 36 institutions we identified
              were either equity insolvent or in severeenough financial condition as
              of December31,1989, that they were likely to becomeinsolvent soon if
              they were not recapitalized, none of the institutions have agreementsor
              were negotiating with the regulators to receive assistancefrom the Bank
              Insurance Fund. Consequently, these institutions did not meet the condi-
              tions for probable loss required by generally acceptedaccounting princi-
              ples for recording a loss in the Fund’s financial statements.
              FDIC included a note to its financial statements disclosing the possibility
              that financial assistanceto failing banks may be required and that this
              assistancecould have a material impact on the condition of the Fund.
              FDIC’S note did not mention that we had identified 36 banks that may fail
              in the near future. FDIC believes it is not possible to identify the timing of
              assistance.This position strengthens our concern that generally
              acceptedaccounting principles regarding loss contingenciesmay be
              unduly delaying loss recognition. The criteria for determining when a
              loss is probable allow too much subjective judgement that management
              can use to not recognizelossesand still meet generally accepted
              accounting principles. Chapter 6 further discussesour concernsand
              suggestions.
              Becauseof the significant impact these 36 institutions would have on
              the Fund if they failed in the near future, we have included an explana-
              tory paragraph in our opinion on the Fund’s 1989 financial statements
              to discloseour concernsand the effect of these potential failures on the
              Fund’s financial statements. As of the date of our opinion, June 28,
              1990,9 had already failed. Basedon March 31,1990, call data we found
              that the remaining banks’ financial conditions had not improved.

              The Bank Insurance Fund faces significant costs in the near future due
Conclusions   to the severely deficient financial condition of 35 problem banks. The
              Fund balance could be significantly reduced if these banks fail or

              4At December 31,1989,6 of the 36 banks were insolvent on the basis of regulatory capital. These
              banks were subsequently closed in 1990 and their costs incurred in the Bank Insurance Fund’s 1990
              operations.



              Page 40                                                 GAO/APMD-9@100Bank Insurance Fund
                      Chapfer 3
                      Problem Banlra Expose the Bank Insurance
                      Fund to Significant Risks




                      require assistance.The Fund faces additional loss contingencieslater
                      from other institutions whose current financial condition makes them
                      susceptible to failure if their regional economiescontinue to deteriorate.
                      While we have estimated the potential exposure facing the Fund from
                      these problem institutions, we cannot be certain that these banks will
                      fail. The decision to close an institution ultimately rests with its char-
                      tering authority. Our estimates are also limited becauseof the question-
                      able quality of the call report data the bank reported to the regulators
                      and which we used in our analyses.Becausethe call report information
                      doesnot always accurately state the financial condition of these institu-
                      tions, the Bank Insurance Fund’s potential loss exposure may actually
                      be greater than we have estimated. Furthermore, inaccurate call reports
                      may also keep banks in severefinancial condition from appearing on
                      F+DIC’Sproblem bank list. Becausethe regulators are increasingly relying
                      on call report information in their off-site monitoring of banks to supple-
                      ment on-site, full scopeexaminations, early warnings of potential bank
                      failures and their impact on the Fund may not occur.

                      We recommendthat the Chairman, Federal Deposit Insurance Corpora-
Recommendation        tion; the Chairman, Federal ReserveBoard; and the Comptroller of the
                      Currency annually perform on-site, full scopeexaminations of problem
                      banks and large banks.

                      In its written commentson a draft of our report, FRB agreed with our
Agency Comments and   recommendation that regulators should perform annual on-site, full
Our Evaluation        scopeexaminations of problem and large banks, stating that its current
                      policies exceedthis standard. F'RB also concurred with our views
                      regarding the importance of on-site examinations. (Seeappendix IV.)

                      FDICcommentedthat its recent goals have been to increase efforts in on-
                      site as well as off-site monitoring. (Seeappendix III.) However, it does
                      not intend its improved off-site monitoring to substitute for an effective
                      on-site examination program.
                      occ questioned our recommendation as well as the accuracy of our por-
                      trayal of its approach to bank supervision. (Seeappendix V.) occ stated
                      it utilizes both on-site and off-site examination techniques that use its
                      resourcesefficiently while at the sametime provide current information
                      about the condition of each bank under occ’s supervisory authority. occ
                      believes its present approach to bank supervision allows its examiners


                      Page 41                                    GAO/AFMD!W1OOBank Insurance Fund
Chapter 2
Problem Banka Expose the Bank Ixwranw
F’und to Sieplurcant Rhlu~




both flexibility and accountability in determining what types of supervi-
sory activities to perform at the banks for which they are responsible
and when these activities are to be performed.

Our work found that occ doesnot perform annual full scopeexamina-
tions on large and problem banks. Failure to perform full scopeexami-
nations increasesthe likelihood that a large bank could experience
severefinancial deterioration and not be identified in a timely manner.
An example of this is the recent failure of the National Bank of Wash-
ington which, prior to its failure, had a CAMEL rating of lessthan 4,
implying that it was not in danger of failing. Additionally, the failure to
perform annual full scopeexaminations of problem banks increasesthe
risk that any further deterioration of a problem bank’s financial condi-
tion would not be reported. Thus, a bank that should be closedcould
remain open and ultimately result in increasedcoststo the Bank Insur-
ance Fund due to the delay in closing the bank.
Our report is consistent with occ’s description of its supervision process.
OCC’Soff-site monitoring system is similar to that of the other regulators.
However, like FDICand FRB, we believe that enhancedoff-site monitoring
of banks should complement vigorous on-site examinations, not replace
them or reduce their scope,as we believe o&s current supervisory
approach has done.

While the scopeof an examination would, and should, vary from bank to
bank, a comprehensive,full scopeexamination is the most accurate
meansof assessinga bank’s financial health. Annual full scopeexamina-
tions of large and problem banks, complementedby off-site monitoring
and resident examiners in large banks, would produce a supervisory
system capable of identifying troubled banks and aiding in timely inter-
vention by regulators.
CKXalso commentedthat the report’s estimates about the number of
potential banks failures and their impact on the Bank Insurance Fund
are basedon limited and insufficient data. occ stated that while loss
rates experiencedby FDICon bank failures could increase,occ’s new clo-
sure policy should mitigate this increase.CKZalso stated that the report
doesnot estimate the extent to which inaccurate call report data have
led to understating problem banks’ financial conditions or additional
coststo the Fund.
Our report acknowledgesthe limitations of the data used to identify the
number of banks that are likely to fail within the next year. However,


Page 42                                    GAO/AFMD-WlOO Bank Insurance Fund
Problem Banka Expooe the Bank l~urance
Fund to signimant Biaka




experience to date in 1990 supports the processwe used to identify
these potential bank failures. As of August 16, 1990, more than one
third of the 36 banks we identified as likely to fail had already failed. In
addition to those that had already failed, FLIIC acknowledged that
another bank would require assistance.This report doesnot specifically
identify the 36 banks, as we are statutorily prohibited from disclosing
the names of any open banks to the public. However, we can disclose
and have disclosedthis information to the regulators.
Our report acknowledgesOCC’S    policy of closing banks when they
becomeequity insolvent. While this policy states ocx will consider clo-
sure at the point of equity insolvency, it doesnot affirmatively state
that all equity insolvent banks will be closed.occ could allow a bank
that is equity insolvent to remain open under this policy, thus not
reducing the cost of the eventual bank failure to the Fund. Also, as
acknowledged in our report, we did not conduct a detailed review of the
scopeand quality of bank supervision practices, including the quality of
bank call reports. However, our future plans include such a review and
at that time we will be better able to correlate the impact of inaccurate
call report and other bank prepared data on the timing of supervisory
actions and, ultimately, on the Fund.




Page 48                                    GAO/AFMD-90-100J3ankInsurance F’und
Chapter 4

ReportedPerformanceand Condition of the                                               ’
BaxMn.suravlceF’und

              The Bank Insurance Fund ended the year 1989 with a balance of $13.2
              billion, as compared to $14.1 billion at year-end 1988, and reported a net
              loss in 1989 of $862 million. Loss reservesrelating to 206 bank failures
              and one assistancetransaction along with certain increasesto existing
              loss reservesfrom prior years’ bank failures contributed to the loss. At
              December31,1989, the ratio of the Fund balance to insured deposits
              equaled .7 percent, the lowest ever in the history of the Fund (down
              from .83 percent at year-end 1988). From 1980 through 1987, the ratio
              of the Fund balance to insured deposits averaged 1.17 percent. Thus, the
              past 2 years have seensharp declines in the Fund’s reserve ratio.
              FIRREA  authorizes FDIC to increase annual assessmentseach year begin-
              ning in 1990 to eventually achieve a minimum reserve ratio to insured
              deposits of 1.26 percent, or up to 1.6 percent if the FDIC determines that
              a significant risk of substantial future lossesjustifies a higher reserve
              ratio for a particular year. However, FIRREA also places various con-
              straints on the amount and timing of the increasesFDIC can impose.
              Becauseof these assessmentconstraints and the Fund’s exposure to
              risks, our estimates show the Fund will not achieve the minimum
              reserve ratio by 1996. Further, we question whether the assessment
              authority under FIRREA is too restrictive to build a Fund balance that
              would protect the taxpayer in the event of a recession.
              While the 1.26 percent minimum reserve ratio designatedby FTRREA is
              comparable to the averagereserve ratio of 1.17 percent for the period
              from 1980 through 1987, we question whether it is sufficient consid-
              ering the existing and future exposuresthe Fund faces.We believe the
              Fund is faced with greater risks today than ever before. We are not
              aware of any study that was done to determine the basis of the min-
              imum and maximum reserve ratios prescribed by FIRREA. The uncertain-
              ties related to the sizeableHLT exposure, the growth in real estate
              lending, the persistent LLZdebt problem, along with insufficient growth
              in the industry’s equity capital compared to the growth in
              nonperforming loans causeus to believe the current $13.2 billion fund
              balance is too thinly capitalized. The riskier nature of the industry’s
              loan portfolio coupled with a recessioncould deplete the Fund balance,
              resulting in coststo the taxpayer.




              Page 44                                   GAO/AFMD-90-100Bank Inmrance Fund
    .


                      Chapter 4
                      Beport.adPerformance and condition of the
                      BankInmranceFund




                      FIRREA provides for FDIC to  charge incrementally increasing annual
FIRREA Authorizes     assessmentrates to insured commercial banks beginning in 1990. The
AssessmentIncreases   statutorily prescribed rate of .083 percent of a bank’s adjusted average
to Reach Minimum      deposit liability for 1989 increasesto .12 percent for 1990 and -16 per-
                      cent for 1991 and beyond. FDIC charged the prescribed rates authorized
ReserveRatio          for 1989 and 1990. FIRREA also authorizes FDIC to increasethese pre-
                      scribed rates under certain circumstances,but limits all authorized
                      increasesto ,076 percent of insured deposits in any given year, and the
                      assessmentrate itself cannot exceed.326 percent of insured deposits.
                      The circumstancesunder which FDIC may increasethe rates are tied to
                      the Fund’s reserve ratio.
                      Under FIRREA, for each year beginning in 1989, the Fund’s designated
                      minimum reserve ratio to insured deposits is to be 1.26 percent. It may,
                      however, be at a higher level not to exceed 1.60 percent if FDIC’S board
                      of directors determines on a yearly basis that a significant risk of sub-
                      stantial future lossesto the Fund justifies a higher ratio. From 1989
                      until the earlier of January 1,1996, or January 1 of the year in which
                      FDIC first expects the Fund to attain the designated reserve ratio, FLNC
                      may increasethe statutorily prescribed rate only if the Fund’s reserve
                      ratio is not increasing on a calendar year basis. Thereafter, FDIC may
                      also increasethe assessmentrate if it determines that the Fund reserve
                      ratio is expected to be less than the designatedreserve ratio.

                      FJIIC has developedtwo projections of the Fund balance and its ratio to
FDIC Projections of   insured deposits for each year from 1990 through 2000. Table 4.1
Attaining the         presents FDIC’S projections through 1996. Scenario 1 usesFDIC’S most
Minimum Reserve       optimistic estimate of failure and assistanceexpenses.Scenario 2 uses a
                      more conservative estimate of these costs.Both projections use opti-
Ratio May Be Overly   mistic projections of income earned from investments. They use the
Optimistic            beginning-of-the-year balance of investment principal, when on average
                      this balance has declined over the last 6 years. We believe FDIC’S esti-
                      mates of costs associatedwith failure and assistancetransactions in sce-
                      nario 1 are unrealistic in light of the institutions we believe are likely to
                      fail in the near future or later. Also, FDICassumedannual growth of 6.9
                      percent in both the assessabledeposit base and insured deposits. The
                      actual insured deposit growth rate has averaged 6.6 percent over the
                      last 6 years. The assessmentrates prescribed under FIRREA of .12 per-
                      cent for 1990 and .16 percent thereafter were applied to the assessable
                      baseto derive the assessmentrevenues.




                      Page 46                                     GAO/AFMD-90-100Bank lnsuranm Fund
                                            Chapter 4
                                            Beported Performance and Condition of the
                                            Bank Imurance Fund




Table 4.1: FDIC ProjectIona of the Bank Inauranco Fund Reserve Ratio for 1990 Through 1995
Dollars in billions
Scenario 1                                            1990          1991           1992         1993       1994        1995
Insured deposits                                  $2,002.2       $2,140.3       $2,288.0     $2,445.1   $2,614.7    $2,795.1
Assessable base                                    2,418.l        2,584.g        2,763.3      2,953-g    3,157.a     3,375.7
Assessments                                            2.9            3.9            4.1          4.4        4.7         5.1
Failure and assistance expenses                        2.3            2.3            2.3          2.3        2.3         2.3
Net income                                             1.6            2.7            3.2          3.8        4.4         5.2
Fund balance                                          14.8           17.5           20.7         24.5       28.9        34.1
Gtio of fund balance to insured deposits
   hercent)                                           0.74           0.82           0.91         1.oo       1.11        1.22

Scenario 2
Insured deDosits                                  $2.002.2       $2.140.3       $28288.0     $2.445.1   $2.614.7    $2.795.1
Assessable base                                    21418.1        21584.9        21763.3      2,953.g    31157.8     31375.7
Assessments                                            2.9            3.9            4.1          4.4        4.7         5.1
Failure and assistance expenses                        3.8            3.8            3.8          3.8        3.8         3.8
Net income                                             0.1            1.1            1.4          1.8        2.3         2.8
Fund balance                                          13.3           14.4           15.8         17.6       19.9        22.7
Ratio of fund balance to insured deposits
   lowcent)                                           0.66           0.67           0.69         0.72       0.76        0.81


                                            FDIC’S most optimistic  scenario projects that by 1996 the Fund balance
                                            will come closeto but will not achieve the minimum reserve ratio desig-
                                            nated by FIRREA. Under scenario 2, the 1996 reserve ratio would be far
                                            below that designated minimum ratio. Under scenario 1, the Fund would
                                            exceedthe 1.26 percent minimum reserve ratio in 1996. Under scenario
                                            2, FDIC projects that the Fund would achieve the minimum reserve ratio
                                            of 1.26 percent by the year 2000.

                                            The following tables present our projections of the Fund’s balance and
GAO Projections of                          its ratio to insured deposits for each year between 1990 and 1996 under
Attaining the                               three scenarios.Basedon these projections, we do not believe that it is
Minimum Reserve                             likely the ratio will reach the 1.26 percent minimum reserve ratio desig-
                                            nated by FTRREAby 1996.
Ratio
                                            We present three scenariosusing FDIC’S projections of annual growth in
                                            insured deposits and the assessablebase.We used FDIC’S projections for
                                            determining assessmentincome and insured deposit growth becausewe
                                            believe the positive impact from higher assessmentsis largely offset by
                                            a higher insured deposit basein computing the Fund’s reserve ratio.


                                            Page 46                                        GAO/AFMD4W1OOBank Insurance Fund
                                            chapter 4
                                            Reported Performanm and Condition of the
                                            J3ankInsuranceFund




                                            Also, we applied FIRREA’S assessmentrates to each year’s assessable
                                            base.Growth in all other revenue sourcesand expenses,other than the
                                            differing lossesassociatedwith failure and assistancetransactions for
                                            each scenario, is basedon their averagegrowth between 1986 and 1989.

Table 4.2: CUO Prolectlon of the Bank lnrunnce   Fund Reserve Ratio for 1990 Through 1995 - Scenario 1
Dollars in billions
                                                      1990          1991          1992        1993          1994       1995
Insured deposits                                  $2,002.2       $2,140.3      $2,288.0    $2,445.1      $2,614.7   $2,795.1
Assessable base                                    2,418.l        2,584.9       2,763.3     2,953.g       3,157.8    3,375.7
Assessments                                            2.9            3.9           4.1         4.4           4.7        5.1
Failure and assistance expenses                        2.5            2.5           2.5         2.5           2.5        2.5
Net income                                             1.7            2.6           2.8         3.0           3.2        3.5
Fund balance                                          14.9           17.5          20.3        23.3          26.5       30.0
Ratio of fund balance to insured deposits
  hercent)                                            0.74           0.82          0.89        0.95          1.Ol       1.07


                                            Table 4.2 presents an optimistic picture for the Fund. The assessment
                                            rate applied to the assessablebaseequaled .12 percent for 1990 and .16
                                            percent for 1991 through 1996. This scenario also assumesthat losses
                                            associatedwith failure and assistancetransactions remain at the
                                            averagelevels between 1986 and 1987, when the Fund incurred no
                                            lossesfrom the failure of a large institution. While the Fund’s balance
                                            and its ratio to insured deposits increasesfrom 1989 to 1990 and each
                                            year subsequently under this scenario, by 1996 the ratio is still below
                                            the minimum reserve ratio designatedby FIRREX


Table 4.3: QAO ProJectIon of the Bank lnrurance Fund Reserve Ratio for 1990 Through 1995 - Scenario 2
Dollars in billions
                                                      1990          1991          1992        1993          1994       1995
Insured deposits                                  $2,002.2       $2,140.3      $2,288.0    $2,445.1      $2,614.7   $2,795.1
Assessable base                                    2,418.l        2,584.g       2,763.3     2,953.g       3,157.8    3,375.7
Assessments                                             2.9           5.0           4.1         4.4           4.7        5.1
Failure and assistance exoenses                         5.2           2.5           2.5         2.5           2.5        2.5
Net income (loss)                                      (1.0)          3.7           2.8         3.0           3.2        3.5
Fund balance                                          12.2           15.9          18.7        21.7          24.9       28.4
Ratio of fund balance to insured deposits
   hercent)                                           0.61           0.74          0.82        0.89          0.95       1.02




                                            Page 47                                        GAO/AFMD-B&100Bank Insurance Fund
                                                                                                                         ,
                                            Chapter 4
                                            B.eportadPerformance and Condition of the
                                            Bank Insurance Fund




                                            Under scenario 2 (table 4.3) we include loss estimates for the larger
                                            banks from the 36 institutions which we have identified as likely to fail
                                            in the near future. This significantly decreasesthe 1990 Fund balance
                                            and its ratio to insured deposits. Becausethe ratio of the Fund balance
                                            to insured deposits declines in 1990 compared to 1989, our projections
                                            assumeFDICwill utilize the authority granted by FIRREA and will increase
                                            the 1991 assessmentrate by ,076 percent over the rate charged in 1990,
                                            the maximum allowable increase.In 1991, therefore, we assumedthe
                                            assessmentrate applied to the assessablebaseto be .196 percent.
                                            Becausethe Fund’s ratio to insured deposits is projected to increase in
                                            each of the following years, we assumedthe assessmentrates for 1992
                                            through 1996 would revert back to the statutorily prescribed rate of -16
                                            percent. Under this scenario,the Fund’s balance and reserve ratio will
                                            increaseeach year after 1990 but will remain thinly capitalized and well
                                            below the 1.26 percent minimum reserve ratio.

Table 4.4: GAO Projection ot the Bank lnrursnce Fund Reserve Ratio for 1990 Through 1995 - Scenario 3
Dollars in billions
---.-
                                                      1990          1991           1992       1993         1994         1995
Insured deposits                                  $2,002.2       $2,140.3       $2,288.0   $2,445.1     $2,614.7     $2,795.1
Assessable
----..          base
          ._.- -..-~.--                            2,418.l        2,584.g        2,763.3    2,953.g      3,157.a      3,375.7
Assessments
_--.--_--                                               2.9           5.0            4.1        4.4          4.7          5.1
Failure and assistance expenses
~--                                                     5.8           4.2            4.2        4.2          4.2          4.2
Net income (loss)                                      (1.6)          2.0            1.1        1.3          1.6          1.8
Fund balance                                          11.6           13.6           14.7       16.0         17.6         19.4
I__--
Ratio of fund balance to insured deposits
   hercent)                                           0.58           0.63           0.64       0.65        0.67          0.69


                                            Under scenario 3 (table 4.4), we included the failure of both the larger of
                                            the 36 banks we identified as likely to fail in the near future and other
                                            large institutions which could fail if negative economicand financial
                                            trends persist. For the latter, we applied our estimated midpoint cost
                                            associatedwith these failures evenly over the S-year period from 1991
                                            through 1996. For the institutions we identified as likely to fail in the
                                            near future, we assumedthe cost to be the midpoint of our loss range.
                                            Under this scenario,the Fund’s ratio to insured deposits declines in 1990
                                            compared to 1989. Consequently, our projections assumeFDIC will
                                            increasethe 1991 assessmentrate by .076 percent over the rate charged
                                            in 1990, thereby charging a rate of .196 percent. Becausethe Fund’s
                                            ratio to insured deposits is projected to increasein each of the following
                                            years, we assumedrates for 1992 through 1996 would revert back to the


                                            Page 48                                        GAO/AFMD9O-100Bank Insurance Fund
chapter 4
Reported Perfommnce and Condition of the
Bank Inmrance Fund




statutorily prescribed rate of .16 percent. While the Fund balance and
its ratio to insured deposits increaseeach year after 1990, the Fund
would remain thinly capitalized through 1996 and would fail to achieve
the 1.26 percent minimum reserve ratio under this scenario.

Our projections illustrate significant contingent lossesfacing the Fund in
the 1990s.The significance of these projections is that they raise serious
doubts about the Fund’s ability to achieve the minimum reserve ratio of
1.26 percent by 1996 under the current assessmentprovisions of FIRREA.
Furthermore, our scenariosdo not consider other factors which may
exposethe Fund to even greater risks. A recessionor a severedecline in
the Northeast economy similar to what occurred in the Southwest could
result in the failure of many banks not included in our estimates and
costs that would deplete the Fund. Also, the banking industry’s
increased dependenceon riskier assetscould result in additional losses
and bank failures. For example, if these conditions resulted in the
failure of two or three large money center banks, those failures would
have a disproportionately large impact on the Fund. Additionally, the
questionable quality of call report information may have resulted in our
actually understating the Fund’s exposure in the near future. Some
banks which appear healthy basedon call report information may actu-
ally have a deteriorating financial condition.

Becauseof these concerns,we believe the Fund balance needsto be built
up to a level likely to withstand the cost of bank failures in a recession.
We recognizethe concern that raising assessmentsto build a more ade-
quately capitalized Fund could significantly impact the profitability and
competitiveness of banks. Also, it may not be feasible to achieve ade-
quate protection for the Fund and ultimately the taxpayer solely
through assessmentpremiums.
FIRREA  requires that the Department of the Treasury study deposit
insurance reform. We believe such a study should assessthe banks’
ability to pay higher premiums and estimate at what point such higher
premiums may becomecounterproductive. Treasury’s study should also
consider other meansof reducing the Fund’s exposure, such as requiring
banks to maintain higher capital levels, and other options to further pro-
tect the Fund and ultimately the taxpayers.




Page 49                                    GAO/Al?MIW@190Bank Insurance Fund
                        chapter 4                                                               ,
                        zeEc;~ce          and   Cmdition of the




                        With the failure of First RepublicBank Corporation in 1988, FDIC intro-
Separate Asset Pools    duced the separate assetbank concept. The failure of other large banks
Present Liquidity and   in Texas have also resulted in the creation of other separate assetbanks.
Asset Valuation         In many respects,this concept is similar to the noncashtransactions the
                        Federal Savings and Loan Insurance Corporation entered into in the
Exposures to the Fund   latter days of its existence due to the decline in its cash resources.These
                        transactions require lower cash outlays upfront with the expectation
                        that the disposition of acquired assetswill generate cash sufficient to
                        meet future needs.Further, if such cash outlays were made, they would
                        be large enough to significantly impair the Fund’s cash position, Because
                        separate assetpools significantly leveragethe Fund’s assetsthrough
                        future exposure, they raise the concernthat the Fund may becomeover-
                        extended beyond its ability to pay,
                        The separate assetbank concept allows the bank acquiring a failed insti-
                        tution to create and establish on its books a separate assetpool for all
                        failed bank nonperforming assets.The Fund is obligated to (1) pay
                        interest costson the book value of the pool assetsat the acquiring
                        bank’s cost of funds rate less income received on the separate asset
                        pool’s assets,(2) pay all expensesincurred in managing and liquidating
                        the assets,(3) fund writedowns to market incurred on assetswhich can
                        be transferred to the separate assetpool account during a specified
                        period of time, (4) fund losseson the disposition of pool assets,and
                        (6) purchase the remaining pool assetsat the final settlement date when
                        the separate assetpool is removed from the acquiring bank’s books
                        basedon the terms of the assistanceagreement.
                        FIX  considers all of the above factors when determining the ultimate
                        cost of a transaction. At December31,1989, the Bank Insurance Fund’s
                        exposure for separate assetbank assetswas approximately $8.0 billion.
                        The three separate assetpools that in substanceexisted at December3 1,
                        1989, resulted in an estimated interest cost to the Fund of $1.6 billion.
                        This cost would have been avoided if the pool assetshad been paid for
                        in cash. However, had cash outlays for these pool assetsbeen made at
                        December31,1989, cash and cash equivalents and investments in U.S.
                        Treasury obligations held by the Bank Insurance Fund would have
                        decreased,and net receivables from bank assistanceand failures would
                        have increased,by $8.0 billion, Such cash outlays would have signifi-
                        cantly impacted the Fund’s liquidity position. This in turn could have
                        impacted its ability to handle future bank failures due to insufficient
                        cash resourcesor required Treasury borrowings.




                        Page 60                                   GAO/AFMD-90-100Bank Insurance Fund
chapter 4
Beportml Performance and condition of the
Bank Insurance Fund




Further, the terms of the bank assistanceagreementsrelated to these
three separate assetpools allow the acquiring bank to transfer loans
that were originally acquired into the separate assetbank if they
becomenonperforming after the consummation date. Generally, the
dollar amount of loans that can be transferred for the first 12 months
after consummation is limited only by the failed bank’s total loans at the
consummation date. However, from months 13 through 24 after the con-
summation date, the acquiring bank can continue to transfer loans to the
separate assetbank up to an amount specified in the assistanceagree-
ment. For example, in 1989, North Carolina National Bank (NCNB), the
acquirer of the failed First RepublicBank Corporation in Texas, trans-
ferred $1.1 billion from the $8.7 billion of loans that could have been
transferred in the first year. This resulted in $163 million in cash pay-
ments associatedwith the lossesresulting from the writedown to
market value on the assetstransferred. In addition, NCNB can put up to
$760 million in the separate assetbank during 1990, the secondyear.
Thesetransfers further increasethe Fund’s potential liquidity exposure
from separate assetbanks.

The Fund is also exposedto the risk of further deterioration in the value
of the assetsin the separate assetbank. The book values of these assets
are often basedprimarily on appraisals. Our review of certain assetsin
the separate assetbank created from the failure of First RepublicBank
Corporation identified instanceswhere the recoverable values deter-
mined and recorded were overstated due to (1) the appraiser’s unreal-
istic assumptions and (2) FDIC guidelines that baserecorded values on
the most recent appraisal.
We reviewed the estimated cash recovery (FXR) value for all separate
assetpool loans with a book value greater than $10 million and all other
real estate owned (OREQ)l valued at more than $2 million. The estimated
cash recovery is the basis for the book value of assetsin the separate
assetbank. If an EcR is less than the current book value of an asset,the
book value would be reduced by a valuation reserve to equal the ECR.
Also, if the ECR value is greater than the book value, the book value can
be increased up to the asset’soriginal value when it was transferred into
the separate assetbank.
Our review of ECRs for loans identified recoverable values comparable to
those determined by the acquiring bank. However, we disagreedwith 67

‘Other real estate owned coneiets of properties that are acquired either directly from a failed bank, as
a result of a foreclosure of a loan, or as part of a settlement with a borrower.



Page 51                                                    GAO/AFMD-90-100Bank Insurance Fund
chapter 4
Beported Perf’ommnceand Condition of the
Bank lnaurance Fund




of the 133 ECRS for OREOassetsanalyzed due to the unrealisticassump
tions used in determining these assets’appraised and recorded values.
We estimated that 133 OREOassetswith book balancesof $488 million
were overstated by about $76 million. While we disagreedwith the valu-
ations, they appear to have been made in compliance with FDIC
guidelines.
The ECR prepared on a shopping center was one example of overstate-
ment of the recorded value due to unrealistic appraisal assumptions.
The former bank acquired this OREOproperty on August 6,1986. From
August 6, 1986, through September30, 1989 (the date of the ECR), this
shopping center had approximately lo-percent occupancy at below
market rentals. However, the appraisal value assumedincremental
increasesin occupancy of 6 percent every 6 months at market rent
rates. These estimates were used to compute 10 years of cash flow to
determine the appraised value. The practice of estimating increasesin
occupancy and rental rates is acceptablein the appraisal industry. How-
ever, basedon the historical experience of this property (that is,
lo-percent occupancy over 3 years and below market rents) and the
absenceof any documented reason to expect improvement, these
assumptions appear unreasonable,especially considering the property’s
separate assetpool status and the need for values that can be used for
current transactions. We estimated that this property was overvalued
by 30 percent. Basedon a subsequentappraisal, the acquiring bank per-
sonnel revised the ECR for this property to an amount comparable to our
estimate. Two appraisers will often assessthe sameproperty quite dif-
ferently becausethey use differing assumptions in the appraisal pro-
cess.This occurred in caseswhere the acquiring bank personnel
reordered appraisals becausethe original appraisal was deemed
unreasonable.
Appraisal quality has a significant impact on the accuracy of valuations
for OREOand, on a larger scale,significant financial implications to the
banking industry. Appraisals basedon unrealistic assumptions could
result in a bank making loans in excessof the loan collateral’s realistic
value. Further, loss reservescould be understated if they are basedon
unrealistically high appraisal values for the underlying assets.This
could causea bank’s financial condition to be misstated.

A recent policy advocated by the Resolution Trust Corporation (RTC)
Oversight Board could also affect the Bank Insurance Fund’s exposure
to separate assetpools. This policy allows RTC to sell property for
amounts ranging from 86 percent to 70 percent of appraised value. In


Page 62                                    GAO/AFMDfM&1OO
                                                        Bank Insumme Fund
              chapter 4
              Beported Performance and Cendttion of the
              BmkI~~ceF’und




              addition, certain assetscan be sold to the highest bidder regardlessof
              the appraisal. While this policy will probably result in quicker asset
              salesby RTC, it may also affect the market value for assetsin the Bank
              Insurance Fund separate assetpools. Additionally, this policy could
              have serious implications for commercial banks either holding real
              estate or involved in real estate lending.

              As discussedin chapters 2 and 3, we are concernedthat the Fund is
Conclusions   vulnerable to a number of factors. A number of troubled banks already
              exist that we believe are likely to fail in the near future, whose costs
              would significantly reduce the Bank Insurance Fund. A continued eco-
              nomic downturn in the Northeast and Southwest could significantly
              raise the cost of these and existing failures to the Fund and could result
              in additional banks failing, with their costsbeing borne by the Bank
              Insurance Fund. The current downward trends in the real estate sector
              pose a threat to the health and stability of the Northeast banks and to
              the recovery of banks in the Southwest. Also, the performance of LDC
              loans continues to plague the profitability of large banks, and future
              lossesassociatedwith these loans could occur. In addition, uncertainties
              exist with regard to the effect loans involving HLTS, were they to begin to
              experienceperformance difficulties, would have on the commercial
              banking industry and on the Fund. The Fund also faces uncertain expo-
              sures from FDIC policy changesregarding salesof acquired assetsand
              the ultimate financial impact of separate assetbanks upon termination
              of the assistanceagreements.

              Becauseof the exposuresit currently faces,the Bank Insurance Fund
              balance is too thinly capitalized, Further, the assessmentincreasesand
              minimum reserve ratio designatedby FIRREA will be insufficient in the
              event of a recessionthat results in significant bank failures. While the
              Fund has sufficient resourcesto handle the exposure it faces from the
              institutions we believe are likely to fail in the near future or later, other
              uncertainties facing the Fund could further reduce or deplete the Fund
              balance. The Fund’s reservesneed to be increasedto ensure that, on a
              short-term and long-term basis, a recessionwill not deplete the Fund
              and result in costs to the taxpayer.
              FIRREA increasedthe  annual assessmentrate for 1990 and requires
              another increase in 1991. However, the potential exposure the Fund
              faces in 1990 could result in significant costswhich would consumethe
              increased assessmentrevenue, significantly impair its cash resources,
              and reduce the Fund’s reserve ratio to insured deposits from its year-


              Page 88                                     GAO/-WlOO       Bank Insurance Fund
                      chapter 4                                                                .
                      Beported Performance and Condition of the
                      Bank Inmrance Fund




                      end 1989 level. Given the statutory restrictions on FDIC’S authority to
                      increase assessmentsand the outlook for the Fund, it is unlikely that the
                      minimum reserve ratio designatedby FIRREA of Fund balance to insured
                      deposits of 1.26 percent will be achievedby 1996.

                      We recommendthat the Congressamend FIRREA to give the Chairman of
Recommendations       the Federal Deposit Insurance Corporation the authority to raise rates
                      beyond those provided in FIRREA so that the Fund achievesthe minimum
                      reserve ratio of 1.26 percent designated in FIRREA by 1996.
                      We recommendthat the Secretary of the Treasury ensure that the
                      Department’s study of deposit insurance reform (required by FIRREA)
                      determine (1) the reasonablenessof the minimum and maximum reserve
                      ratios designatedby FIRREA in light of the banking industry’s present
                      condition and the exposure to the Fund, (2) a reserve ratio target that
                      would protect taxpayers by maintaining the Fund in the event of reces-
                      sion, and (3) meansin addition to premium assessments,such as
                      increased capital levels in banks, that would reduce the Fund’s potential
                      liabilities. The results of this study should be reported to the Congressin
                      a timely manner.

                      We recommendthat the Chairman of the Federal Deposit Insurance Cor-
                      poration (1) revise FDICguidelines for recorded values of assetsheld in
                      separate assetpools to include a critical review of the appraisers’ under-
                      lying assumptions in valuing assetsacquired from failed banks or assets
                      maintained in separate assetbanks and adjust recorded values, if neces-
                      sary, to reflect these assets’realistic values in light of their historical
                      experience and current conditions, and (2) monitor the use of separate
                      assetpools to ensure the Bank Insurance Fund has cash resourcesto
                      meet its commitments.

                      In their written comments,neither the Department of the Treasury nor
Agency Comments and   OCC,a component of Treasury, specifically addressedour recommenda-
Our Evaluation        tion regarding the need for Treasury’s study of deposit insurance reform
                      to include steps to maintain the Fund’s soundnessin the event of a
                      recession.(Seeappendixes V and VI.)
                      FRBrecognized,however, the need for Treasury’s study, and for the Con-
                      gress,to consider all possible steps for maintaining the strength of the
                      deposit insurance system and for protecting the taxpayers’ interest. (See



                      Page 64                                     GAO/AFMD-90-100Bank Insurance Fund
cllaptir4
Beport4xl Perro-   and condition of the
BankIMnrancephnd




appendix IV.) FFtB specifically mentioned the need to consider adjust-
ments to deposit insurance rates and their impact on institutions’ profit-
ability as well as the capital adequacy of institutions. We believe FRB’S
commentsreflect the intent of our recommendations.
occ commentedthat becausewe project that the Fund balance will rise,
our later statement that the Fund could be depleted is contradictory and
makes this comment appear alarmist. occ stated that it is difficult to
estimate the impact of a recessionon the number of bank failures and
that the report doesnot present data (1) to support its assertionsthat
the changing composition of bank loan portfolios may raise the cost of
bank failures or (2) to assessthe impact of a recessionon the number of
bank failures.
We believe that the deterioration of the Fund’s balance during 1988 and
1989, years of perceived national economicgrowth, support our con-
cerns about the Fund’s ability to withstand a recession.The broader
conceptual issue of our report is that the Fund balance should attain and
be maintained at a level that would protect taxpayers from incurring
costs due to bank failures. A recessionis an economicevent that could
reasonably occur, and we believe the Fund should be adequately capital-
ized to withstand such an event. When an economicdownturn occurred
in the Southwest, almost every major bank failed. If this occurs in the
Northeast, a region that currently is exhibiting signs of economicdeteri-
oration similar to those present in the Southwest’in the early 19809,
many of its large banks could fail. We believe the Fund should be capi-
talized to withstand the failure of several large banks in that region. Our
projections of Fund balance growth are basedon foreseeableconditions
as of the date of our report and assumea stable economy. However, as
stated throughout the report, we believe that known exposuresand
recent economicindicators present sufficient causeto be concerned
about the Fund’s low level and, ultimately, its solvency.

FDIC recognizedthat the Fund is undercapitalized and on August 14,
1990, announcedits proposal that the assessmentrate for 1991 be
increasedby the maximum amount allowable under FIRREA. If this pro-
posal is implemented, the Fund would receive $1.1 billion more in
assessmentincome than it would have under the statutorily prescribed
rate of .16 percent. FDIC’S actions follow recent statements made by its
Chairman that the Fund could incur significant lossesresulting from
bank failures in 1990 and reflects FDIC’S concernsthat the Fund is
undercapitalized. We concur with FDIC’S proposed action and stress the
need for the Fund to be increased and maintained at a level that will


Page 65                                   GAO/AFMD-@O-100 Bank Inauranm F’und
Chapter 4
mported PerronnuIce and condition of the
BmkInmmnceFnnd




allow it to deal with the costsof future bank failures and protect tax-
payers from incurring these costs.
FDIC observedthat appraisals of assetsheld in separate assetpools are
redone periodically and that salesvalues are compared to appraisals to
determine if any adjustments are necessary.(Seeappendix III.) FDIC also
stated that appraisers working in its environment had little motivation
to overstate values. Our findings show, however, that in accepting
appraisals, appraisers and bank managementoften assumeoptimistic
recoveries for other real estate owned. We continue to believe that FDIC
needsto tighten its appraisal guidelines to ensure realistic values in light
of historical experience and current conditions.




Page 66                                    GAO/AFMD9O-100Bank Inmrame Fund
Accounting and Reporting IssuesFacingthe
Banking Industxy

               Our limited review of call reports and examination reports for certain
               problem banks showed that call reports, when compared to examination
               reports, are not always serving as an accurate early warning to regula-
               tors of an institution’s deteriorating financial position. This problem
               takes on greater significance when the known exposure to the Fund is
               significant enough to impair the Fund balance and the prospects for
               achieving the minimum reserve ratio designatedby FIRREA by 1996 are
               limited.
               Public officials and others have also acknowledged that regulators need
               more timely and reliable data on the financial condition of depository
               institutions to more effectively work with managementto restore the
               health of troubled institutions and to minimize lossesto the insurance
               fund. A principal concern raised is whether financial data currently
               being prepared in accordancewith generally acceptedaccounting princi-
               ples are adequate for this purpose. The general presumption of those
               that advocate the use of someform of market value accounting in finan-
               cial reporting is that write-downs from historical cost to market value
               under generally acceptedaccounting principles have failed to provide an
               effective early warning system. In that respect,two principal problems
               with generally acceptedaccounting principles are (1) that they may
               unduly delay application of fair market value to problem assetsand
               thus defer the resultant loss recognition and (2) the stated definition of
               fair market value presumesthat the seller is not compelled to sell, which
               is not typically the casefor a troubled bank. In general, call report data
               are accounted for and reported in accordancewith generally accepted
               accounting principles becausethe banking regulations that apply to the
               preparation of such data are based,to a large extent, on these
               principles.
               In responseto these concernsand the problems with call reports we
               have identified, we are currently reviewing whether a changein the cri-
               teria for write-downs from historical cost to market value or someform
               of market value accounting would have provided more reliable informa-
               tion on the decline in assetvalues for banks that failed. While our study
               is focused on bank accounting and reporting, these issuesalso impact
               accounting and reporting by the Bank Insurance F’und.As discussedin
               chapter 3, the criteria for determining whether and when to record a
               loss from bank failures, i.e., probable occurrenceof a bank failure, are
               conceptually the sameas those used in determining whether and when
               fair market value accounting should be applied-the probability of
               whether a loan is collectible from the borrower. In addition, our review
               of 39 banks that failed in 1988 or 1989 also indicates that serious


               Page 67                                  GAO/AFMD-90-100Bank Insurmw F’und
                         internal control weaknessesexisted that contributed significantly to
                         their failure.

                         This chapter presents someof the issuesthat our work has identified.
                         Our work has not progressedfar enough to frame recommendations;
                         however, we believe that early disclosure of the problems we are finding
                         will help the Financial Accounting Standards Board,’ the regulators, and
                         others to better define the problems and make the changesthat are
                         neededto minimize lossesto the Bank Insurance Fund.

                         For our ongoing study of bank accounting and reporting issues,we
Banks’ Reported          selecteda sample of 39 banks which failed in 1988 or 1989 and
Financial Condition      reviewed their most recent call reports and audited financial statements,
Before Failure           the regulator’s examination reports and assetvaluation reports at the
                         time of failure, and other relevant financial information. These banks
Dramatically Different   were selectedfor review baaedon assetsize and geographical location
Than After Failure       and accountedfor about 90 percent of the total assetsof the 406 banks
                         that failed in those 2 years. Our objective was to determine if the banks’
                         financial condition was adequately communicated by the reports of
                         managementand, if not, to evaluate the merits of somechangein
                         accounting principles as a possible solution to this problem.

                         Although our review of the financial reports is not complete, our find-
                         ings tend to confirm the results of our limited review of call reports for
                         certain problem banks as discussedin chapter 3. Generally, we found
                         that the values reported in call reports for reservesfor loan lossesand
                         for OREO losseswere significantly less than the values reported by the
                         regulators as a result of examinations or other reviews conducted about
                         the time the bank failed. When financial statements were available that
                         were audited by an independent public accounting firm, we found that
                         they generally agreed with the call reports. Therefore, the audited
                         financial statements also reported reserve values for loan lossesand
                         OREO lossesthat significantly overstated assetvalues compared to the
                         values established by the regulators. Our findings indicate that call
                         reports and audited financial statements are of limited use to the regula-
                         tors for assessingthe true financial condition of banks and for triggering
                         timely intervention.



                         ‘The F’inancial Accmnting Standards Board is the body that sets generally accepted accounting
                         prindples.



                         Page 68                                                 GAO/AFMD-BO-100
                                                                                               Bank Inswce               Fund
                          chapter6
                          Accounting and Reporting ImsueeFacing the
                          -       Industry




                          Our work suggestsseveral possible reasonswhy bank managementand
                          its auditors are reporting values for loan lossesand OREO reservesthat
                          are significantly different than the values established by the regulators.
                      l The criteria which must be satisfied before problem assetsare written
                        down from cost to fair value2under generally acceptedaccounting prin-
                        ciples unduly delay the recognition of loss. Also, the somewhat subjec-
                        tive nature of these criteria gives bank managementand auditors too
                        much latitude in applying the intent of the accounting principles.
                      . Regulators more conservatively apply the provisions of generally
                        acceptedaccounting principles for both the timing and determination of
                        write-down to fair market value.
                      l Bank credit functions, related information systems, and other elements
                        of bank internal controls are insufficient to identify the facts neededto
                        determine the timing of when an assetshould be written down from cost
                        to fair market value.
                      l Bank managementis not always motivated to reflect known lossesfrom
                        write-downs to fair market value at a time when it is struggling to pre-
                        serve the institution and its control over it, and oversight by a bank’s
                        board of directors may not be sufficient to prevent misstatements of
                        assetvalues.

                          Under generally acceptedaccounting principles, the basis of accounting
Financial Reporting       for a bank’s portfolio is cost, except where loss is probable and measur-
Issues for F’urther       able. For banks, as well as for most other types of entities including the
Study                     Bank Insurance Fund, lossesare recognizedonly when it is probable
                          that they will be incurred and the amount can be reasonably estimated.
                          Further, specific rules relating to the timing of recognition and the defi-
                          nition of fair value may tend to defer loss recognition and limit the
                          amount of loss taken.

                          There are two basic questions relating to the application of the principle
                          of loss recognition which we are studying as part of our ongoing work.
                      . Is the requirement for the recognition of loss unduly delaying banks’
                        reporting of losseson loans in adversesituations where an early
                        warning of loss is needed?


                          *Financial Accounting Standards Board Statement (SFAS) No. 16 defines fair value as “the amount
                          that the debtor could reasonably expect to receive in a current sale between a willing buyer and a
                          willing seller, that is other than a forced or liquidation sale.”



                          Page 69                                                  GAO/AFMD9@1O9Bank Inmramm Fund
                       chaptm 6
                       AcconntlngurdReporting~Fadngtl~e
                       BrnLineIndurtry




                     . Is basing the estimate of any loss on a traditional fair value concept-a
                       seller is under no compulsion to sell and has time to negotiate a sale-
                       appropriate when the adequacy of a bank’s capital can be critical?

                       If it is found that current accounting rules result in delayed loss recogni-
                       tion and recognition of insufficient losses,then the government’s
                       interest as insurer should lead to a changein these rules.
                       We are also considering the role of bank directors in the determination
                       of the amount of bank capital. An argument can be made that directors
                       of institutions with government deposit insurance should be required to
                       assume,in addition to their existing responsibilities to stockholders and
                       others, fiduciary responsibility to protect the government’s interest.
                       Under this theory, the directors could be charged with the responsibility
                       to make a reasonableinvestigation of the representations of bank man-
                       agement’asto assetvalues. The Investment Company Act of 1940
                       required that directors establish fair values for the portfolios of invest-
                       ment companies.Depending on company type, the stock of such compa-
                       nies sell at net assetvalue or a function of net assetvalue. Therefore,
                       net assetvalue, a capital concept used by investment companies,is crit-
                       ical in that situation. Becauseof the potential for managementconflict
                       of interest, the directors were given the responsibility for determining
                       fair values. In the caseof banks, this type of responsibility is consistent
                       with existing directors’ responsibilities becausean accurate determina-
                       tion of bank capital is fundamental to effective bank management.The
                       accurate determination of bank capital is critical if the government’s
                       interest as insurer is to be protected. This is especially true in light of
                       bank capital levels in relation to the increasedportfolio risk and the lim-
                       ited protection provided by the Bank Insurance F’und,as discussedin
                       chapters 2 through 4.

                       We previously reported that serious internal control weaknessescited
Internal Control       by federal regulators contributed significantly to virtually all of the 184
WeaknessesContinue     insured banks which failed in 1987.3Cur findings from reviewing exami-
                       nation reports of our sample of 39 banks which failed in 1988 or 1989
                       also indicate serious internal control weaknessesin many of the institu-
                       tions. Bank managementand the boards of directors have a responsi-
                       bility to operate their institutions in a safe and sound manner. Safety
                       and soundnessrelates not only to overseeingthe day-to-day operations

                       3Bank Failures: Independent Audits Needed to Sbengthen Internal Control and Bank Management
                       Cm,                 May 31,lQSQ).


                       Page 80                                              GAO/AFMDBO-100Bank Ineurance Fund
    of the bank, but also to establishing and maintaining an effective
    internal control structure. We also previously reported that regulator’s
    examination reports and related data showed numerous and sometimes
    blatant violations of laws and regulations at 26 failed savings and loans
    that we reviewed to determine the causeof their failureB4
    The recommendationsin our May and June 1989 reports have not been
    adopted. Cur recommendationsto the Congressincluded that, as a con-
    dition for deposit insurance,
9 insured commercial banks be required to undergo an annual indepen-
  dent financial audit, as is currently required of federally insured savings
  and loans;
9 federally insured banks and savings and loans be required to issue man-
  agementreports on their internal controls and compliance with laws and
  regulations; and
l auditors of federally insured commercial banks and savings and loans be
  required, as part of their audit, to report on the adequacy of manage-
  ment’s assertionswith regard to the institution’s internal controls and
  compliance with laws and regulations.

    The regulators did not adopt our recommendationsfor reasonsof cost
    and their belief that sufficient guidance already exists on management’s
    responsibilities. We do not agree with the regulators’ views and find that
    these sameinternal control weaknessescontributed significantly to bank
    failures in 1988 and 1989 as they did in 1987.

    We believe that our proposed managementand auditing reporting
    requirements are needed.In our forthcoming report on bank accounting
    and reporting issues,we will discussthe specific internal control weak-
    nessesthat regulators found in the 39 failed institutions we reviewed.
    In addition, we believe that other reforms may be needed.We provided
    additional suggestionson enhancing the quality of management,audit,
    and financial reporting for federally insured financial institutions in our
    March 7,1990, letter to the Secretary of the Treasury in connection with
    Treasury’s study of deposit insurance reform as required by FIRRFX. We
    also suggesteda number of reforms that would (1) result in increased
    communication between regulators and an institution’s independent


    4Thrift Failures: Costly Failures Resulted F’rom Regulatory Violations and Unsafe Practices (GAO/
    -42,          June 16,lQSQ).



    Page 61                                                 GAO/~WloO            Bank I.nmmwe F’md
auditor and (2) require the independent auditor to recognizea responsi-
bility to the public when auditing a federally insured institution. A copy
of our letter to Treasury including our detailed suggestionsis included in
appendix II.




Page 62                                   GAO/AFMD9O-100Jhnk Insurance F’und
Pam 68   GAO/AFMBBOMO Bank Inawance Fund
                                                                                                       .
Appendix I

Reportson the F’inancialStatementsof the                                                                    *
Bank InsuranceF’undfor the Years Elnded
December31,1989 and 1988


             GAO     United Staten
                     General Accounting Of&e
                     Wuhington, D.C. 20548

                     ComptroUer General
                     of the United Starer

                     B-114831



                     To the Board of Directors
                     Federal Deposit Insurance            Corporation

                     We have audited    the accompanying        statements    of financial
                     position   of the Bank Insurance        Fund as of December 31, 1989
                     and 1988, and the related         statements     of income and fund
                     balance and statements       of cash flow for the years then
                     ended.    These financial      statements     are the responsibility
                     of the Federal Deposit       Insurance     Corporation’s    management.
                     Our responsibility      is to express an opinion         on these
                     financial   statements    based on our audits.
                     We   conducted our audits            in accordance       with generally
                     accepted government auditing                 standards.       Those standards
                     require     that we plan and perform the audit to obtain
                     reasonable      assurance       about whether the financial               statements
                     are free of material            misstatement.         An audit     includes
                     examining,      on a test basis,           evidence supporting          the amounts
                     and disclosures         in the financial          statements.        An audit also
                     includes      assessing      the accounting        principles      used and
                     significant        estimates     made by management, as well as
                     evaluating       the overall       financial      statement     presentation.
                     We believe      that our audits          provide     a reasonable       basis   for
                     our opinion.
                     In our opinion,      the financial      statements   referred    to above
                     present   fairly,     in all material      respects,   the financial
                     position   of the Bank Insurance          Fund as of December 31, 1989
                     and 1988, and the results          of its operations      and its cash
                     flows for the years then ended, in conformity               with
                     generally     accepted accounting       principles.
                     As stated       in note 7, the accompanying        financial       statements
                     include    an     estimated   loss of $3.8 billion       for those banks
                     which the       regulatory   process has identified          as being
                     distressed        and where ongoing negotiations         and/or current
                     agreement       terms indicate     that bank assistance        will    be
                     necessary.         Also, as stated     in note 13, the Federal Deposit




                   Page 64                                              GAO/-100           Bank Immrance Fund
     lrppencur1
     Raportaonthe  Flnan&I Stat4ment~~of the
     Bank I~nrsnce Fund for the Yeam Ended
     December31, lsss nnd 1988




B-114831


Insurance   Corporation      is monitoring        the financial      condition
of certain   large banks, predominately              located    in the
Northeast,   that are experiencing           the effects      of softening
real estate markets and weakening state economies.
Depending on the extent          of the economic downturn,           these
banks may require      financial      assistance,       which could have a
material   impact on the Bank Insurance              Fund.
We have identified            35 banks with total            assets of
$45.1 billion          that we believe      are troubled1            for which an
estimated      loss has not been recorded               because no
negotiations         for assistance       have occurred           and the
regulators       consider      them to be viable           institutions.
Generally,       the regulators        have implemented             supervisory
agreements for these banks and have allowed them to operate
under recapitalization             plans devised by the banks that do
not include        regulatory      assistance.         Due to the subjective
judgments made by the chartering                   authorities--the            state or
the Comptroller           of the Currency        in the case of national
banks --in determining            whether and when to fail               a bank, we
were unable to determine              whether or not these banks will
fail.       However, if these banks fail,               we estimate          that the
Fund balance would have decreased,                   and the Fund’s
liabilities        for estimated       bank assistance            would have
increased,       by amounts ranging          from $4.4 billion             to
$6.3 billion         as of December 31, 1989.                Our estimate         is
based on the Fund’s historical                 loss experience           for failed
bank transactions.
As disclosed       in footnote       1 in the accompanying      financial
statements,      enactment of Public Law 101-73, the Financial
Institutions       Reform, Recovery,        and Enforcement     Act of 1989
 (FIRREA) on August 9, 1989, resulted               in a change in
reporting     entity.      The Bank Insurance         Fund was previously
reported     as the Federal Deposit          Insurance    Corporation
 (FDIC) from inception          through December 31, 1988.           The
effect     of this change in reporting           entity   is immaterial   to
the financial        statements     as reported     herein and no
restatement      of the prior       year’s   amounts was necessary.

lOur definition         of a troubled    bank is one that has negative
 equity       or a minimal    level   of equity     capital    based on
 generally       accepted accounting       principles       and that we believe
  is probable      to fail    in the near future         unless it receives
 additional       capital.      The regulators      believe    that such
  institutions       are viable     and would not be conducting         ongoing
 negotiations        for assistance.




    Page 65                                                  GAO/AFMDBO-100Bank Insuranm Fund
    &m*       1
    Report8 on the FhandaI BtNmnenta of the
    BankIxbmmmeFnndfortheYeMEnded
    December81,1889and1988




B-114831



The following    comments provide        supplementary     information on
the financial    condition    of the banking industry,           the
exposure to the Fund as a result           of problem banks, concerns
over the quality     of financial      information     reported     by
banks, the performance       and condition       of the Bank Insurance
Fund, and accounting       and reporting      issues facing the
banking industry.
COMMERCIAL BANKING INDUSTRY'S
FINANCIAL CONDITION
The performance        of the commercial            banking industry
deteriorated        in 1989 compared to 1988.               Growth in real
estate     loans and nonperforming               assets outpaced the growth
in the industry's         equity      capital.        This was particularly
prominent      in the Northeast         region , where the equity capital
to asset ratio        declined      in 1989 and was significantly                lower
than the industry's          average.          Industry    earnings     declined
34 percent       to $16.3 billion          in 1989 from their          1988 levels
of $24.8 billion,         primarily       due to the poor earnings
performance       of large banks and banks in the Northeast
region.       The earnings      performance          of these banks declined
due to the increasing            level of nonperforming             real estate
loans and losses recognized               by large banks on loans to
lesser developed        countries.
Real estate     loans and leases totaled    $762 billion
 (37 percent    of total   loans) at December 31, 1989, compared
to $438 billion       (27 percent)  at December 31, 1985.
Nonperforming      real estate loans increased   from $16 billion
in 1988 to $22 billion        in 1989.
The 50 largest     bank holding        companies reported           that their
bank and nonbank subsidiaries            collectively         had $126 billion
in loans categorized         as highly    leveraged        transactions     at
December 31, 1989.          Because of their        relative      newness, the
performance     of loans categorized          as highly       leveraged
transactions,     as well as their        impact on future           bank
failures,     is uncertain.
The overall        growth in nonperforming         loans suggests that the
industry       faces a higher      level of risk than it has
historically.          The level     of nonperforming      real estate
loans,      coupled with the potential          for bank losses on loans
categorized        as highly    leveraged    transactions,      could lead to
additional        bank failures      in the 19909, with the costs of
these failures         being incurred      by the Bank Insurance       Fund.




    Page66                                                 CiAO/iUMD-9@100Bank Inmrawe Fund
    APpendir 1
    Report@ on tie Fkwdrl       8tatements   of the
    BsnkIMlmnceFundfortIleYurrEnded
    Decemberal,1999 and 1999




B-114831



About 843 billion      of the $54 billion     in troubled       loans to
lesser developed     countries    are held by nine large banks.
The banks’ average reserve        level   for these troubled        loans
was about 49 percent at December 31, 1989.               These banks do
not appear to be in danger of failing.            However, additional
losses from loans to lesser developed           countries,      combined
with significant     losses from other portfolio           concentrations
such as highly    leveraged    transactions     or real estate loans,
could make some of these banks more vulnerable               to failure.
PROBLEM BANKS POSE SIGNIFICANT
EXPOSURE TO THE BANK INSURANCE FUND
While the number of banks considered                          to be problem
institutions         by the regulators              has declined       from 1,406 in
1988 to 1,109 in 1989, we believe                      that a number of troubled
institutions         are in danger of failing,                  the costs of which
would significantly              impact the Bank Insurance                Fund.    We
identified        35 institutions           in such severe financial
condition        at December 31, 1989, that,                   without    some form of
recapitalization,            they will        likely     fail     in the near future.
If all of these banks fail,                   we estimate         that they would
cost the Bank Insurance                Fund between 84.4 billion               and
$6.3 billion.           We also identified             other banks which could
fail     later    if their       financial       condition        and regional
economies continue             to deteriorate.             If these banks fail,        we
estimate       their    cost could significantly                  impact the Bank
Insurance        Fund.     In addition,           there are several         other large
banks that could fail               if the economy experiences               a
recession.          Their failure          could result         in depletion     of the
Fund.
Our loss estimates      are based on FDIC’s historical     loss
rates on bank failures,       which may not reflect    the
increasing   amounts of real estate      loans and highly
leveraged  transactions     in bank portfolios.
CALL REPORT QUALITY IS A CONCERN
AS REGULATORS PLACE GREATER RELIANCE
5
ON  F -
We did not review the overall           quality     of call reports.     In
reviewing    examination     reports    for 10 problem banks, we
found indications      that call     report     accuracy may depend on
whether the regulators        have recently        examined the troubled
institution.      Generally,     the call reports        understated  loan
loss reserves     and overstated       net income when compared to




    Page 67                                                  GAO/AFMIHO-100 Bank humnce Fund
    -1
    amplwbr-* Pble&alstatementsofthe
    BulklnrorrneeFllndfortIleYeamEnded
    December81.1988 end 1888




B-114831


the examiners’    reports.    Also, we found that of the 406
banks that failed     in 1988 or 1989, 22 never         appeared on the
problem bank list,      and 9 failed    after   appearing    on the list
only one quarter     prior  to failing.       While we did not
compare the call and examination         reports    for these banks,
we are concerned that the call reports            apparently   did not
provide  adequate warning to regulators           about the conditions
which caused these banks to fail.
As the regulatora        are increasingly       relying     on off-site
monitoring     systems in their       supervision       of banks, the
accuracy     of call reports , which are an integral              part of the
off-site     monitoring     process,   becomes more critical.           We
believe    that the quality       of call report        data may prevent
the off-site      monitoring     process from being a more effective
early warning system of potential             bank failures.
THE FUND'S RESERVES WILL NOT LIKELY
   CH MINIMUM DESIGNATED LEVELS BY 1995
The Bank Insurance        Fund ended 1989 with a net loss of
$852 million,      which reduced the Fund balance to
$13.2 billion.        Losses relating     to 206 bank failures    and
one assistance      transaction     in 1989, along with increases      in
existing    estimated     losses for previous     failures,
contributed     to the Fund’s net loss.        At December 31, 1989,
the ratio     of the Fund balance to insured deposits          equaled
.7 percent,     its lowest level      ever.
FIRREA provides      for FDIC to charge incrementally            increasing
annual assessment rates to increase         the Fund’s reserves.
However, the rate increases       are tied,    in part,      to whether
the ratio    of the Fund balance to insured deposits               annually
increases    and reaches the minimum reserve         ratio    of 1.25
percent   designated     in FIRREA by 1995.      FDIC projections           of
Fund growth shows under one scenario , that the Fund balance
will   almost achieve the designated       minimum reserve ratio             of
1.25 percent     in 1995.    However, we believe       that FDIC’s
assumptions    in this scenario     are overly    optimistic        and that
it is likely     that the Bank Insurance      Fund will      fall     far
short of the minimum reserve        ratio  by 1995 without          using
annual assessment rates higher         than those allowed by
FIRREA.




    Page 88                                           GAO/APMD-88188Bank Insurance Pund
    iiizizcthe xuandalBmt4wnnt8oftha
    BanklllmuumFuadfertheYeurEnded
    Ik!cember 81,ln?M uul MB8




B-114831


SEPARATE ASSET POOLS COULD
SIGNIFICANTLY REDUCE THE
FUND’S CASH RESERVES
In addition       to its exposure from problem institutions,                the
Fund faces exposure from existing               failure    and assistance
transactions        due to the potential        cash payment requirements
that could significantly           reduce the Fund’s cash position.
As a result       of large bank failures,           FDIC has used the
separate      asset bank concept as a cash management method.
This concept allows FDIC to defer paying for the bad assets
of a failed       bank to a later      date, rather      than making
payment when the assistance             agreement is consummated with
the acquiring        bank.    At December 31, 1989, the Bank
Insurance      Fund had an $8 billion          exposure for separate
asset bank assets that it will              have to pay for at a future
settlement      date if the assets are not disposed             of by then.
If large banks continue          to fail     and more separate asset
banks are created,         this type of noncash transaction            will
need to be carefully          monitored     to ensure that it does not
result    in an accumulation         of payment deferrals       that are
greater     than the Bank Insurance           Fund’s future    cash
resources.
Another exposure from existing               assistance     transactions      also
results     from overvaluation          of assets acquired        from failed
banks or assets maintained              in separate     asset banks by other
acquirers      that can be returned          to FDIC.     We found a number
of instances       where unrealistic         assumptions      were used by
appraisers       in valuing      these assets.       Reliance     by FDIC on
appraised      values for these assets could result                 in FDIC
establishing       insufficient       levels   of valuation       allowances
and lead to higher           levels   of losses on the sales of these
assets than expected.
ACCOUNTING AND REPORTING ISSUES
FACING THE BANKING INDUSTRY
We are  currently  reviewing   the financial reports  of
39 banks that failed     in 1988 or 1989 and which account                    for
about 90apercent   of the assets of banks that failed    in
those ,years.
This ongoing study has not progressed        far enough to make
recommendations;    however , early disclosure       of the problems
found serve to help the accounting       profession,      regulators,
and others   to better  define   the problems and make the




    Page 69                                              GAO/AFMD-@MOOBank bmuance F’und
      4w-        1
      Ibp4WtSOllth     Fhandal   statements   of the
      BankInmwameFundfortbeYeurEnded
      December 31,lSaB and 1988




B-114831


necessary   changes that             are needed to minimize           losses     to the
Bank Insurance    Fund.
Findings    from our study of 39 failed            banks suggest that the
use of generally      accepted accounting          principles        to value
the assets of troubled        banks results        in overstated        asset
values compared to the values established                  by the regulators
in the event the bank were to fail              and FDIC would be called
upon to dispose of the assets.              The criteria        under
generally     accepted accounting       principles        that is applied          by
bank management and its independent               auditors      in valuing       the
assets of problem banks may result              in unduly delaying            the
recognition     of losses.      Consequently,        the use of generally
accepted accounting       principles      in reporting        financial       data
by bank management could be preventing                 timely     recognition
of a troubled      bank by the regulators.             The lack of an early
warning,    which would permit regulators              to intervene
promptly    with a troubled       bank , exposes the Bank Insurance
Fund to additional      losses.
Our   review of the regulators'           examination      reports     for the
39 banks that        failed     in 1989 or 1988 also indicates            that
serious     internal      control   weaknesses existed        that
contributed       significantly      to their   failure--a       problem we
previ usly found and reported            on for banks that failed              in
1987. s
In our previous           report,       we recommended that all federally
insured       depository       institutions        be required       to issue
management reports            on their       internal     controls      and
compliance       with laws and regulations                and undergo annual
independent        financial        audits.       We also recommended that
auditors       be required,          as part of their        financial      audits,     to
report      on management's assertions                with regard to the
institution's          internal       controls     and compliance        with laws
and regulations.             These steps would increase                management's
awareness of the importance                  of internal       controls     and would
help establish           accountability.           These recommendations            have
not been adopted.
In addition  to requiring    that management assess and report
on internal  controls,    we believe   that other issues must
also be considered,     such as increasing   or better  defining

lBank Failures:             Independent  Audits Needed to Strengthen
  Internal  Control           and Bank Management (GAO/AFMD-89-25,
 May     31,   1989)    .




      Page70                                                 GAO/AFWD-W1OOBankIneuranceFu.nd
.
        APpendir 1
        Reportsontb FlmmdaI Statement4 of the
        Bank Inauranee Fund for the Yemn Ended
        December81,lVSS and 1988




    B-114831


    directors’     responsibilities        either    by statute      or
    regulation.
    We also believe     that improved reporting       by auditors        and the
    sharing   of regulator’s    reports   with auditors        would result
    in improved communication       between the regulators           and
    independent   auditors   and would enhance their           effectiveness
    in carrying   out their   respective     responsibilities.
    We are continuing     to review        these    accounting     and auditing
    and related   issues.
    CONCLUSIONS
    The level     of deposit     insurance        reserves      necessary      to
    reasonably     ensure that no cost to the taxpayer                    will    occur
    as a result      of bank failures         likely      to occur in a recession
    requires    further    study.      The risk levels           associated       with
    the industry’s      loan portfolio          have increased         over the past
    decade.     Levels of bank equity             capital     have not changed
    appreciably      so that the increased            portfolio      risk is not
    cushioned    by additional       capital.         Bank Insurance          Fund
    reserves    set a 1.25 percent         of insured deposits             may not be
    sufficient     to accumulate       a reserve that will             carry the Bank
    Insurance     Fund through a recession.
    We believe    the level of deposit   insurance   reserves
    necessary   to meet the Fund’s liabilities     in the event of a
    recession   should be addressed as part of the deposit
    insurance   reform study required    by FIRREA.     In addition    to
    considering     premium increases  to protect  the financial
    integrity   of the Fund, other means of reducing        the Fund’s
    exposure should be considered.
    In conjunction       with this report we have issued a report
    that extensively        discusses   the concerns cited       in this
    opinion    on the Bank Insurance        Fund.    Our report,     Bank
    Insurance    Fund : Additional        Reserves and Reforms Needed to
    Strengthen     the Fund (GAO/AFMD-90-100          September 11 1990),
    recommends that the Congress enact ligislation                 to Lrovide
    additional     reserves     that are needed in the Bank Insurance
    Fund due to the more risky environment              of the banking
    industry    and the many financial         exposures   it faces.      We
    also recommend other reforms that are needed to strengthen
    bank supervision.




        Page 71                                             GAO/AFMDWlOO Jhk Inourm       Fund
                                                                                   .



    Eeporta on the lUandaI Statements of the
    BankIluurance F’und for the Yew Jhded
    Decmnber21,lBfJBand 1988




 B-114831


 In addition       to this report      on our examination      of the Bank
  Insurance     Fund’s 1989 and 1988 financial           statements,      we are
 also reporting         on our study and evaluation         of FDIC’s
  internal     control     structure   and compliance     with laws and
 regulations.          Also, during our examination,         we identified
 matters     that do not affect        the fair presentation       of the
  financial     statements,       but nonetheless   warrant management’s
 attention.        We are reporting       them separately     to the
zzsti




 Charles A. Bowsher
 Comptroller  General
 of the United States
 June 28, 1990




    Page 72                                           GAO/AF’MD-fM%lOO
                                                                     Btmk Insursnce Fund
                           APPn-       1
                           Baporta on the Finmdal     Sta~nta   of the
                           Bank-FllndfortheYeaImEnded
                           Decemr 31,lsfM and 1988




Report on Internal
Control Stfucture

                               unlt4?d
                                 Stu4?s
                         GAO   General Accouathg OfIke
                               WadIngton, D.C.20548

                               Comptroller General
                               of the United States


                               B-114831



                               To the     Board   of Directors
                                Federal     Deposit  Insurance        Corporation

                               We have   audited   the financial     statements       of the Bank
                               Insurance    Fund for the years ended December 31, 1989 and
                               1988, and have issued our opinion            thereon.        This report
                               pertains   only to our study and evaluation              of the Federal
                               Deposit   Insurance    Corporation's      internal     control      structure
                               as it relates     to the Bank Insurance         Fund for the year ended
                               December 31, 1989.       The report     on our study and evaluation
                               of the Corporation's       internal   control      structure      for the
                               year ended December 31, 1988, is presented                 in GAO/
                               AFMD-89-63, dated April         28, 1989.
                               We conducted      our audit    in accordance     with generally
                               accepted government auditing          standards.      Those standards
                               require    that we plan and perform the audit to obtain
                               reasonable     assurance    about whether the financial         statements
                               are free of material        misstatement.
                                In planning      and performing   our audit of the financial
                                statements      of the Bank Insurance     Fund for the year ended
                                December 31, 1989, we considered          its internal    control
                                structure     in order to determine     our auditing     procedures for
                                the purposes of expressing        our opinion    on the financial
                                statements      and not to provide    assurance    on the internal
                                control    structure.
                                The Corporation's         management is responsible              for
                                establishing       and maintaining        an internal       control    structure.
                                In fulfi,lling       this responsibility,          estimates       and judgments
                                by management are required             to assess the expected benefits
                                and related       costs of internal        control     structure      policies
                                and procedures.          The objectives      of an internal          control
                                structure      are to provide management with reasonable,                     but
                                not absolute,        assurance   that assets are safeguarded                 against
                                loss from unauthorized          use or disposition,            and that
                                transactions       are executed in accordance             with management's

                     Y




                           Page 18                                               GAO/AFMD-SO-100BankI~uranceF'end
     &we*  1
     B@JpO~OXlthePbandal Statement8 of the
     BankInanrance Fund for the Yeaxn Ended
     December 81,lBtM and 1988




B-114831


authorization          and recorded properly         to permit the
preparation        of financial      statements       in accordance with
generally       accepted accounting         principles.          Because of
inherent      limitations       in any internal         control     structure,
errors     or irregularities         may nevertheless           occur and not be
detected.        Also, projection         of any evaluation           of the
internal      control     structure     to future      periods      is subject  to
the risk that procedures             may become inadequate             because of
changes in conditions             or that the effectiveness             of the
design and operation            of policies      and procedures         may
deteriorate.
For purposes of this report,           we have classified       the
Corporation's      significant    internal    control    structure
policies     and procedures    into the following       categories:
--     treasury,   consisting     of policies      and procedures   over
       cash disbursementa,       cash receipts,      and investment
       activities,   and
--     assistance    to problem banks , consisting     of policies            and
       procedures    over FDIC's supervision     and liquidation
       activities    for failed  or assisted   banks.
For all of the internal              control      structure     categories
listed    above, we obtained           an understanding          of the design of
the relevant        policies      and procedures          and whether they have
been placed in operation,              and we assessed control             risk. We
performed     limited       tests of control           procedures    for all the
categories      listed      above, except that we found it more
efficient     to rely solely          on substantive         audit tests for
investment      and caeh receipt           activities.        For all
categories,       we performed        audit tests to substantiate
account balances associated                with each control         category.
Such tests can also serve to identify                      weaknesses in the
internal    control       structure.
Our consideration         of the internal       control    structure    would
not necessarily        disclose   all matters       in the internal
control     structure     that might be material        weaknesses.        A
material      weakness is a condition         in which the design or
operation      of one or more of the specific            internal    control
structure      elements does not reduce to a relatively               low
level    the risk that errors        or irregularities         in amounts
that would be material          in relation      to the financial
statements      being audited     may occur and not be detected
within     a timely    period by employees in the normal course of
performing       their  assigned   functions.        We noted no matters




 Page 14                                              GAO/AF’MD-BO-100 Bank Insurance Fund
B-114831


involving the internal   control        structure  and its operation
that we consider   to be material        weaknesses as defined
above.
However, we noted certain          matters   involving      the internal
control     structure   and its operations        that do not affect     the
fair    presentation    of the Bank Insurance          Fund’s financial
statements,       but which nevertheless       warrant management’s
attention.        We are reporting     these other matters separately
to the Corporation’s        management.




Charles A. Bowsher
Comptroller  General
of the United States
June 28,     1990




   Page 78                                         GAO/APMD-W-188Bank Insnrance Puncl
                       &Pen-I
                       Baportr0nthe    Flmndd     Ststoment4   of tha
                       BankIMsmncaFnndfortheYeamEndsd
                       ~ecsmber ai, lea9 and ieea




Ropoft on Complirnco
With hwe and
Rogulrtlonr

                           UsIted state0
                           General Aceoantlng OfBee
                           WaaNngtm, D.C.20848

                           Cemptroller General
                           of the UnIted States

                            B-114831



                            To the Board of Directors
                            Federal Deposit Insurance               Corporation

                           We have audited       the financial     statements    of the Bank
                           Insurance     Fund for the years ended December 31, 1989 and
                           1988, and have issued our opinion            thereon.      This report
                           pertains     only to our review of the Federal Deposit
                           Insurance     Corporation’s     compliance     with laws and
                           regulations      as they relate      to the Bank Insurance       Fund for
                           the year ended December 31, 1989.              Our report     on the
                           Corporation’s      compliance     with laws and regulations         for the
                           year ended December 31, 1988, is presented               in GAO/
                           AFMD-89-63, dated April         28, 1989.
                           We conducted      our audit in accordance       with generally
                           accepted government       auditing   standards.      Those standards
                           require    that we plan and perform the audit to obtain
                           reasonable      assurance about whether the financial          statements
                           are   free   of material   misstatement.
                           The Corporation’s       management is responsible             for  compliance
                           with laws and regulations           applicable    to the Bank Insurance
                           Fund.    As part     of obtaining      reasonable     assurance     as to
                           whether the financial          statements     were free of material
                           misstatements,       we selected     and tested     transactions      and
                           records    to determine      the Corporation’s        compliance     with
                           certain    provisions     of the Federal       Deposit     Insurance    Act,  as
                           amended (12 U.S.C. 1811 et. seq.),              which,     if not complied
                           with,   could have a material         effect    on the Bank Insurance
                           Fund’s financial       statements.        However, it should be noted
                           that our objective        was not to provide        an opinion      on the
                           overall   compliance      with such provisions.
                           Because of the limited  purpose for which our tests of
                           compliance were made, the laws and regulations   tested did
                           not cover all legal requirements   with which the Corporation
                           has to comply.




                       Page 76
          Reports on the Flnandal Statements of the
          Bank Inenmme Pund for the Yeore Ended
          December ai,ieae   and 1988




    B-114831


    The   results    of our tests indicate      that,    with respect to
    the   items tested,    the Corporation      complied,      in all material
    respects,     with those provisions       of laws and regulations
    that could have a material        effect    on the Fund's financial
    statements.       With respect to transactions          not tested,
    nothing     came to our attention      that caused us to believe
    that the Corporation       had not complied,       in all material
    respects,     with those provisions.




    Charles A. Bowsher
    Comptroller  General
    of the United States
    June 28,        1990




Y




          Page 77                                      GAO/AF’MD-BO-100 Bank Ineurmce Fund
                                                                                                                            ,
                                   Appendir 1
                                                    Flmmdal Statement8 of the
                                   ~~nulc     uranccPMdfortheYeauEnded
                                   ~eesmberai,ia8ad1a8a




(JtatemonW d Pinanclal
Position

                                                FEDERAL    DEPOSIT INSURANCE        CORPORATION
                                                            BANK INSURANCE        FUND
                                                     STATEMENTS     OF FINANCIAL     POSITION
                                                                  (In thou8fulds)



                                                                                                December     31

                                                                                        1989                      1988


                           Cash end cash equivalent8 (Note 3)                       $4,813,914               $2,928,010

                           Investment in U. S. Treaeury
                            obligations, net (Note 4)                                t&926,360               13,292,644
                          Accrued interest receivable on
                           inve8tment.aand other awets                                 279,333                    662,119
                           Net receivables from bank assistance
                            and failures (Note 6)                                    6,496,127                6,813,873
                          Property and building8 (Note 6)                               97.673                    77,634

                                                                                  $ 19,614,407             $22,764,180


                         Llabllitiee   and the Fund Balance

                          Accounts payable, accrued
                           liabilities and other                                        49,701                     64,763

                           Liabilities for estimated bank
                            assistance(Note 7)                                       3,820,297                3,877,376

                          Liabilities incurred from bank
                           aesiatanceand failure8 (Note 8)                           2,412,666                4,661,3&i?

                          Estimated lesseefrom litigation                              122.201                    109,623
                          Total Liabilities                                          6,404,884                3,703,050

                          Fund Balance                                              13,209,623               14,061,130
                                                                                  $19,614,407              $22,784,180


                         See accompanying note8

                   Y




                                   Page78                                           GAO/-100               Bank Ixmuranm Fund
                               lsppendlr 1
                               RepoHs on the Flnadd    Statemente of the
                               BankbuuranceFundfort.heYeamEnded
                               Decenltber 81,1888 and 1988




Statemonta of Income
and tho Fund Balance

                                            FEDERAL
                                                  DEPOSIT INSURANCE       CORPORATION
                                                   BANK INSUBANCE       FUND
                                       STATEMENTS   OF INCOME AND THE FUND BALANCE
                                                         (In thousands)




                                                                                   For the Year Ended
                                                                                      December 31


                                                                                1989              1988
                       B0venue

                        Aeeeeementsearned (Note 9)                           $1,886,029        $ 1,773,Oll
                        Interest on U. S. Treasury obligations                1,371,962          1,396,402
                        Other revenue                                           237,637            178,245
                         Total Revenue                                       3,484,628          3,347,058




                       Expense6     and Losses

                        Administrative operating expenses                       213,855            223,911
                        Merger ae&ance lossesand expenses                       236,314          1,023,926
                        Provision for insurance losses(Note 6)                3,811,290          6,298,266
                        Nonrecoverable insurance expenses                        66,776            42,267

                         Total Expenses        and Losses                     4,346,235         7$88,370

                        Net Income     (Loss)                                 (881,607)        (4,240,712)

                        Fund Balance        - January    1                  14,001,130         18,301,842

                        Fund Balance        - December       31            $ 13,209,523      $14,061,130



                        See accompanying notes




                                  page 79                                     GAO/AFMIMO-106 Banlr Insurance Fund
                              lhporte on the B’handal8tatements of the
                              BankInearance FuadfortheYearsEaded
                              December 81,196)s and 1988




Statementa of Ca8h
Flow8

                                      FEDERAL      DEPOSIT INSURANCE     CORPORATION
                                                    BANKINSURANCEFUND
                                                 STATEMENTS      OF CASH FLOWS
                                                          (In thousands)



                                                                                       For the Year Ended
                                                                                          December 31
                     Cash Flows From Operating       Activities:                     1989               1088
                      Cash inflows from:
                       Assessmentsearned                                         $ 1,885,029        $1,773,011
                       Interest on U. S. Treasury obligations                      1,446,156          1,492,126
                       Recoveriesfrom bank assistanceand failures                  4,285,312         4,461,660
                       Increase (decrease)in accounts payable,
                         accrued liabilities and other                               WGM4)               60,999
                      Cash outflows for:
                       Administrative operating expenses                             214,294            226,245
                       Disbursements for bank assistanceand failures               6,637,407          6,639,154
                       Increase (decrease)in accrued interest
                         receivable on investments and other assets                 (372,786)           204,961
                      Net Cash Provided    by Operating         Activities        1,122,618            707,446

                     Cash Flows From Inveating      Activitiee:
                      Cash inflows from:
                       Maturity and Baleof U. S. Treasury obligations              6,092,095          3,390,ooo
                      Cash outflows for:
                       Purchase of U. S. Treasury obligations                      1,773,967          1,985,938
                       Property and buildings                                         21,527                5,483

                      Net Cash Provided    by Inveeting        Activities         4,296,601          1,398,579
                     Cash Flows From Financing       Activities:

                      Cash outflows for:
                       Payments of liabilities incurred from bank
                        assistanceand failures                                     3,533,21S            502,957
                      Cash Used by Financing      Activities                      3,533,215            602,957
                      Net Increase   in Cash and Cash Equivalents                 1,885,904          1,603,068
                      Cash and Cash Equivalents       - January        1          2,928,OlO          1,324,942

                      Cash and Cash Equivalents       - December            31   $4,813,914         $2,928,010

                      See accompanying notes




                              Page 80                                               GAO/AF’MD-90-106 BanL; Iasurance Fund
                                      Appe-1
                                      Reporta on the pynurdal Statamenta of the
                                      Bank Insurance Fund for the Yewa Ended
                                      December 81.10 and 1988




Not.8 to Bank Inrurance
Fund (@IF)Plnanolal
Statemontr
                          DECEMBER         Bl,1989    and 1988

                          1. Impoat     of FIRREA     Legiirlation:

                          The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 VlRREA) became
                          public law on August 91989. The primary purpose of the legislation was to reform, recapital-
                          ize, and consolidate the federal deposit insurance system so as to restore the public’s con-
                          5dencr in the savings and loan industry and to ensure a safe and stable system of affordable
                          housing finance through major regulatory reforms, strengthened capital standards and
                          safeguards for the disposal of recoverable assets,FIRMA abolished the Federal Savings and
                          Loan Insurance Corporation (FSLIC) and the Federal Home Loan Bank Board (FHLBB).
                          Their functions were transferred, in a prescribed manner, to the Federal Deposit Insurance
                          Corporation (FDIC), the 05lce of Thrift Supervision, the Federal Housing Finance Board, and
                          the Resolution Trust Corporation (RTC).

                          Under FIRREA, the FDIC became the administrator of two separate and distinct insurance
                          funds: the Bank Insurance Fund (BIF, formerly the Deposit Insurance Fund) which insures
                          the deposits of all BIFmmemberbanks, and the Savings Association Insurance Fund @AIF)
                          which insures the deposits of ell SAIF-member savings associations (formerly a function of the
                          FSLIC). Both insurance funds are maintained separately to carry out their respective legisla-
                          tive mandates, with no commingling of assets or liabilities. The FSLIC Resolution Fund
                          (FRF), a third separate fund under FDIC management, and the RTC replaced the FSLIC in
                          case resolution activities. The FRF will complete the resolution of all thrifta that failed or
                          were assisted before January 1, 1989; the RTC will resolve all troubled thrift casesthat occur
                          from January 1,1989 through August 8,1992, after which the SAIF will begin resolving cases.

                          These financial statements pertain to the financial position, results of operations, and cash
                          flows of the Bank Insurance Fund only.


                          2. Summary       of Significant    Accounting   Policies

                          General. These statements do not include accountability for assetsand liabilities of closed in-
                          sured banks for which the BIF acts as receiver or liquidating agent. Periodic and final accoun-
                          tability reports of the BIF activities as receiver or liquidating agent are furnished to courts,
                          supervisory authorities, and others as required.

                          U. S. Treasury Obligations. Securities are shown at amortized cost, which is the purchase
                          price of securities less the amortized premium or plus the accreted discount. Such sroortiza-
                          tions and accretions are computed on a daily basis from the date of acquisition to the date of
                          maturity. Interest is also calculated on a daily basis and recorded monthly using the constant-
                          yield method.




                                      Page 81                                            GAO/AFMIbBB-100 Bank Insurance Fund
             AppcndlxI
             Reportu on the Fhmndal Statements of the
             Bank Insurance Fund for the Years Ended
             December81,1@8@  and 1988




Allowance for Loss on Receivables From Bank Assistance and Failures. The BIF records as a
receivable the funds advanced for assisting and closing banks and establishes an estimated al-
lowance for loss, The allowance for loss represents the difference between the funds advanced
and the expected repayment, based on the estimated cash recoveries from the assetsof the as-
sisted or failed bank, net of all liquidation costs, and also from dividends received from, and
sales of, equity instruments acquired in assistance agreements (the proceeds of which are
deferred pending fund settlement of the assistancetransaction).

Litigation Losses. The BIF establishes an estimate for potential loss from litigation against
the BIF in its corporate and receivership capacity. The FDIC Legal Division recommends
these estimated losseson a case-by-casebasis.

Depmciation. The cost of furniture, futures, and equipment is expensed at time of acquisition.
This policy is a departure from generally accepted accounting principles; however, the finan-
cial impact is not material to the BIF financial statements. The Washington Office Buildings
are depreciated on a straight-line basis over a SO-yearestimated life. The San Francisco Con-
dominium Offices are depreciated on a straight-line basis over a 35year estimated life.
Merger Assistance Losses and Expenses. The costsincurred by the BIF which resulted from ei-
ther providing assistance to open insured banks or merging of insured banks are recorded as
merger assistance losses. These costs, which are not liquidation-related, are specified in the
terms of the agreements and have no potential for recovery by the BIF.

Nonmzovemble Insumnce Expenses. Nonrecoverable insurance expenses are incurred by the
BIF as a result of: (1) paying insured depositors in closed bank payoff activity; (2) administer-
ing and liquidating assets purchased in a corporate capacity; (3) bid-package preparation for
assistance transactions; and, (41bridge bank operations.


Reclassifications.Reclassifications have been made in the 1933 Financial Statements to con-
form to the presentation used in 1989.


3. Cash and Cash Equivalents:

The BIF considers cash equivalents to be short-term, highly liquid investments with original
maturities of three months or less. This includes the purchase of one-day Special Treasury
Certificates (in thousands):
                                                                          December       31

                                                                   1989                       1988
Cash                                                         $      11,443           $      12,644
Cash Equivalents                                                 4,736,471               2,916,366

                                                             $4,813,914              $2,928,010




             Page 02                                             GAO/AFMD4W1OOBank Insurance Fund
            lrppenatrl
            -onthe        FinuIdd Btatamen~ of the
            BankIMnmnceFundfortlIeYearoEnded
            Deoembew 81,198B and 1988




4. U. 6. Treaeury        Obligations:

AII cash received by the BIF not used to defray operating expenses or for outlays related to
assistance to banks and liquidation activities or invested in short-term highly liquid invest-
ments is invested in II. S. Treasury obligations. The BIF investment portfolio consists of the
following (in thousands):

                                             DECEMBER 31,1989
                                        Yield to Maturity      Book          Market           Face
Maturity        Description                  at Market         Value         VaIue           Value

Less than       U.S.T. Bills,
one year        Notes & Bonds                   8.16         $1,812,004     $1824,807      $1,800,000
1-3 years       U.S.T. Notes & Bonds            7.99           6,446,301      6,414,176      6,300,000

3-5 years       U.S.T. Notes & Bonds            7.97           1.667.0&      ilLdszm.1.790.000
                                                            $8,925,380     $8,908,269     $8,800,000


                                             DECEMBER 31,1988
                                        Yield To Maturity       Book                          Face
Maturity        Description                  at Market          Value        FE               VaIue

Less than       U.S.T. Bills,
one year        Notes & Bonds                   9.07         $4,289,304     $4,302,784     $4,280,000
1-3 years       U.S.T. Notes & Bonds            9.21           6,004,351      4,936,706      4,900,000
3-6 years       U.S.T. Notes & Bonds            9.21
                                                            $13,292,044    $13,047,628    $13,080,000


The unamortized premium, net of unaccreted discount, for 1989 and 1988 was $126,360,000
and $212,644,000,respectively. The amortized premium expense, net of accreted discount in-
come, for 1989and 1988was $49,167,000and $95,724,000,respectively.




            Page 83                                                     GAO/AFMWO-100     Bank Insurance Fund
                  Beporta on the Finandal Statementa of the
                  BankIavmrancePnndfortheYeamEnded
                  December 31,1@89 and 1988




    6. Net Reaeivabler         from Bank Aaairtance   and Fedlurer    (in thouaanda):



                                                                                   Dewnber      81
                                                                         l@SQ                        1988

    Reoeivabler        from Bank Aarirtance:

     Open banks                                                      b 1,6;8,;4;              s1,3;6$;;
     Facilitatadeposit assumptions
     Facilitatemerger agreements                                         134:398                  3501648
     Accrued interest receivable                                          14,366                    8,257
     Allowance for losses                                             (1,153,122)              (1.110.328)
                                                                                                 . I
     Deferred settlements                                                 03;198)                      -o--
                                                                        666,887                  686,330
    Bridge    Bank Receivable:

     Capitalization                                                    1,950,000                1,008,241
     Accrued interest receivable                                          93,682                    8,866
     Allowance for losses                                             (1,760,000)                      -o-
                                                                        293,682                1,017,107

    Continental        Bank (CINB)     Assistance:

     Loans and related assets                                          2,018.692                2.153.189
     Dividend receivable                                                                           121797
     Preferred stock/common stock                                        73,426                   515,436
     Allowance for losses                                             ‘m&m;                    (1,280,110)
     Deferred settlement                                                   ,                     (159,090)
                                                                        750,184                1,242,222

    Receivables        from Bank Failures:

     Insured Depositor Payoff                                          4,952,026                3,207,323
     Depositors’ claims unpaid                                            79,055                   32,841
     Purchase and Assumption transactions                              9,347,887                8,456,417
     Corporate Purchase transactions                                     523,239                  500,999
     Allowance for losses                                            (11,114,713)              (9,229,366)
                                                                      3,787,474                2,968,2 14
                                                                     $5,498,127              $6,813,873




Y




              Page 84                                                 GAO/hFMD9olOO          Bank hwurana     hand
        Beporta on the Fkumdal &a&manta    of the
        BaakInmrameFandfortheYunEnded
        December 31, MS and 1888




                                           1989
               ANALYSIS      OF CHANGES IN ALLOWANCE              FOR LOSSES
                                     (In thouran&)




                                    Bizk!zgYtP                          ?tf!i=@Balance
                                                                               Ending
                                                                       Adjwtmentr

Open bar& assistance                $1,110,328         $42,794          $        -0.   $1,153,122
CINB                                  1,439,200       (222,383)          (159,090)       l,O57,727

Bridge Bank                                   -0.            -O-        1,7SO,ooo        1,760,000

Closed Bank:
  Insured Depositor Payoff            2,006,406       1,172,612             W,959)       3,166,069
  Purchase and Assumption             6,925,446        877,658              (77,138)     7,725,965
  Corporate Purchases                   297,515        (74,826)                  -o-       222,689
 Total Closed Bank                   9,229,366       1,975,444              (SO,0971   11,114,713
Liabilities for estimated
  bank assistance                     3,877,376      2,002,757         (2,059,836)       3,820,297

Estimated losses from
 Corporation litigation                   109,523        12,678                  -O-       122,201


Total Allowance    for Losses      $16,765,793      $3,811,290     $    (559,023) $19,018,060




        Page 85                                             GAO/AFMD-~160              Bank Inmrance F’und
        Appdix     I
        Reqortaonthe  Flnandd Statementa of the
        BankInmumeeFnndfortheYesrsEnded
        Decamber 81,19fJ9 and 1988




                                            1988
               ANALYSIS       OF CHANGES IN ALLOWANCE                    FOR LOSSES
                                      (In tbousslnde)




                                                                            Transfers
                                                          pm2P                                 Ending
                                       Bzkzg               Loss
                                                                                And
                                                                           Aajuhnentn          Balance

Open bank assistance                     $115,105              $53,271       $941,952        8 1,110,328
CINB                                     1640,862              (201,652)             4%        1,439,200
Closed Bank:
  Insured Depositor Payoff               1,634,862           423,578            (62,034)       2,006,406
  Purchase and Assumption                6,072,785         1,966,368          (113,708)        6,925,445
  Corporate Purchases                      120,690             179,825            (3,000)        297,515
Total Closed Bank                       k&828,337         2,669,771          (168,742)        9,229,366
  Liabilities for estimated
    hank aMistanc0                       1,236,952         3,877,376        (1,236,952)        3,877,376

  Estimated lossesRom
   Corporation litigation                                                      109,423           109,523

Total Allowance    for Losses         $9,821,846         $6,208,266        $ (354,319)      $15,765,793



The BIF liabilities for estimated bank assistance include amounts transferred to other line
items, adjustments for cash outlays, and deferred settlements.
First RepublicBank/NCNB         Texas National       (Bridge    Bank):

During 1989, the FDIC sold its shares of stock in NCNB Texas National Bank to NCNB Corpo-
ration for $1.1 billion, resulting in a gain of approximately $270 million.
Termination and SnaI asset pool settlement is scheduled to occur on the fifth anniversary
(November 22, 1993) of the agreement. At the time of termination, the FDIC must (a) pur-
chase remaining pnhquidated assets at fair market value; (b) settle with NCNB for the cur-
rent settlement account balance arising from administering the Separate Asset Pool; and (c)
settle with NCNB for deferred settlement account balances arising from gains and losses on
disposition of assetsasweII as charge-offs and write-ups of pool assets.
The Separate Asset Pool balance on December 31, 1989 was 84.7 billion. Total estimated cost
for the length of the entire Assistance Agreement is projected to be $2.9 billion.




        Page86                                                      GAO/AF’MD-ml00           Bank Insurance Fund
          APPmm     1
          Rapomonthe     Fhmndal       st8tfmIente   of the
          BankhuumnceFundfortheYeareEuded
          December 31,1939 anil 1933




MCorp/BancOne       (Bridge   Bank);

On March 28,1989, twenty of the twenty-five MCorp subsidiary banks were declared insolvent
by their chartering authorities and subsequently closed, with the FDIC appointed receiver.
The FDIC or anized a new Deposit Insurance Bridge Bank, N.A., Dallas, Texas, chartered by
the Comptrod er of the Currency (OCC) to purchase all assetsand assumedeposits and certain
non-deposit liabilities from the failed institutions.
On July 5,1989, the FDIC, BancOne Corporation, BancOne Texas Corporation, and BancOne
Texas, N.A entered into a financial assistanceagreement designed to capitalize and stabilize
the new bridge bank. The final approval on January 1,199O of the principal terms of BIF out-
lays and costs for the merger assistanceincluded:
  (a) The BIF will purchase 3,375,OOOshares of Class B non-voting Convertible Common
      Stock and 1,250,OOO  shares of Cless C non-voting Common Stock of BancOne Texas,
      N.A. in exchange for a note payable in the amount of $416.3 million due on or before
      the day on which the FDIC no longer owns any shares of such stock.
  (b) The BIF funded negative equity of the Bridge Bank (including Bridge Bank operating
      losses) during its tenure of operation (March 29,1989 to December 31, 1989), as well
      as mark-to-market for assets and liabilities as of the date of BancOne’s acquisition,
      January 1,199O. During January 1990, total funding of $2.6 biiion was paid by (i) as-
      sumption of FRB indebtedness including principal and interest totalling $1.519 billion
      and forgiveness of a $300 million subordinated note advanced to the Bridge Sank,,and
      (ii) a non-negotiable promissory note to BancOne Texas in the amount of $737 nnllion
      due on or before March 1,199s.
  (c) By terms of the assistanceagreement, the BIF and BancOne Texas, N.A. transferred to
      a Separate Asset Pool $2.5 billion of troubled assets and owned real estate of the in-
      solvent MCorp banks. BancOne retains the right to transfer additional troubled loans
      to the Separate Asset Pool during its first two years of operations. Administration and
      funding costs of the Separate Asset Pool are to be borne by the BIF during its five year
      tenure.
Final settlement on the Separate Asset Pool will occur no later than January 1,1995. At such
time, the BIF will settle with BancOne Texas, N.A. for the current settlement account balance
arising from the administration of the separate asset pool and for the deferred settlement ac-
count balance arising from gains and losses on the disposition of assets as well as charge-offs
and write-ups of pool assets,In addition, the BIF will purchase the remaining unliquidated as-
sets of the pool at fair market value. The total estimated cost to the BIF is $2.7 billion.
Texae American     Banceharee/Texae          American         (Bridge   Bank):

On July 20, 1989, the twenty-four subsidiary banks of Texas American Bancshares, Inc. were
declared insolvent by their chartering authorities and subsequently closed,with the FDIC ap-
pointed receiver. Pursuant to the authority granted in 12 U.S.C. 1821, the FDIC organized a
new national “bridge bank” called Texas American Bridge Bank, N.A., Fort Worth, Texas, to
purchase all assets and assume deposits and certain non-deposit liabilities from the failed in-
stitutions.
Also on July 20, 1989, the PDIC Board of Directors approved the acquisition of Texas Amer-
ican Bridge Bank by Deposit Guaranty Sank, Dallas, Texas. An Interim Management Agree-
ment was executed for the operation of the bridge bank pending completion of the assistance
agreement. The financial assistanceagreement was consummated on January 31,1990, princi-
pal terms of which included: (al the BIF funded negative equity of the Bridge Bank (renamed
Team Bank) including the Bridge Bank operating lossesincurred during its tenure of opera-




         Page 87                                                         GAO/AFMD-90400 Bank Insurance Fund
                                                                                                     .
            Appendix I
            Iteporta on the Finandal Statement8 of the
            Bank Insurance Fund for the Yeam Ended
            December 31,1989 and 1988




    tion July 20,1989 through January 31,1990, aa weII as mark-to-market of certain assetsand
    Liabilities aa of the data of Deposit Guaranty acquisition January 31, 1990; and (b) the FDIC
    and Deposit Guaranty Bank transferred approximately $772 mi.IIion of troubled assets and
    owned real e&ate of the insolvent Texas American institutions to a Separate Asset Pool for
    liquidation. Administration and funding costs of the Separate Asset Pool are to be borne by
    the BIF. Total estimated cost to the BIF is approximately $900 million.
    CINB Assistance:
    The CINB aaaistance cement, entered into on September 261984, between the FDIC, the
    Federal Reserve Boar“6”, the Comptroller of the Currency, and a group of maior U. S. banks
    terminated when it reached its prescribed valuation date on September 26, 1989. The Bank
    Insurance Fund (BIF) made the ilnal payment for the indebtedness assumedof $2.2 biBion on
    September 261989.
    During the term of the agreement, collection proceeds totaled $2.6 billion. Application of the
      roceedswere to administrative costs and interest expense totaling $176 mihion and $1.1 biI-
    Hon, respectively, and $1.3 billion in principal payments owing under the FBB agreement. The
    BIF estimated aBowancefor loss as of December 31, 1989 was $1.0 billion, which represents
    the difference between the amount funded and the amount BIF estimates as recoverable from
    the remaining assets and future proceeds from the sale of equity instruments which wiII be
    deferred until final disposition of the remaining assets.
    Under the terms of the agreement, on the valuation date, the BIF exercised its option to ac-
    quire from Continental Ihinois Holding Corporation (CIHC) the 10,080,809remaining shares
    of Continental Bank Corporation (CBC) common stock. For every $20 of loss the BIF incurred,
    the BIF was entitled to acquire one share of CBC common stock at an exercise price of
    $0.00001per share.
    During 1989, the BD? sold alI its shares (12.838 million) of the Continental Bank Corporation
    (CBC) Adjustable Bate Preferred Stock, ClassA, valued at $280 million, for $273 rnihion. Also,
    7.2 million shares of CBC Junior Perpetual Convertible Preference Stock, valued at $162 miI-
    lion, was sold for $217 million. Cash dividends received for the year ended December 31,1989
    on the Junior Perpetual Convertible Preference Stock and the Adjustable Bate Preferred
    Stock, Class A were $11.4 million and $26.8 million, respectively. The gain on sale and the
    cash dividends received are being deferred until final disposition has been made of the
    remaining assets.
    In addition, the BIF has remaining 3.264 mihion shares of the Junior Perpetual Convertible
    Preference Stock, which has a fair market value as of December 31,1989 of $81 mihion. Also,
    the BIF retains the 10,080,809shares of CBC common stock resulting from the exercise of the
    option, that as of December 31,1989 hss a fair market value of $199 million.
    Net Worth Certificate    Program:

    The net worth certitlcate program was established at the FDIC by authorization of the Gam-
    St Germ& Depository Institutions Act of 1982.Under this program, the BIF would purchase
    a quahied institution’s net worth certificate and, in a non-cash exchange, the BIF would issue
    its non-negotiable promissory note of equal value. The total assistance outstanding to
    qualified institutions a8 of December 31, 1989 and 1988, is $258,539,000 and $321,897,000,
    respectively. As of December 31, 1989 and 1988, the financial statements excluded
    $268,639,000and $321,897,000,respectively, of net worth certificates, for which no lossesare
    expected. The original authority to issue net worth certificates expired October 13, 1986. The
    Competitive Equality Banking Act of 1987 reinstated the net worth certificate program
Y
    through October 13,199l.




            Page 88                                              GAO/AFMD-90-199 Bank Insurance Fund
.


                Am?- 1
                ReporteontheI%mndal Statementa of the
                FhkIluarance     Fund for the Yeam Ended
                December   al,1989 aad 1988




    6. Property      and Buildings    (in thousands):
                                                                                   December       31

                                                                            1989                        1988

    Land                                                                  $31,930
    Office buildings                                                        77,643                 $ xi
    Accumulated depreciation                                               (11,900)                 (10:613)
                                                                          $97,673                 (6 77,634

    The BIF 1776 F Street property note payable of $6,939,000was paid in fuh as of December 31,
    1989.
    A portion of depreciation expense is allocated to the failed banks as liquidation expense. In
    both 1989 and 1988, the amount of depreciation expense allocated to the failed banks was
    $496,000.
    7. Liabilities    for Estimated    Bank Assistance:

    The BIF records an estimated loss for its future or potential assistanceto those banks which
    the regulatory process has identified as being distressed and where ongoing negotiations
    and/or current agreement terms indicate that BIF assistancewill be necessary.The BIF’ out-
    standing liabilities for this estimated bank assistance as of December 31, 1989 and 1988, are
    $3,820,297,000and $3,877,376,000,respectively.
    The BIF has included in the December 31, 1989 Liabilities for Estimated Bank Assistance
    $636,963,000of realized proceedsfrom the sale of equity instruments and other such transac-
    tions associatedwith the assisted institution. BIF defers recognition of such proceeds pending
    final termination of the assistanceagreement. Such proceeds are available to fund future as-
    sistance costs and have been considered in determining the estimated loss to the BIF for fu-
    ture assistance.
    8. Liabilities    Incurred    from Bank Assistance     and Failures    (in thousands):

                                                                                     December      31

                                                                            1989                    1988

    Funds held in trust                                               $        489            $    233,278
    Depositors’ claims unpaid                                               79,065                  32,841
    Notes indebtedness                                                     798,982                 998,818
    Guaranty assistance I                                                    6,660                     14,639
    Federal indebtedness                                                  1,450,000               3,316,178
    Accrued interest/other liabilities                                       77,499                    66,734

                                                                     $2,412,086               $4,661,388

    Maturities of these liabilities for each of the next five years and thereafter are (in thousands):
         1990              1991         1992            1993        1994              1996/Thereafter

    $1,808,614       $206,311         $199,558      $ 103,919      $6,741                 $88,642




                Page 89                                               GAO/AFMIMW1O9 Bank lnsuraace Fund
          Appendix I
          Reporta on the Hlnandal Statt3mentaof the
          Bank Iammmce F’undfor the Yeem Ended
          December31,1@8@   and 1998




The Federal Deposit Insurance (FDI) Act, as amended by FIRREA, directs that the FDIC set
sasessment rates for the Bank Insurance Fund members annually in accordancewith the
legislatively mandated rates against a member’s averageassessmentbase.
The FDI Act also provides for an assessmentcredit to BIF members when the Board of Diiec-
tore determines that the BIP reserve ratio is expected to exceed the designated reserve ratio
in the succeeding ear, after taking into account expected expenses and revenues. ‘Ike FDI
Act defines the BI# designated reserve ratio as (i) 1.25 percent of estimated insured deposits,
or (ii) a higher percentage, not to exceed 1.60 percent, ss determined by the Board of Diiec-
ton, to cover expected risks of future losses.
The assessmentrate is 0.12 percent for calendar year 1990. Based on the present projected
status of the BE’, and anticipated expensesand revenue for the next year, the reserve ratio is
not expected to exceed the designated reserve ratio. Therefore, insured members will not
receive an assessmentcredit in 1990.
10. Pension Plan and Accrued Annual Leave:
The FDIC eligible employees assigned to the Bank Insurance Fund are covered by the Civil
Service Retirement and Disability Fund. Matching employer contributions provided by the
BIF for all eli ‘ble employees were approximately $13,786,000and $13,404,000for the years
ending DeceI4 er S&l@89 and 1988,respectively.
Although the BIF contributes a portion of pension beneflts for eligible employees and makes
the necessary payroll withholdings from them, the BIF does not account for the assets of the
Civil Service Retirement and Disability Fund and does not have actuarial data with respect to
accumulated plan beneilts or the unfunded liability relative to its eligible employees. These
amounts are reported by the U. S. Office of Personnel Management (OPM) for the Civil Ser-
vice Retirement and Disabiity Fund and are not allocated to the individual employers. OPM
also accounts for all health and life insurance programs for retired BIF eligible employees.
The BIF liability to employees for accrued annual leave is approximately $18,430,000and
$14,698,000at December al,1989 and 1988,respectively.
11. Commitmente:
The BIP lease agreement commitments for office apaceare $160,921,000for future years. The
agreements contain escalation clauses resulting in adjustments, usually on an annual basis,
During 1989 and 1988,lease spaceexpensewas $29,390,000and $34,038,000,respectively.
Leasedspacefees for future years are as follows (in thousands):

    19BO           1991        la92           1999           1994         1995/Thereafter

  $31,836      $26,223       $18,363       $14,640        $11,768             $49,202




         Page BO                                               GAO/AF’MD-90-100Bank Insurance F’und
         Appendix1
         Reportaonthe     Finandd     Statementa of the
         BmkhummnceFmulfortheYeurBnded
         December 81,lBBB and 1988




12. Entrance   and Exit Fee Revenue:
In accordance with FIRREA provisions, the BIF will receive both entrance and exit fees for
conversion and transfer trausactions between the BIF and the SAD’. Interim regulations des-
cribing the fee calculations have been approved by the FDIC Board of Directors, however,
revisions are anticipated with final approval expected in the coming year.
The BIP has elected not to record the entrance and exit fee revenues which had been caicu-
Iated using the interim reguiations until the reguIations have been finalized. Approximately
$2.4 million in revenues had been calculated for conversion and transfer transactions con-
summated as of December 31,1989.
13. Contingencies:

The FDIC and bank chartering authorities are directing additional resources to the monitor-
ing of the financial condition of certain large banks predominately located in the Northeast
region. These institutions are experiencing the effects of softening real estate markets and
weakening state economies and may, in time, require financial assistance from the BIF. At
this time, however, the FDIC cannot reasonably estimate the timing of such assistanceor the
expected cost to the BIF. Depending on the extent of the continued downturn in the condition
of these segments of the economy in the Northeast, the financial assistance required could
have a material impact on the condition of the Bank Insurance Fund itself.
14. Supplementary       Information     Relating     to the Statementa     of Cash Flows
    (in thousands):

Reconciliation of net income (loss) to net cash provided by operating activities:
                                                                              For the year ended
                                                                                 December 31
                                                                           1989              1988
Net Income (Loss)                                                   $ (861,607)            $(4,240,712)
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
  Amortization of U. S. Treasury obligations                           49,166                  96,724
  Interest on funds held in escrow                                     26,037                      -O-
  Building depreciation                                                 1,387                     891
  Provision for insurance losses                                     3611,290               6,298,266
  Accrual of assetsand liabilities from bank
     assistance and failures                                             (127,426)              12,934
  Loss incurred for debt assumption                                                          1,000,000
  Loss incurred for forgiveness of note receivable                            :;:              131,769
  Net cash disbursed for bank assistanceand
     failures not impacting income                                  (2,143,042)             (2,447,464)
  Increase (decrease)in accounts payable, accrued
     liabilities and other                                                (16,064)             60,999
  (Increase) decreasein accrued interest receivable
     on investments and other assets                                     372,786             (204,961)
Net cash provided     by operating      activities                 $1,122,618               $ 707,446




          Page 91                                                   GAO/-B&100             Bank Insurance Fund
            Appendix 1
            Reporta on the Fhmndal Statement8 of the
            Bank Insnrance Fund for the Yeare Ended
            December 81.1989 and lB?3fJ




    Schedule of non-cash transactions incurred from bank assistance and failures:
                                                                         For the year ended
                                                                             December 81
                                                                       1989                ia88
      Increase (decrease)in net receivable from
         bank atwidance and failures:
      Preferred stock                                             Sgg8’               $970,000
      Notes receivable                                             I ,                    2,100
      Notee in lieu of cash                                                              18,673
      Depositors’ claims unpaid                                       46,2%              14,124
      Transfer of allowance for loss                              (1,960,OOO)          (941,962)

        Total Increase   (Decreame)                                (463,787)              62,946


      Decrease(increase) in liabilities incurred from
        bank assistanceand failures:

      Notes payable                                               (1,460,OOO)            (990,773)
      Pending claims of depositors                                   (46,213)             (14,124)

      Liabilities for estimated assistancetransfer                 1.960.000             941.962

        Total Decrease   Uncreaeele)                                  463,787            (62,945)

                                                                  $       -O-        $        -O-




Y




            Page 92                                              GAO/AFMD-B0-100 Bank Insurance Pund
Appendix II

GAO’s March 7,1990, Letter to the Secretaryof
the Treasury




                  March    7,   1990
                  The Honorable        Nicholas  F. Brady
                  The Secretary        of the Treasury
                  Dear Mr. Secretary:
                  This letter    responds to the notice published         in the Federal
                  Register    on December 6, 1989, in which you requested
                  comments on the topics     being addressed by the Department of
                  the Treasury’s     study of the federal     deposit   insurance
                  system.     We are only commenting on the issues identified
                  under the topic of auditing      and on-site     examination    as they
                  relate   to banks and savings    associations.
                  Under this topic,           you requested     comments on whether a
                  closer    relationship         between the auditors      and regulators           of
                  depository       institutions        would benefit    the deposit       insurance
                  system.      You also asked for comments on the feasibility                       of
                  adopting     regulations         that are the same as, or similar             to,
                  the audit provisions            of England’s    Banking Act of 1987.
                  Overall,     we support establishing           a closer    relationship
                  between auditors           and regulators     and implementing
                  regulations        similar     to many of the audit provisions             in the
                  Banking Act.          We also believe      that other improvements            are
                  needed to better           ensure the safety       and soundness of insured
                  depository       institutions.
                  The Financial    Institutions        Reform, Recovery,    and
                  Enforcement   Act of 1989 (FIRREA) also requires            us to study
                  and report on deposit         insurance    issues and to conduct a
                  comprehensive   study of the credit           union system.   Our
                  studies  are currently        in process.
                  Other,work       that we plan to complete this year will                 also
                  address some of the other issues you raised.                       At the
                  request of the Subcommittee              on Financial     Institutions
                  Supervision,        Regulation     and Insurance,       House Committee on
                  Banking,     Finance and Urban Affairs,             we are currently
                  reviewing      the condition       of the Bank Insurance           Fund and the
                  banking industry.           In addition,     due to our concerns that
                  current     accounting      requirements     may not meet the
                  regulators’        needs, we recently       started     a study of bank
                  accounting       practices.       Our purpose is to determine            whether
                  market value accounting            would provide       more useful
                  disclosure      of the true financial          condition     of banks.




               Page@8
                                                                                                     .
    4w*         Il
    GAO’0 March 7,1@@0,Letter to the Secrew
    of the Treaoury




GAO SUPPORTS MORE COMPREHENSIVE
AUDITING AND REPORTING REQUIREMENTS
AS you are aware,          GAO has long been an advocate of and
continues       to strongly      support     audit and management
reporting       requirements.        We believe       that the management of
all insured banks and savings                associations       should be
required      to issue reports         assessing      the effectiveness       of
their    internal      control    structures       and their     compliance    with
laws and regulations           related     to safety      and soundness.
Further,      all insured banks and savings associations                    should
be required        to undergo annual financial             audits.      Also, the
role of auditors         should be expanded to have them review
and report on management's assertions                    contained    in their
report    on internal       controls      and compliance.          Our opinion     on
the need for management reporting                  and audit requirements          is
driven     by three fundamental           beliefs.
First,      the federal       government,         as insurer       of deposits,    has
a significant         contingent        liability        to honor those deposits
in the event of default.                  It therefore        needs adequate
mechanisms to protect              its interests.            FIRREA included      many
needed reforms,          including        strengthened        capital
requirements,         limits     on the activities            of insured
institutions,         and strengthened            supervision       and
enforcement.          However,       these reforms are not meaningful
unless we ensure that institutions                       maintain     strong internal
controls,        adhere to laws and regulations,                   and properly
report      their   financial        condition.          Requiring     management
and audit reports            would help fill           a void in our current
supervisory        and examination            structure.        These requirements
would also provide            the federal         government with a strong
tool to help protect             its interests.
Second, management of banks and savings associations                                   have a
fiduciary        responsibility            to operate       their     institutions        in a
safe and sound manner and protect                        the interests          of their
depositors.           However,       our work on the causes of savings
association         and bank failures             showed that these failures
were caused in large part by internal                           control      weaknesses
and noncompliance              with laws and regulations                 directly      within
the control         of management.             This failure          by management to
fulfill       its fiduciary          responsibility           for operating         the
institutions           in a safe and sound manner occurred even
though guidance,             regulations,         and directives           were in place
regarding        their      responsibilities.              Requiring       management to
report      to the regulators             and deposit         insurer      on their
responsibilities              for establishing           and maintaining           an
effective        internal        control      structure,        including       controls
for compliance            with laws and regulations,                  and on the
effectiveness            of their      internal       controls       would help ensure
that controls            are being maintained.




    Page 94                                                    GAO/AFMDM-100         J3ank Insurance Fund
     GAO'0 March 7,1080, Letter to the Becrem
     of the Treaoury




Third,     we believe      that the accounting                 profession      has a
responsibility         to protect         the government's             and the
taxpayers'       interests     when accepting               an audit engagement of
an inSured depository             institution.              As such, the
profession       should take a proactive                  role in assisting
institutions        and the regulators               to identify,        prevent,     and
correct      problems in financial               reporting        and internal
controls.        Regulators      have come to increasingly                   rely on
"off-site"       monitoring      using reported              financial
information.          Therefore,        it is imperative             that this
information        be accurate       and reliable.               The accounting
profession       is in a unique position                  to help ensure the
accuracy      of this financial             information.           Further,     expanding
the role of auditors            to require           them to report on
management's assertions              on internal            controls     and compliance
with laws and regulations                 is in keeping with our belief
that the accounting           profession           has to assume greater
responsibility         than it currently               has when accepting          an
audit engagement of an insured                     in6titution.l          It would also
help ensure the validity               and reliability             of the management
report.
You have asked for             comments on three         specific     proposals:
--   Requiring      auditors      to report      audit    results     to the
     regulators,
--   Requiring      regulators      to share      reports     on an institution
     with its      auditors,      and
--   Requiring   auditors    to participate              in conferences        between
     the regulator     and the institution.
In general,      we support       the general       concepts of these three
proposals.       However, the full          benefit    of establishing      a
closer   relationship        between depository          institution   auditors
and regulators       will    not be achieved unless all institutions
are required      to issue a management report as we have
proposed on their         internal     controls      and compliance    with
laws and regulations,           and to undergo an annual financial
audit.     Consequently,        in addition       to establishing
requirements      that would allow a closer relationship                between
auditors    and regulators,          auditing    and management reporting

lThe accounting      profession     also has to assume greater
  responsibility     when accepting      an audit engagement of any
  public    company.    Our opinion     on the need for management
  reports     and an expanded role for auditors       applies  to
  public    companies as well as insured banks and savings
  associations.




     Page96                                                   GAO/APMD-90-100Bank Insurance F’und
   GAO*8Much 7,1@80,Letter to the l3euetw
   of the Treasury




requirements       for   banks and savings         associations        should    be
implemented.
We have previously         supported      and continue      to Support
requiring    the results        of any audit to be reported              to the
regulators.        such a requirement         is already      in place for
savings associations          and should be implemented             for all
insured depository         institutions.         We also believe         that
regulators’      reports     on institutions        should be shared with
the auditor.        Although      section    931(a) of FIRREA requires          an
institution      to ahare audit and examination               r.eports with its
auditor,    we would, with exceptions             to cover sensitive
situations,     support regulations           to specifically         require
regulators     to share information           with the auditor.
We generally       support the concept of auditor              participation
in meetinga between regulators              and insured      institutions.
Such participation         would help auditors        better      fulfill       their
audit responsibilities.            It may also provide          the regulator
with additional       perspective       on issues being addrereed.
However, the responsibility             should be on the regulator                or
the institution        to request that the auditor             attend
meetings.       Also, auditor      participation       in conferences
should be balanced with appropriate               protection        for the
auditor    from liability       for disclosing       information          which
might otherwise        contravene     any duties     to the client.             Our
detailed     comments on the three issues are provided                     in
Enclosure     I.
Under the same topic,            you also asked about rpecific
provisions        in England’s      Banking Act of 1987. We would
support      regulations      similar     to many of the specific
sections       in that act on which you asked for comment. We
have previously          supported    many of the concepts raised in
those set t ions, euch as required                audits  of entities
applying       for federal      deposit     insurance    coverage and direct
notification        by the auditor        to the regulator       if the auditor
is removed or replaced,             resigns,      or does not seek
reappointment.
Nonetheless,    we have various          concerns with adopting
requirements     and authorities         similar    to those contained      in
some of the Banking Act’s provisions.                   For example,   the
institution’s     auditor     of record should be appointed            by the
institution    rather     than the regulator.            Also, any
additional    auditor     responsibility         to directly   report
information    to the regulators           should be balanced with
appropriate    protection       from liability        for the auditor.
In some cases, we have no comments on specific         provisions
of England’s    Banking Act other than to note that there
currently    are similar federal  laws and regulations.         Our




   Page 80                                                GAO/AFbfDWlOO Bank Inmuuw     I;Flmd
detailed comments on each of the sections                   in the Banking
Act are provided in Enclosure  II.
OTHER RELEVANT ISSUES
Management reporting            and audit requirements         should go a
long wsy toward preventing              internal    control   weaknesses an
noncompliance          with laws and regulations.           However,    this
belfef      is predicated       on the quality      of both management’s
asgesament of internal            controls     and compliance      with laws
and regulations           and the auditor’s       work, and on the
auditor’s        independence.       Our prior     work on audit quality
showed that certain           rteps should be taken to improve
auditing       and financial      reporting.       Many steps, such as
revising        and improving     auditing     standards,    have already
been taken.          Some remain to be accomplished.             In
particular,         two items should be considered           as a means to
eneure the quality           and reliability       of management and
auditor       reports.
First,    insured depository        institutions        should be required
to establish      audit committees made up of outside                 directors.
These directors        should be independent          in fact and
appearance.       As the Treadway’ Commission noted in its
October 1987 report,         audit committees         can play an
important     role in preventing         and detecting       fraudulent
financial     reporting     and overseeing       internal      controls.       The
audit committee ahould be responsible                 for appointing        and
reviewing     the work of the auditor.            As such, it would
enhance auditor        independence      by serving      as a buffer      between
management and the auditor.
The audit committee should include            at least one attorney
familiar      with laws and regulations.affecting          insured
institutions.        Requiring   an attorney      to serve on the
committee would provide        a legal perspective        on the
application       of laws and regulations       and the relevant
policies      and procedures   to achieve compliance.
Second, serious         consideration      should be given to requiring
mandatory peer reviews for all auditors                  of insured
depository     institutions.          Peer reviews      serve as the
cornerstone      of the accounting         profession’s      quality
assurance program.            They help ensure that auditors           maintain
high quality      operations        and adhere to professional
standards.       Although       the American Institute        of Certified
Public    Accountants        (AICPA) has implemented         a mandatory peer
review program for its members in public                  practice,     not all
aCCOUnting firms are members of the AICPA. We have
QreViOUSly recommended that the Securities                   and Exchange
Commission (SEC) require             all firms practicing        before it to
undergo periodic         peer reviews.        The federal     government     is




  Page 97                                              GAO/AFMD9@199 Bank Insurance F’und
          GAOb March 7,1999, Lsttm to the &crew
          OftlWReMuy




    exposed to potentially     tremendous losses from it8 deposit
    insurance    program.  Therefore,    every step possible,
    including    mandatory peer reviews of accounting      firms doing
    audits of insured institutions~       should be taken to protect
    its interests.
    In addition       to steps to ensure the qualify       of management
    and   auditor     reports  and the independence      of the auditors,
    two other issues should be considered            as a means to enhance
    financial      reporting.    First,   insured   banks and savings
    associations       should be required     to provide   more disclosure
    in their      annual reports    on the risks and uncertainties
    facing     them that are relevant       to assessing   their financial
    condition.
    Currently,      the SEC requires      management of public          companies
    to include      in their     annual reports     a section     often entitled
    *Management’s        Discussion    and Analysis    of Financial
    Condition      and Results of Operations         (MD&A).”       The Office    of
    Thrift     Supervision      (OTS) also requires      a savings
    association       applying    to convert    from mutual to stock form
    to include      an MD&A section      in its request.         In the MD&A
    section,     the SEC and OTS require          management to discuss
    known material        events and uncertainties        which would be
    relevant     to an assessment of the entity’s             financial
    condition,      results    of operations,      and future      prospects.
    Requiring     all insured banks and savings associations           to
    provide     more information    on risks    and uncertainties    in
    annual reports      would help regulators,       the deposit  insurer,
    depositors,      and other financial     statement   users make better
    judgments on the areas of operations           that deserve
    additional     supervisory   focus and on the continued       viability
    of the institution.
    Second, auditing   and on-site     examination     requirements
    should be augmented for money center banks and other large
    banks and savings associations        that,   if they fail,     would
    cause a signif icant loss to the insurance           funds.   OQt ions
    that could be considered     include:
    --    allowina      the reaulator  to aoooint     an auditor  to conduct
          a joint-audit      05 the instituiion      with the auditor
          apQoi,nted by the institution,
    --    requiring   that the quarterly        financial   information
          submitted   to the regulators       by such institutions         be
          reviewed by auditors       using   procedures   established       by the
          regulators    in consultation      with the accounting
          profession,     and
    --    requiring   more frequent,      on-site    regulatory      examinat ions
          of larger   institutions.

Y




           Page 99                                          GAO/AF’MD-99-199 Bank Insurance Fund
  GAO*@  March 7,1999, Letter te the 9ecretsry
  of the Treasuly




CONCLUSION
American taxpayers           are having to pay billions              of dollars    to
resolve      the savings and loan crisis.                I believe      that we owe
it to them to take whatever steps are necessary to prevent
another crisis          of this magnitude.           Positive     action    to
identify       and correct       internal    control     weaknesses,
noncompliance         with laws and regulations,              and fraudulent
financial        reporting     is crucial.       Enacting      requirements
similar      to England’s        requirements      for auditor       and
management reports           and communications          between the
regulator       and the auditor         would be an important           step in the
right     direction.       As we have stated,          consideration        should
aleo be given to establishing                other requirements           to enhance
the quality         of management, auditor,           and financial
reporting.
Sincerely     yours,




Charles A. Bowsher
Comptroller  General
of the United States
Enclosures     - 2




   Page 99                                               GAO/APMD9@199Bask Issersncs Pund
          Aew*       Il
          GAO’r blarcll7,1BBo, IMter to the WvetsrF
          of the lkeamry




ENCLOSURE I                                                                             ENCLOSUREI

            GAO Comments on Establishing    a Closer Relationship
           Between Regulators and Financial    Institution   Auditors
          This responds to the Department of the Treasury                            request    for
comments on whether a closer relationship                            between ‘depository
 institution          auditors     and regulators         would benefit         the deposit
insurance         system.        As requested,       we have addressed the following
issues t (1) should the independent                       auditors        and accountants       of a
federally         insured       depository    institution          be required       to report      the
results       of any audit         of the institution            to the appropriate
regulator(a);             (2) should the appropriate               regulator(s)        be required
to share        reports        on a depository       institution          with the institution’s
independent           auditors     and accountants;           and (3) should the
independent           auditors     and accountants          of a federally         insured
depository          institution        be required      to participate          in conferences
between the regulator                and the depository            institution.
      In summary, we would support authorizations         and requirements
for federally   insured banks and savings    associations     similar   to
those reflected    by the three issues raised,    and which are contained
in many of the provisions     of England’s Banking Act.
       England’s     Banking Act of 1987 contains               requirements       applicable
to English     banks and their         auditors    and accountants         which address
some of the three issues presented                above.      As a preliminary
observation,      we note that England’s           Banking Act of 1987 builds               on
the provisions       of the Companies Act of 1985 requiring                   f nancial
audits    and reports      by banks and other public              companies.   f     Unlike    in
England,     banks in the United States are under no general statutory
or regulatory       requirement      to have annual independent              audits.
However, some banks are subject               to audit as part of the Federal
Reserve bank holding          company regulations,          Securities       and Exchange
Commission requirements,            or state chartering           laws.    In addition,
under a Federal Deposit Insurance               Corporation         (FDIC) policy
statement,     applicants       for deposit     insurance       coverage will        be
required     to obtain     an independent       annual audit for at least the
first    3 years after       FDIC grants deposit         coverage.        Federally
insured savings        associations      are required       to be audited annually             by
regulation,      rather    than by statute.
      Some of the auditing and reporting     requirements     of England’s
Banking Act address issues related     to improving    financial
management and disclosure  that GAO has been concerned about over
the years.   For example, we supported    efforts    to include   language

1The Companies Act of 1985 is largely          a consolidation     of prior   acts
 that predate  1985.     In addition,    audit and reporting       requirements
 for “building  societies,”     the equivalent     to our savings
 associations,  are contained       in England’s   Building    Societies    Act of
 1986.




         Page 100                                                   GAO/APMD-B@lOO
                                                                                 Bsnk Insursnce Fund
          Appendix II
          GAO’8 March 7, lrm, Imtt.lw to the L?JamUq
          0ftheTrasury




ENCLOSURE I                                                                              ENCLOSUREI

 in the Financial           Institutions       Reform, Recovery,               and Enforcement       Act
of 1989 (PIRREA) that would have required                          institutions         to iSSue
reports      on the effectivenese            of their        internal        COnttOlS and
compliance        with laws and regulations              , and to undergo an annual
financial       audit.       As part of this audit,               we proposed that the
auditor      iseue a report           to the Federal Deposit               Insurance      Corporation
on management'r           aSSertionS       contained       in its report;              Also, in
recent     studies,       we have recommended annual independent                        audit and
reporting       requirements          and direct      notification           to regulators       by
terminated        auditors.         We also supp0rted.a            general       requirement      that,
under     certain      circumstances,        auditors        report      information       outside    of
the audited        companies.
Issue     I - Should Independent   Auditors and Accountants    of a
              Federally  Insured Depository  Institution    be Required to
              Report the Results of Any Audit of the Institution       to the
              AQQrOQriate Regulators
         United Kingdom legislation              requires    management to submit to
the     regulator       audit reports       on a bank’s internal        control    system.
Section       235 of England’s          Companies Act of 1985 requires            bank
directors        to report on the development              of the bank’s business.
Schedule 3 of England’s               Banking Act of 1967 requires           banks   to
maintain       accounting       records and internal          controls.     The Bank of
England,       the principal         regulator    of banks in the United Kingdom, in
interpreting          these Qrovisions,        requires     the auditors     to report      to
the directors           or senior     management on the bank’s internal             control
system.        In addition,        sections    236 and 237 of the Companies Act
require       annual audita and reports             on banks’ accounting        records and
financial        statements,       including     assertions     made in the directors’
report      concerning       such accounts.
        We Support requirements               applicable        to all federally          insured
banks and savings associations                   for annual audits            and reports.            Such
a requirement         is already        in place for savings            associations.             Office
of Thrift       Supervision         (OTS) regulations           require     that an independent
auditor’a       report on the institution’s                 financial       statements         and an
audit     report    on any material           weaknesses in internal               controls        be
filed     annually      by the institution            with the regulator.              Also,      as
noted above,        we had Supported            as part of FIRREA a proposal                   for
auditing      and reporting          requirements        for all federally           insured
banks and savings associations.                     The proposal        we supported           would
have required         inatitutionsl         management to report              on their      internal
control      structures,        including       controls      to ensure compliance              with
laws and regulations              related     to safety       and soundness.           It also
would have required             annual audit reports              on institutions’           financial
statements       by independent           auditors,      including      reports      on the
assertions        in the management reports.




          Page 101                                                   GAO/AFMD-fIO-100 Bank Inmranm Fund
                                                                                                            .
          AppendixII
          GAO% March 7,19@0,Letter to the Beeretary
          of the Tre55uly




ENCLOSUREI                                                                             ENCLOSURE I

         In our recent stud155 of the factors                        causing banks and
saving5 association              failures      , we found that serious              internal
control       weaknesses contributed                significantly         to the failures        of
those institutions.2                 In our reports , we recognized                 that management
is responsible           for maintaining            adequate internal           control     systems,
and that management              reQOrtS       and auditor        reviews are needed to
provide       reasonable       assurance        that the controls            are being
maintained.          To addresa the serious                 internal     control     weaknesses,       we
recommended that COnQresS, as a condition                            for federal        deposit
insurance,        require      each insured          bank and thrift          to (1) prepare
annual management reports                   describing       management's resQonsibilities
for preparing          financial        statements         and for establishing            and
maintaining         an effective          internal      control      structure,       including
controls       to ensure compliance              with laws and regulations,                 and
(2) obtain an annual independent                       audit of its financial              statements.
The auditor        would be required              to issue an opinion            on the
institution's          financial        statements         and a report on management's
assertions        regarding        the effectiveness             of the institution's
internal       control      structure        and compliance          with laws and
regulations.
Issue    II   - Should the AQQrOpriate    Requlators                   be Reauired to Share
                Reports on a Devositorv    Institution                   with the
                Institution's Independent     Auditors                  and Accountants
        Section 83 of England's       Banking Act               of    1987 authorizes        the
Bank of England to disclose         information               to     a bank's   auditor      or
reporting      accountant    if it would assist               the     Bank of England        in the
discharge      of its functions    under the act                or    otherwise   would      be in
the interest       of depositora.
        We support the concept of requiring                     regulators,       except in
limited       circumstances,         to share reports          with an insured
institution's           auditors     and accountants.           Such report sharing           would
help ensure that high quality                   audits , which are in the regulators'
best interests,             are performed       on insured       institutions.         Requiring
federal       regulators         to bring matters       to the attention          of a
depository         institution's        auditor      is especially         important    when the
regulator        believes        a matter    is so important           that the auditor's
knowledge of it could significantly                     affect      the form of the audit or
the way in which the auditor's                   responsibilities            are carried    out.
We note that OTS currently                has regulations           which authorize       it to
provide       a savings association's              independent         auditor   with access to

2Bank Failures:       Independent  Audits Needed to Strengthen      Internal
 Control   and Bank Management (GAO/AFMD-89-25, May 1989); Thrift
 Failures:     Costlv    Failures Resulted From Regulatory   Violations      and
 Unsafe Practices       (GAO/AFMD-89-62, June 1989).




          Page 102                                                    GAO/AF’MD-9&100 Bank Insurance Fund
ENCLOSURE I                                                                      ENCLOSUREI

the institution’s        examination        reports    if     the auditor       agrees in
writing    not to disclose         the examination          report    or any Portion
thereof.      In addition,        section     931(a) of       FIRREA requires        federally
insured    financial     institutions         to provide        their   auditor     with copies
of the institutions’          most recent reports            of condition        and
examination,       and certain       information     on     supervisory       aCtiOnS
concerning      the institutions.
         However, we do not believe           the requirements       of section     931(a)
of FIRREA are sufficient           because that provision           relies    on the
institution       to provide    the auditor       with reports      and information.
We believe      the regulator      should be required          to notify    the auditor
of the existence        of pertinent      regulatory       reports,    and respond to
the auditor’s       requeat for such reports.             However, there should be
exceptions      to any general      requirement       for report     sharing    by
regulators      to cover sensitive        situations       such as those involving
litigation      and ongoing actions        or investigations.            In such cases,
the regulator       should notify      the auditor       that the reports       are not
available     and explain     why they are not available.
Issue   III   - Should Independent          Auditors and Accountants   of
                Federally     Insured Depository      Institutions   be Required
                to Participate       in Conferences     Between the Regulator    and
                the Depository       Institution
       While England’s       Banking Act does not expressly           authorize     or
require    auditors     to participate        in meetings between the Bank of
England and banks, section              47 of the act authorizes      auditors     to
communicate      information      to the Bank in good faith         on a matter which
they become aware of in their              capacity   as auditors,    and which is
relevant    to any function         of the Bank under the act without           being
regarded as having contravened               any duty to which they may be
subject    whether or not the communication              was in response to the
Bank’s request.        Audit Guideline          307, which was issued by the Bank,
indicates     that section      47 of the act permits        auditors    to
communicate with the Bank at meetings.                  (See Enclosure     II for our
comments on the section           47 authorization       for auditors    to
communicate      in good faith        to the Bank.)
        We generally    support     the concept of auditor           participation          in
meetings     between  regulators       and insured depository            institutions.
Such meetings, are an appropriate              means of exchanging          information
between the regulator,           the institution,         and auditor.        Specifically,
they would provide       an opportunity          for the auditor       to discuss        the
affairs    of the institution,         including       the opportunity        for the
auditor    to explain    any accounting           issues which may be of concern
to the regulator,       and to hear the regulator’s             concerns directly.
However, auditor      participation         in meetings or conferences               should




         Page 109                                                GAO/APMD-90-100Bank Insurance Pund
ENCLOSURE I                                                                    ENCLOSUREI

only occur      when it    is requested      by the    institution      or the
regulator.
        While  we support auditor           participation        at conferences     with
regUlatOra      and depository       institutions        , we are concerned that any
such participation          be balanced with appropriate             protection      for the
auditor.      In this regard, we ‘note that section                 47 of England’s
Banking Act insulates          the United Kingdom auditor             from any liability
for disclosure        of information        which might otherwise          contravene     any
duties    to the client.        There is no such protection              for U.S.
auditors.       (See discussion        in EnClOsUre        II, Item F.)       Any provision
for   auditor    participation       in meetings should also provide               a
corresponding       limit    on auditor       liability      for any potential
disclosures      by the auditor        at such meetings which could place the
auditor     in breach of any duties             owed to its client.




         Page 104                                             GAO/APMD-S@loBBauk BMuance Pund
ENCLOSURE II                                                                     ENCLOSURE I I

                                     GAO COmsbSntS on
                             Significant      Provisions of
                           England’s     Banking Act of 1987
         In addition    to requesting     comment0 on the three iSSUeS
addressed      in Enclosure    I, the Department of the Treasury          AlSO
requested      comments on the feasibility          of adopting regulations    that
are    the same as, or similar        to , the audit provisions     of England’s
Banking Act of 1987, which affect             the Bank of England’s
relationship       with auditors    and reporting.accountants.         You
specifically       mention sections      8, 39, 41, 45, 46, 47, 82, 03, 85,
and 94 of that act.         This enclosure       responds to your request to the
extent     that comments    on those provisions        have not been provided     in
Enclosure      I.
       We have examined the cited provisions                  of the Banking Act of
1987 and would support federal     regulations                containing  requirements
and Authorities   similar  to those contained                 in the fOllOWing
provisions.
       --   Section 8(S),      requiring   auditor       reports      in connection      with
            an application       to do business;
       --   Section   39(l)(b)    and (2), authorizing     the regulator               to
            require   a bank to provide    supplemental      audit report8               and
            to prescribe      the form and content     of audit reports1
       --   Section 41, authorizing      the regulator      to appoint
            investigators     and impoeing a duty on auditors         to provide
            such investigators     with requested     information;
       --   Section 45, requiring      audited        account8      and audit      report6      to
            be open to public     inspection;
       --   Section    46, requiring       direct    notice      regarding   a   change of
            auditor;    and
       --   Section    47, authorizing   an auditor  to communicate                 to the
            Bank of England certain      information   or opinions
            notwithstanding     any duty to the auditor's     client.
        Except in certain           circumstances     , we do not support federal
regulations       similar       to the requirement        in section    39(2) that
reporting      accountants         be nominated or approved by the regulator.
In addition,       other than to note that there are similar                   authorities
and requirements           in U.S. law, we have no comments on section                   82,
placing      general     restrictions       on disclosure     of confidential
information       by any person receiving             such information;       sections     83
and 85, providing            exceptions     to restrictions      on disclosure       of
confidential        information;         and section     94, imposing criminal




        Page 106                                                 GAO/AFMD4Kb1OO
                                                                              Bank Inmwuwe Ruwl
                                                                                                      .

                                                                                                          i-
          APpendi* Il
          GAO’r March 7,1BBO, Letter to the Secretary
          of the Treasury




ENCLOSURE II                                                                           ENCLOSURE II

penalties       for     providing      false   or misleading          information       to
regulators.
A.    Reports         Required      in Connection        with   Application         to DO Business
       Section    S(S) of England's   Banking Act of 1987 authorizes                            the
Bank of England to require        an auditor's   report   on information
provided     to the Bank in connection      with an application     to do
business.
       We support      federal     regulations      which would have a similar
effect    with regard to InStitUtiOns              applying      for federal      deposit
insurance,        We believe     that it is necessary            for institutions
applying     for federal       deposit     insurance     to be subject        to the same
auditing     and reporting       requirements        as institutions        already
insured.       Imposing such requirements             on applicants       would help
ensure that their         operations       and financial       affairs    are being
conducted      in such a way that the interests                of depositors       will   be
protected      and that they ultimately            would not pose a risk to the
insurance      funds.      Proposals    which we previously            supported     (see
Enclosure      I) required      annual financial         audits of institutions
applying     for   federal     deposit     insurance.
B.    Power to Obtain SuPvlemental                  Reports;   APPointment            of Reporting
      Accountant;  Form and Content                 of Reports
         Section   39(l)(b)      of England's  Banking Act requires        a bank to
provide      the Bank of England with a report          by an accountant        on
information      which the Bank has required         or could require        for the
performance      of its functions        under the act.    We support
regulations      similar      to this requirement.      If federal     regulators
need supplemental          information    from an insured    financial
institution,       they should have the flexibility          to require      that such
information      be reported       on by an auditor    or accountant.
        Section    39(2) of the Banking Act requires                 that an accountant
reporting      under section       39(l)(b)     of the act be a person nominated
by the Bank of England.              We recognize       that U.S. regulators            already
have the authority         to employ auditors           and accountants          to assist
them in the examination            and inspection        of insured       institutions.
In general,       we would   not support        a requirement        which would result
in the regulator        approving       an institution~s         auditor     of record.
Nomination       and approval      of reporting       accountants        by a federal
regulator      is generally      unnecessary        as long as an accountant              meets
professional       standards     established        by the accounting          profession          and
atate regulatory        authorities.         Further,      requiring      institutions          to
establish      an audit committee,          which would appoint           and review the
work    of the auditor,      is a more appropriate             means to ensure auditor
independence.




          Page 106                                                   GAO/AFMD-90-100 Bank Insurance Fund
          GAO’8March 7, 1990,Letter to the Secretaq
          of the Treasury




ENCLOSURE II                                                                         ENCLOSUREII


         Nonetheless,   auditing     and on-site    examination     requirements
should be augmented for banks and savings              associations       that,    if
they fail,      would cause a significant        loss to the insurance          funds.
One option      to augment current      requirements    would be to allow
regulators      to appoint    auditors    to conduct joint      audits of such
institutions       with auditors     appointed   by the institutions.
         Section       39(2) of the Banking Act also authorizes                        the Bank of
England to prescribe              through notices           (regulations)         the form and
content      of audit reports.             We support regulations               similar     to this
requirement.            The proposal       which we previously             supported was
similar       in that it would have authorized                    the Federal Deposit
Insurance         Corporation        (FDIc),     in consultation          with the Comptroller
General,        to determine        the form and content             of audit and management
reports.          This aspect of our proposal                was linked       to specific
criteria        for management reports              and auditing        standards.        The
proposal        required     that FDIC, in consultation                with the Comptroller
General,       prescribe       specific      criteria      for management reports.               It
also required           the use of generally             accepted auditing           standards
(GAAS) for financial             statement         audits,     and that FDIC prescribe
attestation          standards      for application          to management assertions              made
in management reports.
        Criteria       for management reports    and auditing    standards   for
financial        statement   audits  are essential   ingredients     to accurate
financial        reporting.    Thus, we support regulations        imposing such
requirements.
C.    Investigations
       Sections  41(l)    and (5) of the Banking Act authorize          the Bank
of  England to appoint       persons to investigate       banks and impose a
duty on auditors      providing    reports    under sections   8(5) and 39 (1) (b)
of the act to disclose         such information    as requested    to the
investigators.
        We recognize   the benefit      of such a requirement.      The duty
imposed on auditors        would require      them to produce all documents
relating     to the financial    institution      which are in their   custody                     or
control,     including   the auditor's       own working papers.
        However,       we have serious       concerns regarding     the impact of such
a requirement          on the auditor/client         relationship.     As we noted in
Enclosure        I, section    47 of the Banking Act provides           the English
auditor     who discloses       certain      client    information  with protection
from liability          for such disclosures.            It should be made clear that
any auditor         reporting   or disclosing        information   under a duty
similar     to that imposed by section              41(S) of the Banking Act and




          Page 107                                                 GAO/AFMLMW1OOBank Insurance F’und
ENCLOSURE II                                                                         ENCLOSURE II

with similar       protection      from liability  would              be beneficial  to any
investigative        process because such protection                   would enhance
auditor     cooperation      without   fear of breaching               any duty to the
auditor’s     client.
D.    Audited     Accounts      and Reports        Open to Public          Inspection
       Section    45 of England’s    Banking Act requires   a bank to make
available     for public  inspection    its most recent audited accounts at
United Kingdom offices       where it holds itself     out as accepting
deposits.
       We support such a requirement.      The proposal     which we
previously    supported  required  copies of audit reports       filed                       with
regulators    to be made available    for public  inspection     by
regulators,    unless restricted   by law or regulation.
E.    Notice     Regarding      Change of Auditors
     Section    46 of England’s   Banking Act requires      that                    the Bank of
England muat be notified       by (1) a bank, if an auditor                         is removed or
replaced,    and (2) the auditor,     if the auditor   resigns,                       does not
seek   reappointment,   or decides to make qualifications                           to the bank’s
accounts.
         There are no statutory              notification           requirements        in U.S. law.
However, some insured financial                     institutions          are subject        to
notification          requirements         as part of the regulatory                process under
Securities        and Exchange Commission (SEC) and Office                          of Thrift
Supervision         (OTS) regulations.              Both SEC and OTS require                 indirect
notification          from the audited          institution,           rather    than direct
notification          from    the auditor.          Under SEC regulations,                the
institution         must report        the change of auditor               to the SEC, and
provide       a letter      to the SEC from the former                   auditor     stating      whether
the auditor         is in agreement with the reasons for the change.                                 OTS
regulations         provide      a similar      procedure         for savings and loan
associations,           except for an additional                requirement        that the auditor
must discuss          the reasons        for the termination              or change with the
regulator,        after     notification        of the change by the thrift.                      Under a
recent American Institute                  of Certified         Public Accountants             (AICPA)
rule,       accounting      firms which are members of the SEC practice
section       must notify        the SEC directly            if the auditor          resigns,      does
not seek reappointment,                or is dismissed.
       The AICPA’a direct  notification          rule does not apply to all
auditors   who may be engaged to audit an insured             institution.
Therefore,   we support a direct       notification     requirement        similar                  to
that in section    46 of England’s      Banking Act.




         Page 108                                                  GAO/AFMD&O-106Bank Insurance Fund
ENCLOSURE II                                                                        ENCLOSUREII

F.    Communication        by Auditor       with    Regulator
       A6 we noted in Enclosure       I, section  47 of England’s   Banking
Act   authorizes    auditors   to communicate information     to the Bank of
England in good faith        on a matter which they become aware of in
their   capacity    as auditors , and which is relevant     to any function
of the Bank under the act without         being regarded as having
contravened      any duty to which they may be subject     whether or not
the communication       was in response to the Bank’s request.
        There i8 no similar          provision      in U.S. law.           We SUQQOrt       a
similar     provision      with limits      on auditor      liability         because it could
help protect        the interests       of depositors       of the institution              when
there is an adverse occurrence                or change of circumstances                 involving
the institution.           In our recent study of the implementation                        of
changes to improve auditing               and financial       reporting         of public
companies,      we supported       a general requirement              that,     under certain
circumstances,         accountants      report    information,          particularly        on
fraud,    outside      the audited      company.1       We noted that the extent to
which such reporting           should be required         has not been resolved,                  and
that there ir no consensus on this issue among the public
accounting      profession      and others who are concerned with audit
quality    and the accuracy         and reliability         of financial           disclosures.
Nevertheless,        we concluded       that such reporting             is necessary and
appropriate       in certain     circumstances.
       While we rupport         the concept , we note that the institution
should continue            to be the regulator’s          primary    source of
information,         an arrangement      which preserves          the auditor/client
relationship,          and insulates     the auditor         from liability       for breach
of any duties          owed to the institution.              The responsibility         to
provide       the rogulator       with information,         should be placed on the
auditor       only when the institution             fails    to report      the information
or the auditor           no longer has confidence            in the institution's
directors        or senior management.            In such situations,          the auditor
ehould first         attempt    to report     the information         through the
institution’s          audit committee.         If the audit committee is
unavailable         or does not act promptly,             then the auditor        should be
authorized        to report     directly    to the regulator          without     being
subject       to liability      for breach of any duty owed the institution.




1CPA Audit Quality8      Status of Actions  Taken to Improve Auditing
 and Financial   Reporting    of Public Companies (GAO/AFMD-89-38, March
 1989 1 .




         Page 109                                                 GAO/AFMD-88180 Bsnk Insurance Fnnd
          Appendix II
          GAO’s March 7, 1990, Letter to the Secretary
          of the Treasury




ENCLOSURE I I                                                                             ENCLOSUREII

G.    Restricted         Information;        Disclosure        of Information
         Section 82 of England’s          Banking Act places general
restrictions     on disclosure         by any person of confidential
information     obtained       under or for purposes of, the act.                Section 83
of the act provides           excegtions    for regulatory       disclosure      by
permitting    the Bank of England to disclose               confidential       information
(1) for the purpose of assisting               it to discharge        its functions
under the act, (2) if seeking advice from a qualified                       person, or
(3) if disclosure         to an auditor       would assist     the Bank to discharge
its functions      under the act or is otherwise             in the interests         of
deQOSitOrS-      Section       85 of the act provides        additional      exceptions
to the general       restrictions        on disclosure     imposed by section          82.
       We have no comments other than to note that various                        federal
laws currently        place general          restrictions      on the disclosure      of
confidential       information        contained        in audit and examination       reports
of insured     financial       institutions,           and also provide    exceptions     to
the general      restrictions         placed on the disclosure          and use of such
information.
H.    Civil    and Criminal           Penalties       for   Providing        False    or Misleading
      Information
       Section    94 of England’s      Banking Act makes it a criminal
offense     to knowingly   or recklessly          provide    the Bank of England, or
an investigator      appointed     by the Bank under section             41 of the act,
with materially      false   information        in purgorted      comgliance     with the
act or in connection       with an application            to do business.        Sect ion
94 also makes it a criminal          offense       to fail     to disclose    relevant
information     to the Bank when it is known that withholding                     the
information     was materially      significant         to the exercise      of the
Bank’s functions.
          We have no comments other                  than to note that Title                 IX of the
Financial          Institutions          Reform, Recovery,            and Enforcement           Act of
 1989 provides            civil      and criminal       penalties        that go far beyond the
 scheme provided              in section        94 of the Banking Act.                Specifically,
subtitle        A of Title           IX increased        the civil       money penalties           banking
agencies may impose for violation                          of the banking laws, expands the
conduct warranting                 the imposition          of such penalties,             and
 significantly            strengthens         the banking agencies’              enforcement        powers.
Subtitle        E imposed civil             penalties       on financial         institutions        or
officials         who act knowingly              or with reckless           disregard        in violating
 laws, regulations,                or orders.        Subtitle       F increased         criminal
penalties          for certain         financial       institution         offenses       and provides
 for civil         and criminal          forfeiture        procedures       for any property
obtained         in actions          or transactions          constituting         financial
 institution          offenses.          In addition,         it is a felony          under the
federal       criminal          code to knowingly           and willfully         provide      false
statements          to the federal           government-




           Page 110                                                     GAO/AFMDW1OO Bank Insurmm             Fund
Appendix III

CommentsFrom the Federal Deposit
Insur~ce Corporation

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.
                                                     tg   FEDERALDEPOSIT INSURANCE CORPORATION, washmgton.
                                                                                                       DCzoa

                               OFFICE   OF THE CHAIRMAN



                                                                             August   14,   1990




                             DaarMr.Bmsher:




See comment 1 I




See comment 2




See comment 3.




                                   Page111
                                                                              u
    AppendlxJ.u
    Commenti From the Federal Depoeit
    hmrancecorparation




                                        L. Willialn seidlnan
                                        ulab


lfle -18      marlea A. Bumher
cxaptmller-
U.S. General Aaamthg Office
441 G Street, N.W., IIlerm6114
Waebb@m,DC      20548




    Page 112                                 GAO/~80400        Bank Lnaurance Fund
     .

 c
               CommenteFmm the Federal Depoolt
               Inaumnee Corporation




               The following are GAO’S comments on the Federal Deposit Insurance Cor-
               poration’s letter dated August 14, 1990.


               1. See“Agency Commentsand Our Evaluation” section in chapter 3.
GAO Comments
               2. Discussionof separate assetpools in chapter 4 was modified to reflect
               me’s  comment.
               3. See“Agency Commentsand Our Evaluation” section in chapter 4.




               Page 113                                GAO/AFMD-90400 Bank Inmrance Fund
Appendix IV

CommentsFrom the Board of Governors of the
Federal ReserveSystem

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.
                                                         BOARD     OF GOVERNORS
                                  *.....                            OF tnc

                                             :        FEDERAL     RESERVE             SYSTEM
                             :                              WASHINQTON,   D.   C.   20551
                             :
                                                                                               .00”1..   OI.ICIAL CO”“r.COYDC*OI
                                                                                                            TO 7°C .D.“O


                                                                 August 15, 1990


                                 Mr. Donald H. Chapin
                                 Assistant  Comptroller General
                                 Accounting and Financial
                                    Management Division
                                 U.S. General Accounting  office
                                 Washington, D.C. 20648
                                 Dear Mr. Chapin:
                                            This letter outlines the views of the Board of
                                 Governors of the Federal Reserve System on the recommendations
                                 contained in the GAO draft report entitled  "Bank Insurance Fund:
                                 Additional  Reserves and Reforms Needed to Strengthen the Fund."
                                            The draft report presents the results of the GAO's
                                 audit  of the Bank Insurance Fund's financial     statements for the
                                 years  ended December  31, 1989 and 1988. It is the GAO's opinion
                                 that the Fund's financial   statements are fairly     presented in
                                 accordance with generally accepted accounting principles.
                                           As part    of the analysis relating      to its audit opinion,
                                 the GAO estimates    that losses of $4 billion       to $6 billion    could
                                 be incurred  on banks the GAObelieves        are likely   to fail in the
                                 near future  unless these banks are recapitalized.           The draft
                                 report acknowledges that these estimated losses do not meet the
                                 degree of certainty     for loss recognition    under generally accepted
                                 accounting principles.      For this reason, these GAO-estimated
                                 losses are not included in the Fund's financial          statements.
                                 However, the GAO believes the accounting principles            applicable   to
                                 the FDIC should be modified so that, in the GAO's view, the
                                 recognition  of losses that could reduce the Fund balance is not
                                 unduly delayed.
                                              The Board is not in a position    to comment on the
                                 results of the GAO's audit or on the analysis,       judgments, and
                                 assumptions employed by the GAO to arrive at its estimates of
                                 potential    future losses to the Fund. However, in addition to
                                 these matters,     the report also contains several recommendations
                                 regarding ways to strengthen the Fund or reduce the exposure of
                                 U.S. taxpayers.       The Board's views on these recommendations are
                                 set forth below.




                                           Page 114                                         GAO/-90-100               BankInaursnceFund
                        AppendlrN
                        CmnmentuPromtheBeardofGovemo~of
                        the Federal   I&serve   System




                                                         -2-
                              First,  the GAO recommends that Congress amend FIRREA to
                 authorize the FDIC Chairman to raise the deposit insurance
                 assessment rates beyond those already provided in this statute.
                 In addition,     the GAObelieves the FDIC Chairman should use this
                 authority    to achieve the minimum reserve ratio of 1.25 percent
                 designated in FIRREA by 1995.
                              As the GAO is aware, the Department of the Treasury, in
                 conjunction      with a number of other government agencies, including
See comment 1.   the depository        institution      regulatory   agencies, is studying a
                 broad   range of possible reforms for addressing and strengthening
                 the Federal deposit insurance system. In conjunction                    with this
                 study, and separately,            the agencies and the Congress will no
                 doubt wish to consider all possible steps for maintaining                    the
                 strength of our deposit insurance system and for protecting                     the
                 interests    of taxpayers.           As part of this broad public policy
                 review, it is reasonable to consider all feasible options,
                 including    appropriate         adjustments to deposit insurance rates.            Of
                 course, the potential            impact on the profitability       of insured
                 depository     institutions         and the need for appropriate       phase-in
                 arrangements to avoid disruptions               are both important
                 considerations        in assessing the feasibility          and efficacy of
                 higher deposit insurance premiums.
                               The GAO also recommends that the Treasury study address
See comment 1.   other means to protect taxpayers in addition to premium
                 assessments and their impact on banks. FIRREA mandates that the
                 agencies study a number of specific         topics concerning the
                 operation     of the Federal deposit    insurance system. As noted
                 above, it seems entirely      appropriate     to give consideration      to a
                 wide range of feasible options for safeguarding the interests               of
                 taxpayers.      In this regard, the Treasury has agreed to add to the
                 interagency     study a section on capital adequacy and its critical
                 importance in protecting      the Fund and limiting       the risks to U.S.
                 taxpayers.      The Board believes that the recently-adopted          risk
                 based capital      framework and strong minimum capital ratios can
                 strengthen the incentives       of bank owners to manage risks
                 prudently     and provide an appropriate      buffer between the mistakes
                 of bank managers and the deposit insurance fund.             In addition to
                 capital,    it is the Board's understanding        that the Treasury study
                 will address the importance of on-site examinations and prompt
                 corrective     action in safeguarding the deposit insurance system.
                             The GAO report also addresses the central role of on-
See comment 2.   site examinations.    In particular,      the report recommends that the
                 Federal bank regulatory     agencies perform on-site full scope
                 examinations of problem banks and large banks on an annual basis.
                 We agree with the thrust of this recommendation and would carry
                 it further.    For example, the Federal Reserve's examination
                 frequency guidelines    currently    require on-site full scope
                 examinations of all state member banks at least annually,        with
                 more frequent examinations for problem banks and large banks.




                        Page116
                           CemmentsFrom the Jkwd of Governor9 of
                           the Fe&ml ReeerveSyetem




                                                          -3-

                 For     small,    nonproblem institutions,         the Fedmral    Reeervo will
                 aaoept,      bn an alternate     year   basis,     examinations    conduated by
                 state authorities;      however, for all large and problem banks, an
                 annual examination by the Federal Reserve is required.            The
                 Federal Reeervete support for annual on-site          supervisory
                 examinations was reiterated       in recent testimony delivered     by
                 Chainnan Greenepan      before the Senate Banking Committee on July
                 12, 1990. The Board believer         that off-premise   monitoring and
                 surveillance,    while helpful,     cannot substitute   for an on-site
                 supervisory    evaluation    of bank assets and operating controls.
                             Finally,  the GAOmakes two recommendations regarding
See comment 1.   the operation OS separate asset banks set up by the FDIC to
                 manage problem assets in connection with federally         assisted
                 merger or acquisition    transactions.     One recommendation calls for
                 revising  the appraisal guidelines      used in connection with the
                 disposal of the assets of these banks to reflect         more realistic
                 values.   The other calls for enhanced monitoring        of the use of
                 separate asset pools.      The G&Obelieves this is necessary to
                 ensure that the Fund has the resources to meet its commitments to
                 purchase the assets that could be put back to the FDIC by the
                 acquiring bank in a federally      assisted transaction.
                            Since these recommendations relate to the operation of
                 the FDIC and its liquidation    activities,    it is difficult for the
                 Board to comment on the specific      details of the recommendations
                 at this time.   However, as a matter of policy,       accurate
                 appraisals  and close monitoring of asset values are obviously
                 important elements of any plan to dispose of assets in a way that
                 protects the Fund and the position       of U.S. taxpayers.
                                  The Board appreciates         the opportunity    to respond to the
                 draft      GAO   report.




                                                   William W. wiles
                                                Secretary of the Board




                           Page 116                                         GAO/-90-100    Bank Insurance Fbnd
               AppemBx   N
               c4nnmeat4FromtheBoeNlof-of
               the Federal Rmarve t3y&m




               The following are GAO'S commentson the Board of Governorsof the Fed-
               eral ReserveSystem’s letter dated August 15,199O.


               1, See“Agency Commentsand Our Evaluation” section in chapter 4.
GAO Comments
               2. See“Agency Commentsand Our Evaluation” section in chapter 3.




        J




               Page 117                              GAO/AFMBS@1OO Bank hmranm   Fund
                                                                                                        .

Appendix V

CommentsFrom the Office of the Comptroller
of the Currency

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




                             Comptroller of Ihe Currency
                             Admlnlrtrator of National Bankr

                             Washington, D.C. 20219
                             August    9,   1990


                             Mr. Donald Ii. Chapin
                             Assistant Comptroller General
                             U.S. General Accounting Office
                             Washington, D.C. 20549
                             Dear Mr. Chapin:
                             As  you requested, we have reviewed your draft report titled          "Bank
                             Insurance Fund: Additional       Reserves and Reforms Needed to
                             Strengthen the Fund" and are pleased to have this opportunity            to
                             comment on it.       We found the report to be, for the most part,
                             factually    accurate, but we have three general concerns with it.
                             First,    we believe that the report does not accurately portray the
                             OCC's approach to bank supervision.         Second, the report draws
                             inaccurate conclusions       about the condition    of the banking system
                             and the Bank Insurance Fund. Third, estimates            about the number of
                             bank failures      and their impact on the Bank Insurance Fund (Fund)
                             are based on limited and insufficient         data.


                             The primary function of bank supervisors        is to ensure a safe and
See comment 1.               stable banking system. At the OCC, we accomplish this by assessing
                             the level of risk in each individual       bank, the role that risk may
                             play in the stability     of the overall national      banking system,     and
                             actions that bank management has taken to identify           and control
                             those risks.     Every national bank is supervised on an ongoing basis
                             by an examiner assigned to monitor the bank. The OCCexaminer
                             designs a strategy    for supervising    each bank, based on analysis of
                             comprehensive data gathered from bank visits,          call reports,
                             specialized   bank-generated reports,     regular contact with bank
                             management,   8and the bank's supervisory    history.      The supervisory
                             strategy is updated annually and allocates         a level and type of
                             supervision   commensurate with the risks that are identified           and the
                             bank's systems that are in place to control those risks.             The focus
                             of the supervisory    strategy for an individual       bank is continuously
                             modified as needed to address any significant          changes in the bank's
                             condition   or the financial    environment in which the bank operates.
                             As part     of this ongoing supervision, we maintain a computer-based
                             data file     on each national bank. The data base includes the
                             results     of examinations and other analyses of the bank's




                                      Page118                                  GA0/AFMD-ftO-100BankI~urtu1ce Fund
            APpendtrV
            CommentsPromthe Offlceof the
            C43mptroller 0ftheCurrency




    operations,    statistical     data on the bank's performance and
    condition,    summaries of co~unications        with a bank's management and
    board of directors,        and information   about the progress the bank has
    made in addressing identified         problems.    This data base provides a
    current,    comprehensive overview of the condition         of the individual
    bank and is an important means by which the OCC conducts its
    ongoing supervision.
    The OCC's supervisory     approach, which utilizes    both on-site and
    off-site  supervisory   capabilities,     promotes an efficient    use of our
    resources to provide us with current information         about the
    condition   of each individual     bank. We are able to monitor the
    condition   of stable banks and focus our examination resources on
    the banks and bank activities        that represent the greatest risk to
    the national banking system. Our continuous supervision            is
    designed to identify    emerging problems in individual        banks and the
    banking system and to reassign resources as needed.
    Before the OCCdeveloped its current method of bank supervision,            we
    operated on a calendar-driven        examination schedule that provided
    for periodic on-site examination of every national bank based on
    asset size and/or CAMELrating.          Those examinations took several
    forms,  but, for the most part, an examination meant that when the
    schedule indicated that a bank was due for an examination,           a group
    of examiners went into a bank and completed a set of defined
    procedures.    Unfortunately,     this approach provided only a snapshot
    of the bank's condition:      there was little      ongoing analysis of a
    bank's condition    between examinations,        except for those banks
    already known to be experiencing        significant    problems.
    This method was adequate when the business of banking was simpler
    and the economy was more stable, but with the sometimes dramatic
    changes in bank condition   that have occurred in the past decade, it
    haa become more difficult   to detect risks through periodic
    examinations.    Thus, our approach to bank supervision   has evolved.
    The important change can be summarized as follows:      examiners have
    more flexibility   and accountability in determining what activities
    to perform at their banks, and when to perform them.
    It is not uncommon for this approach to bank supervision           to be
    misunderstood.        In fact, it is not as different    from the approaches
    of other supervisors        as many think.    The OCCdevises a supervisory
    strategy for each national bank annually.          National banks receive
    reports from examiners at least once a year.           Examiners are in
    regular contact with bank management. We give the highest priority
    to large banks and to problem banks. In fact, in our multinational
    banks, we have "resident"        examiners who continuously    supervise the
    institutions.        We have recently decided to significantly     increase
    the staffs of those examiners.          Likewise, many of our regional
    banks have dedicated examiners who supervise those banks on a
    fulltime      basis.
    Thus we are somewhat perplexed by the recommendation that
    full-scope examinations should be performed annually in large banks
Y   and problem banks. Without knowing what is meant by nfull-scope,n
    it is not easy to respond.    In our largest banks, the resident




            Page119                                    GAO/APMlH@199BankInsuraacePuad
                           APP* v
                           CemmentaFmmtl~e~ofthe
                           CemptrolleroftheCanvmcy




                     sxarniners develop and carry out those bank's supervisory
                     atratsgies.       If a particular    area, activity, or process ia not
                     sxaminad in any given 12-month period, it would be a result           of an
                     informed     decision to target re8ources elsewhere in the
                     inrtitution.        Regarding problem bank8, the approach is generally
                     the same. While examiners are not necessarily           in residence, they
                     perform annual on-site examinations that they complement with
                     frequent off-site        analyses.   Again, without knowing what ia meant
                     by ~full-scope,m       it would seem that our continuous supervision,     at
                     a minimum, fulfill8        the expectations  of the recommendation for
                     annual on-site examinations.
                                 of the J
                     In the two years ending December 31, 1989, 406 FDIC-insured banks
                     failed and more than 1,100 remained on the FDIC's list of problem
                     banks. The number of failures  and their cost to the FDIC were the
                     highest in the history of the Fund and resulted in a decline in the
                     fund balance, both in absolute terms and relative  to insured
                     deposits.
                     Those developments, recent increases in past due and nonaccrual
                     real estate loans, and the potential           for future losses on loans to
                     finance highly leveraged transactions           or loans to developing
                     countries have understandably        given rise to concerns over the
                     condition     of the banking system and the health of the Bank
See comment 2.       Insurance Fund. Unfortunately,          we do not believe that the GAO
                     audit is sufficiently       rigorous to assess those concerns.           For the
                     most   part, data cover only two years, 1988 and 1989, an
                     insufficient      span of time from which to draw substantive
                     conclusions      about industry trends.      Most comparisons, moreover,
                     involve aggregate data, which offer a static and limited
                     perspective      about the future viability       of individual    banks. A more
                     reliable     assessment would be based on evaluations           of banks of
                     different     sizes and in different     locations     and would cover a longer
                     period of time.
                     The assessment of the health of the Bank Insurance Fund i8 a190
                     incomplete and, to a certain extent,           misleading.         Absent is an
See comment 2.       evaluation     of the financial    characteristics       of failed      banks during
                     the years immediately preceding their failure,               or some comparable
                     statistical      method of specifying    criteria      to be used for
                     projections      of future bank failures.        Also   missing is a recognition
                     that the OCChas taken steps to close banks earlier                   than in the
                     past.     Under current OCCpractice , a bank can be declared insolvent
                     as soon as it has depleted its equity capital;               by closing banks
                     when equity 'is depleted, the exposure of the Fund to losses will be
                     reduced whenever reserves are available              to absorb some of the
                     failure     costs.


                     The report's   outlook on the condition   of the banking system forms
See comment 1.       the basis for the GAO’s estimate of the number of institutions         with
                 Y
                     assets of more than $100 million     that are highly likely    to fail or
                     require  regulatory   assistance in the near future.    Insufficient




                           Page 120                                      GAO/AFMDM-100    Bank Insurance Fund
                            Appendix V
                            Cwnmenta From the Of&e of the
                            Comptroller of the Currency




                     detail about the selection  criteria was provided to evaluate the
                     reliability of the assertion that "it is highly likely   that many,
                     if not all, of [those banks] will fail."
                     After estimating     the number of banks that are likely  to fail in the
                     near future,   the report attempts to make the case that many more
                     banks may actually     be at risk and the Fund could become insolvent
                     because the FDIC's loss rates might increase above historical        rates
                     in the future;    call report data are unreliable   and may understate
                     the losses to which the fund could be exposed, and a national
                     recession or severe regional economic downturns could cause the
                     failure  of banks that were not in the GAO's estimates.
                     It is difficult      to estimate the risk that such developments or
See comment 3.       deficiencies     pose to the Fund, however, without supporting analysis
                     or confirming data.       While FDIC loss rates could increase in the
                     future,    the OCC's new closure rule should dampen the effect.     With
                     respect to inaccurate call report data, moreover, the report does
                     not estimate the extent to which problems had been understated in
                     the past, whether those reporting       inaccuracies had delayed
                     supervisory     actions, and the costs, if any, to the Bank Insurance
                     Fund that resulted from call report inaccuracies.
                     Similarly,    it is difficult    to estimate the impact of a recession on
See comment 3.       the number of bank failures,         or even to distinguish  among
                     recessions of differing       severity.    No data are presented to support
                     assertions    that the changing composition of bank loan portfolios
                     may raise the cost of bank failures,         to demonstrate the relative
                     effectiveness     of on-site and off-site      examinations, or to assess
                     the impact of a recession on the number of bank failures.
                     GAO's projections       imply that the Fund's balance would rise from
See comment 3.       $13.2 billion      at the end of 1989 to $27.7 billion        in 1995. Given
                     that projection,      assertions       that the Bank Insurance Fund could be
                     depleted seem alarmist.         Care should be taken not to exaggerate the
                     situation      and adversely impact the ability        of the bank regulators
                     and the Fund to deal with problem banks in an orderly way. By the
                     same token, we are concerned that the reference to an explicit
                     number    of banks likely     to fail may draw market attention       to the
                     identification      of those institutions.        The risk is that GAO’s
                     prediction      becomes a self-fulfilling       prophecy.
See comment 4.       Thank you for the opportunity      to comment. Provided separately,   for
                     your consideration,    is a page by page listing    of suggestions to
                     clarify specific    GAO statements   contained in the draft report.


                     Sincerely,



                     Judith\A. Walter
                 Y   Senior Deputy Comptrol .ler for Administration




                            Page 121                                   GAO/-ml00       Bank Innuance Fund
               AppendxV
               Commenta From the Office of the
               Comptroller of the Currency




               The following are GAO'S commentson the Office of the Comptroller of
               the Currency’s letter dated August 9, 1990.


               1. See“Agency Commentsand Our Evaluation” section in chapter 3.
GAO Comments
               2. See“Agency Commentsand Our Evaluation” sectionsin chapters 2
               and 3.
               3. See“Agency Commentsand Our Evaluation” section in chapter 4.

               4. The page by page listing of suggestionsis not included in this report
               at the request of occ.




               Page 122                                  GAO/AFMD-90-100 Bank Insurance Fund
Appendix VI

CkxnmentsFrom the Department of
the Treasury

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.
                                                                DEPARTMENT     OF THE   TREASURY
                                                                             WASHINGTON


                             UNDER SECRETARY                          August 13, 1990



                                   Dear        Mr. Chapin:
                                          My Staff and I have reviewed your draft report on the Bank
See comment 1                      Insurance Fund. The Office of the Comptroller     of the Currency
                                   here in the Treasury Department    ie sending you its own very
                                   detailed    comments. I direct your attention  to them.
                                          You have atudied bank regulatory      practices     and made some
See comment 2.                     assumptions about the number of troubled institutions              and the
                                   likely    cost to the Bank Insurance Fund of addressing their
                                   problems.     We have some apprehension about the level of
                                   specificity    in the report regarding problem institutions.             For
                                   example, it does not seem crucial to your analysis to mention 35
                                   problem institutions     and their potential        dollar losses.    It
                                   could be detrimental     to specific   banks, if readers were to become
                                   that interested     in so small a number of institutions         and their
                                   adverse financial     condition.
See comment 3.                           In general, we applaud the effort your staff has devoted to
                                   preparing    this report.    We do not necessarily agree with their
                                   conclusions,     but the report should be a useful contribution   to a
                                   better understanding      of the Bank Insurance Fund.
                                               If    I can be of further assistance         as you complete the
                                   report           do not hesitate to contact me.




                                                                               Under Secretary     for Finance
                                   Mr.  Donald H. Chaplin
                                   Assistant  Comptroller General
                                   General Accounting Office
                                   Washington, DC 20548




                                          Page123                                             GAO/APMD-8@188BanklnmrancePund
               The following are GAO’S comments on the Department of the Treasury’s
               letter dated August 13,199O.

               1. The Office of the Comptroller of the Currency’s commentsare
GAO Comments   addressedin appendix V.
               2. See“Agency Comments and Our Evaluation” section in chapter 4.
               3. No changeto report needed.




(916HB)        Page 124                               GAO/AF’MD-90-100 Bank Inaurmce Fund
.




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