1Juited States General Accounting Office GAO Report to the Congress BANK INSURANCE FUND Additional Reserves and Reforms Needed to Strengthen the Fund % HI Ill1 lllllll 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 Chapter 3 Problem Bale Expose the Bank Insurance 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 Chapter 8 Problem Gnaw Expore the Bank Iauuranm Fund to Si@fkant Riakr 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 . Ordering Information The first five copies of each GAO report are free. Additional copies art’ $2 each. Orders should be sent to the following address, accom- panied by a check or money order made out to the Superintendent of Documents, when necessary. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. lJ.S. General Accounting Office I’.(). 130x 6015 Gaitht~rsburg, MD 20877 Orders may also be placed by calling (202) 275-6241. Y
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)