oversight

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

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

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

I


    *                                         U n ite d S ta te s G e n e ral A c c o u n tin g   O f& e     / $ L ? /B b

        ” GAO
                                              T e s tim o n y




         For R e l e a s e                    A d d itio n a l    R e s e r v e s a n d R e fo r m s a r e N e e d e d to
         o n Delivery                         S tre n g th e n    th e B a n k In s u r a n c e F u n d j
         E xpecte d a t
         1 O :O O a .m .
         Tuesday
         S e p te m b e r 1 1 ,        1990




                                              S ta te m e n t of
                                              Charles A . B o w s h e r
                                              C o m p troller    General           o f th e       Unite d     S ta tes
                                              B e fo r e th e
                                              C o m m itte e o n B a n k i n g ,       Housing,            and Urban         A ffairs
                                              Unite d      S ta tes S e n a te




        G A O /T-A F M D - 9 0 - 2 8                                                                                G A O F o r m 1tM ( l W 8 7 )   .
                      ADDITIONAL RESERVES AND REFORMS ARE NEEDED
                         TO STRENGTHEN THE BANK INSURANCE FUND
                           TESTIMONY OF CHARLES A. BOWSHER
                       COMPTROLLER GENERAL OF THE UNITED STATES
                            BEFORE THE COMMITTEE ON BANKING,
                               HOUSING, AND URBAN AFFAIRS
                                  UNITED STATES SENATE
                       TUESDAY,     10:00    a.m.,      SEPTEMBER 11,      1990

       Not    since    its birth   during      the Great Depression          has the
federal     system of deposit        insurance       for commercial      banks faced such
a period      of danger     and uncertainty        as it does today.           Issues
arising     from our audit       of the Bank Insurance           Fund's     1989 financial
statements,        the report    on which is being         issued    today,      cause us
both apprehension          and concern      for the safety       and soundness        of the
Fund in the 1990s.
         The Fund reported        a loss of $852 million        in 1989, its second
consecutive        loss,   which reduced    the Fund balance         to $13.2 billion.
The record       level   of bank failures       that occurred      during      the last
two years has reduced           the Fund's    ratio  to insured       deposits       to only
,7 percent       at December 31, 1989, its lowest            level     in the Fund's
history.       FDIC now believes        the Fund could     suffer      another     loss as
high as $2 billion          in 1990, due to the high level            of bank failures
that     is continuing      in 1990.
         The increasingly          risky     nature     of the industry's          loan portfolio
is resulting        in increasing          loan performance         difficulties         which
could      severely    impact      the Fund.         We have identified          35 large      banks
in such severe         financial        condition       that without        some form of
recapitalization,            they are likely          to fail    or require       assistance
within      the next year.           We estimate        that these banks,          if they fail,
will     cost the Fund between             $4.4 billion       and $6.3 billion.            We also
identified        a significant         number of other        institutions          that were
experiencing        severe      negative       performance     trends.
        The prospect     for the Fund achieving             the minimum reserve          ratio
of 1.25 percent       by 1995 as designated            by the Financial       Institutions
Reform,    Recovery,     and Enforcement         Act of 1989 (FIRREA) is not good.
Neither    FDIC's nor our projections              of the Fund balance        indicate
that the Fund can achieve            the desired       minimum reserve      ratio      under
the current      assessment     provisions       in FIRREA.      In -fact,   over the
next few years,       the Fund's       low reserve       level  accompanied       by a _
recession     could   lead to a level         of bank failures       that would exhaust
the Fund and require         taxpayer      assistance.
       Our    audit     raises    other     concerns,      including
       l-    the low level   of cash resources                coupled     with existing
             commitments   to purchase  problem               assets    from acquirers         of
              failed        banks,     which     will       lim-it   FDIC’s    options       for   resolving
              future        banks    failures,
         --   overstated         appraised    values    for foreclosed     real estate held
              by acquirers          of failed     banks that can be passed back to
              FDIC could         lead to additional        losses   to the Fund,
         --   accounting         and reporting         by banks,      which is not providing             -
              regulators         with an adequate         early      warning     of financial
              problems        and may reduce         the effectiveness            of off-site
              monitoring         by regulators.          Application         of generally
              accepted        accounting      principles        allow    too much discretion           on
              the part        of bank management          and may be unduly            delaying    the
              recognition         of losses       in the financial           statements,       and
         em
              serious        internal       control       weaknesses       that contributed          to
              the failure          of a number of banks in 1988 and 1989.                          We
              cited      similar       @roblems       in banks and savings             and loans       in
              previous         reports      and made recommendations                for improving
              their      internal        controls.         Unfortunately,         to the detriment
              of the insurance              funds and the taxpayers               these
              recommendations             were not included             in the Financial
              Institutions            Reform,      Recovery,       and Enforcement        Act of 1989.
              These improvements               along with a number of other                 auditing
              and financial            reporting        reforms     are critically        needed to
              protect       the deposit          insurance       funds.
         The Bank Insurance               Fund is too thinly             capitalized         in light         of
the exposures             it faces.         FDIC has recognized             this     and, within          the
constraints          of FIRREAls          assessment         provisions       is proposing          to
increase       the 1991 assessment                 rates.       We commend FDIC’s            timely
actions,       however,        additional         steps are needed to minimize                    the
potential        liabilities          facing      the Fund.          We encourage         the Congress,
regulators,          the accounting           profession,          and others        to implement           the
recommendations              in our report          which we believe            are needed to
minimize       losses        to the Fund.           We must      do everything         possible        to
ensure      that the banking              industry        avoids     the debacle        that consumed
the savings          and loan industry               and is now costing            the nation’s
taxpayers        hundreds       of billions           of dollars.




                                                        2
.




    Mr.      Chairman                and Members                     of        the      Committee:

                                                                                                            .
              We are                pleased              to be here                    today         to discuss                   the         results             of      our
    audit          of     the        Bank         Insurance                    Fund’s             1989      financial                   statements.                       The
    report          on our             1989             audit1            is    being             issued          today,            and           it      addresses
    in    detail              the      issues              we will              discuss.                   The message                    is disturbing.


              --        The Fund                 balance             has        decreased                  28 percent                over               the      last         2
                        years          from             $18.3        billion                 to     $13.2         billion.                    The Fund                 lost
                                                                                                                        .
                        $4.2         billion               in      1988         and          $852      million               in     1989.                 FDIC now
                        believes                 the       Fund          could             suffer          a third               consecutive                     loss         as
                        high         as $2 billion                         in        1990,          due     to      the          continuing                     high
                        level         of         bank        failures.


              --        Our         review          of       the         200         largest             problem             banks            and         the
                        nation’s                 100       largest              banks             showed          35 banks                   in        such      severe
                        financial                 condition                    that          without             some form                of
                        recapitalization,                                they          are        likely          to      fail          or        require
                        assistance                      within           the         next         year.           We estimate                          that      these
                        banks,             if     they           fail,          will          cost         the      Fund          between                 $4.4
                        billion                 and $6.3             billion.


              we
                        We are             concerned                 that            the      Fund’s             cash        resources                    are      too        low
                        to      enable             it      to deal              decisively                  with          problem                 banks.               The
                        Fund         faces              potential               cash          shortages                 from        its           commitment                  to

    lBank, Insurance                            Fund:   Additional                         Reserves and Reforms Needed to
      Strengthen    the                         Bank Insur ante                        Fund (GAO/AFMD-90-100,   September 11,
      1990).
.




         purchase           troubled               assets             from         acquirers              of     failed
         institutions.                     As of         December                  31,         1989,      the         Fund          had         $13.7
         billion           in     cash       and        investments                      but      was contingently                              liable
         for       about        $8 billion               of      troubled                   assets        that             acquirers                   may
         pass       back        to FDIC.                Our      concern                 is      the     low level                  of        cash
         resources.coupled                        with         existing                  commitments                  to purchase
         problem           assets          could         limit           FDIC’s                options          for         resolving
         future         bank       failures.


    --   Another           concern          related              to      the          Fund’s           commitment                   to
         purchase           troubled              assets              from         acquirers              of     failed
         institutions                is     that         the          estimated                  recoverable                 value              of      the
         assets         may not           be realized.                          Overstated                appraisal                     values
         for       foreclosed              real         estate           held            by the          acquirers                  could              lead
         to     add it ional             losses          to      the          Fund.             A sample              of         real         estate

         with       book        values        of        $488          million               showed        an overstatement                                of
         about         $76 million.


    --   At     year-end           1989,          the         ratio           of      the       Fund      balance                 to      insured
         deposits           reached            its       lowest               point            ever,      .7 percent.                           The
         prospect           for      the      Fund            achieving                  the      minimum             reserve                 ratio
         of     1.25       percent          by 1995              as designated                         by the          Financial
         Institutions                Reform,             Recovery,                  and         Enforcement                  Act         of       1989
         (FIRREA)           is not          good.              Further,                  there         appears              to      be no
         empirical              basis       for         the      1.25          percent             minimum             reserve                  ratio.
         We are         concerned             that        even           if        the        minimum          reserve                  ratio
    Y
                                                                 2
.



         could        be achieved,                             it      would               not      be sufficient                       to     protect
         the       taxpayers               in         the            event            of         a recession.                        Over      the         next
         few years,                 low         levels                 of       reserves                  coupled              with         a recession
         could        lead          to     a level                     of       bank             failures             that           would       exhaust
         the      Fund        and         require                    taxpayer                    assistance.


    --   Increased             risks                 in        the         commercial                    banking               industry              are      a
         major        exposure                  to        the          Fund’s               outlook.                  In 1989               problem
         banks        remained                  at        an alarmingly                             high          number,              about         1,100         or
         9 percent             of         the         industry.                          Also,            industry              earnings
         declined            $8.5          billion                     due       to           losses            experienced                  by banks              in
         the      Northeast                and            large             commercial                      banks           as a result                 of
         loss       provisions                   for                real        estate              and         less-developed                    country
         loans.          In      addition                       to         these            concerns,                 the       50 largest                  bank
         holding         companies                        reported                  $126            billion               of    loans
         categorized                 as highly                         leveraged                    transactions.                        The
         performance                 of         these                risky          loans               and       their         ultimate               effect
         on the         financial                     condition                     of         banks            is    unknown            because             of
         their        relative                  newness.                        While             the       commercial                  banking
         industry’s              loan            portfolio                       risks              have          increased,                 there          has
         been       relatively                   no change                       in         the         level         of       the      industry’s
         equity         capital,                 its            cushion                  to       absorb             losses           on loans.


    --   Regulators              need            a more                    timely              early          warning             of     troubled
         institutions                    to minimize                            losses             to       the       insurance                fund.              The
         quarterly             reports                    of         financial                    condition                that         banks         prepare
    Y

                                                                            3
                for       the         regulators                   do not            always             reflect           their            true
                financial                   condition,                    and       this      may reduce                  the        effectiveness
                of      off-site                monitoring                    by regulators,                        We are            concerned
                that           accounting                  principles                  allow            bank       management                 too         much
                discretion                    in        recognizing                  and determining                        loss        amounts                 as
                reported                 in     financial                  statements.


           --   Our       ongoing               review             of      a number                of    banks           that        failed             in      1988
                and       1989         showed              that         serious              internal              control            weaknesses
                contributed                     to       their            failure.                 We previously                     reported                 this
                problem             in        1989         for       banks           and      savings              and      loans           that             failed
                in      1987        and made recommendations                                            for       improving                internal
                controls.                     Unfortunately,                         to      the        detriment               of    the          insurance
                funds           and       the           taxpayers                these        recommendations                         were          not
                included               in       the        Financial                 Institutions                   Reform,             Recovery,
                and Enforcement                            Act       of       1989.           These            improvements                   along             with
                a number               of       other             auditing             and         financial              reporting                 reforms
                are       critically                     needed            to protect                   the     deposit              insurance
                funds.


           FDIC has             recognized                   that          the       Bank          Insurance              Fund        is      too         thinly
capitalized               in     light             of      the       exposures                it        faces       and,          within            the
constraints               of FIRREAls                      assessment                  provisions,                  is      proposing                   to
increase         the        1991          assessment                    rates.              we commend                FDIC’ s timely
actions,         however,                 additional                    steps          are         needed          to minimize                    the
potential             liabilities                       facing          the         Fund.           I would           now like                to        provide
        Y,                                                    .
                                                                                4
.                                                                                  .




    some of          the        details            of         the         issues            facing             the      Bank          Insurance                      Fund
    along         with      my recommendations.


    PROBLEM BANKS EXPOSE THE
    BANK INSURANCE FUND TO
    SIGNIFICANT                 RISKS


                     The Bank               Insurance                  Fund            enters            the         1990s           in     a precarious
    position.                  Between            1980          and        1987,            the      ratio            of       the         Fund             balance            to
    insured          deposits               averaged                 1.17          percent.                    At December                       31,             1989,
    however,             the      ratio           of      the        Fund          balance               to         insured           deposits                      equaled
    .7 percent,                 the        lowest             this         ratio            has      ever            been       in         the          history               of
    the     Fund.              Clearly            the         past         2 years                have         seen         a significant
    deterioration                     of    the         Fund         at       a time              when         its         exposure                   to         potential,
    significant                 losses            is higher                   than          ever.              At December                           31,         1989,        FDIC
    identified                 1,109        banks             with         assets            of      $235            billion               as problem
    institutions.                      The number                    of       problem              banks             continues                   to         be high                and
    poses         a significant                        financial               threat              to         the      health              of         the         Bank
    Insurance              Fund.


              As part             of       our         financial               audit,              we analyzed                       the             financial
    condition              and performance                           of       300          banks.              These           included                     banks         with
    assets          in     excess           of         $100         million                on FDIC's                 December               31,             1989,
    problem          bank         list,           the         100         largest            commercial                     banks               in         the      United
    States,          and        other            institutions                      that           we identified                           as problem                     banks
    based         on regulatory                        and public                  source            information.                           Our             analysis
              6
                                                                                       5
focused              on large              ban’ks     because             experience                 has         shown           that            large            bank
failures                  cause      the       most        significant                 impairment                 of       the        Fund.


             Based          on our          analysis,            we identified                       35 banks                  that          were           in           _
such         severe             financial            condition             at       December               31,        1989,           that             without
some form                  of     recapitalization                     they         are      likely              to     fail          or         require
regulatory                  assistance               within         the        next        year.             These             banks             are
located              principally                in    the      Northeast                  and     Southwest                    and had                 assets
totaling              $45.1         billion           at      year-end              1989.            Generally,                      these             35 banks
had      regulatory                  capital          comprised                primarily                or       only          of     loss
reserves,                  were      insolvent              based         on equity               capital2               or          had minimal
levels          of        equity        capital,              had      excessive                and        increasing                      levels            of
problem          assets,              and had           negative               earning            trends              that,           if
continued,                  would          result       in     their           failure.                 Using           FDIC’s              historical
loss         rates,             we estimate             that        the        cost        to     the        Fund          for        the         failure
of     all      35 banks              would          be between                $4.4        billion               and $6.3                  billion.
Because           the           FDIC historical                  loss          rates         do not              reflect              the         major
changes              in     the     composition                and        quality            of      the         industry’s                      loan
portfolio,                  our     cost        estimates              could          be significantly                               understated.
The      following                 table        shows         key      financial                indicators                     for         the         35
troubled              banks         compared            to other               banks         in our              sample              and         the
industry.




2The major distinction       between                                     equity capital                        and regulatory
 capital    is that reserves     for                                   loan and lease                        losses   are included                                  in
 regulatory    capital.
                                                                           6
.




                              Key Banking Industry                            Financial           Indicators               as of December 31, 1989
                                 --------w----------                         (dollars          in billions)                -----------------------
                                                    Total             Equity Capital                         iroblem         Assets                   Net Income (Loss)
                                                    Assets            Amount Percenta                        Amount          PerCenta                 Amount Percenta
    Problem banks                          $           45.1           $       .6           1.4           $ 4.0                    8.8                 $     (1.6)       (3.5)
       (35)
    Total sampled
      banks (300)                              1,999.g                    100.1            5.0                 79.1               4.0                        1.7           .l

    Total commercial
      banks (12,706)                           31299.0                    206.0            6.2               113.8                3.4                       16.3           .5
          apercentage              of     total         assets

                                                                                                                       .

    As of          August           13,        1990,            15 of          the       35 banks               had         failed.


               In        addition              to       these             35 banks,              we identified                        a significant
    number          of      other          large              banks          that        were          experiencing                     severe            negative
    performance                   trends            as of             December             31,         1989.           While            their         financial
    condition               was not               as severe                  as that             of      the        35 banks,              these           other
    banks          are      at      risk          to     fail             within         the          next      few years,                 particularly
    if     their          regional                economies                  continue                 to deteriorate.                           These        banks
    are      also         located              principally                     in    the         Northeast                 and Southwest.                          If
    both       these         banks             and       the          35 other             banks             were      to      fail,            the       Fund
    could          be severely                    impaired.                   A recession                     could          exacerbate                   this
    problem,              causing              failure            of         other         large             banks         beyond          those           we have
    identified,                   exhausting                    the        Fund,         and      resulting                  in     a taxpayer
    bailout.




                                                                                     7
    .

.

        SEPARATE ASSET POOLS ARE
        A POTENTIAL                    CASH PROBLEM


                    In      addition                     to      the         exposures                that         could        severely             impact            the
        Fund’s            equity                 condition,                   a number                of        existing           failure           and
        assistance                    transactions                        pose            a potential                  future          drain         on the            Fund’s
        cash        resources.                           In      the         last         few years,                FDIC has              entered            into
        agreements                    with             the       acquirers                 of        failed          institutions                   which         under
        certain            limits                     require           FDIC to              purchase                from       the       acquirers               an
        undetermined                        portion               of      the        failed             banks’             remaining            troubled               assets
        that        are      maintained                          and     reported                    as separate                asset         pools         by the
        acquiring                banks.                   At December                      31,        1989,         the      Fund’s           potential                cash
        exposure                for         assets               held         in     separate                 asset         pools         was about               $8.0
        billion.                 We believe                       that          FDIC needs                    to    ensure            that      these
        transactions                        are          carefully                  monitored                 to    avoid          cash        availability
        problems                for         the          Fund       and         to        prevent             overextending                   the     Fund’s             cash
        resources.


                    A related                     concern               is      that         unrealistically                        high        appraised
        values            could         mask              losses              that         the        Fund may incur                     when assets                   held
        in     separate                asset              pools          are         sold.              These          assets          are      recorded               and
        adjusted             based                on appraised                       values,               in      accordance                with     FDIC
        guidelines.                         If         appraisals                   are      based            on unrealistic                    assumptions,
        the        assets’             appraised                    and         recorded                value         may not            reflect            what         FDIC
        could           recover                  at      their          disposition.                          During         our       review         of      the
        largest            of         the         three           separate                 asset           pools,           we estimated                   that        the
                    *
                                                                                                 8
    .

.

        book       balances               of       $488            million               for          the      other            real       estate         owned         that
        was acquired                    through                   foreclosure                       were       overstated                  by about          $76
        million.                We believe                        the     FDIC should                        revise             its     guidelines                for
        recorded            values                of        assets             held          in      separate                  asset       pools.          The
        underlying                   assumptions                        used         by appraisers                         in     valuing           assets         should
        be reviewed                   and         recorded                values               adjusted                  when appraiser                   assumptions
        are       not     based          on the                   assets’             historical                        experience              and current
        conditions.


        OUTLOOK FOR THE
        BANK INSURANCE FUND


                   The outlook                     for        the         Bank          Insurance                   Fund          is dependent               on its
        ability           to maintain                        a sufficient                           level          of      capital            to cope        with         the
        exposures               it      faces.                FIRREA             provides                    for         FDIC to           charge
        incrementally                    increasing                       annual               assessment                      rates       to    insured
        commercial                   banks         beginning                    in      1990.               FIRREA              also       authorizes              FDIC to
        increase           these             prescribed                    rates               if      the         ratio          of    the      Fund’s           balance
        to      insured              deposits                is     expected                   to      decline,                 but     limits          annual
        increases               and      stipulates                       an assessment                            rate         ceiling.             FDIC
        recently           proposed                    to     increase                  the          annual              assessment              rate      to      .195
        percent           for         1991,            the        maximum               increase                   allowable,               because          it
        expects           a loss             in        1990         which             will           reduce              the     Fund       balance          and        its
        ratio       to     insured                 deposits.




                                                                                               9
   .
, .


                  We commend                       FDIC’s              actions.                       We believe,                      however,                  that          the
       proposed              rate            increase                 will              not         be sufficient                           to     restore               the         Fund’s
       capital           position                   to      a level                     adequate                 for       it         to deal              with          large            bank
       failures              that            could         occur                  in       a recession.                           Both           our       projections                        of

       the      Fund’s             ratio            to      insured                     deposits                 and       those             of        FDIC illustrate
       that       it     is        unlikely                that               the          Fund           will         achieve               the        designated
       reserve           ratio               of     1.25          percent                     by 1995                 under           the        current             constraints
       of     FIRREA,              even            in     a non-recessionary                                          environment.


                                              Ratio         of        the         Fund        Balance            to     Insured          Deposits               (Percent)

                                                          1989                      1990                  1991                1992                 1993                 1994                  1995
                                                        (Actual)
       FDIC - Scenario                   1                0.70                      0.74                  0.82                0.91                 1 .oo                1.11                  1.22

       FDIC      - Scenario              2                0.70                      0.66                  0.67                0.69                 0.72                 0.76                  0.81

       GAO -      Scenario           1                    0.70                      0.74                  0.82                0.89                 0.95                 1.01                  1.07

       GAO -      Scenario           2                    0.70                      0.61                  0.74                0.82                 0.89                 0.95                  1.02

       GAO     - Scenario            3                    0.70                      0.58                  0.63                0.64                 0.65                 0.67                  0.69


                  The key distinction                                        between                     the     five           scenarios                  is      the
       assumptions                  regarding                     the             level             of         bank      failures                  and      their              cost           to

       the      Fund.              Under            FDIC-‘s                 first             scenario,                  failure                 and assistance
       expenses              are      assumed                    to     equal                 the         average               actual             costs           incurred                   bY

       the      Fund         over            the        last          ten-years.                           Under           FDIC’S                second            scenario,
       these          costs         are            estimated                      based             on actual                   costs            for       the       last              five
       years,          the         time           period              where                the        Fund            incurred               the        majority                  of      its

       costs.           The FDIC scenarios                                          do not                reflect               the         recent          statements
       made bY the                  Chairman                   that               the       Fund           could           incur             a net          10s~            for         1990
                                                                              .
                  Y
                                                                                                 10
.



    and do not                   reflect              FDIC’s              recent             proposal                 to      increase                   the      1991
    assessment                   rate.               FDIC has              not         revised             its         projections                        to      account
    for       the       estimated                    loss          in     1990         and        the      proposed                     assessment                    rate
    increase              for        1991.


                  Our     projections                       assume             differing                  levels             of         bank        failure                and
    assistance                  expenses                in         increasingly                    more          severity                     based         on banks
    that          we believe                  will          fail          soon         and over                 the         next          few years                   if     their
    negative              financial                   trends             persists.                      Additionally,                          under            all        three
    of      our     scenarios,                     we applied                    the         maximum             allowable                     assessment                    rates
    to derive                  as’sessment                  income.               Despite                this,              none         of      our        projections
    indicate              that          the        Fund            has     the         ability             to         achieve                 the      minimum
    reserve             ratio          of      1.25          percent              by 1995                under              the         current             assessment
    provisions                  of      FIRREA.


              Our         projections                       illustrate                  significant                         potential                  losses
    facing          the         Fund          in      the      1990s.                  I should                also          note          that           both         our
    projections                   and those                  of         FDIC assume                     a stable                  economy.                 A recession
    or      a severe             decline               in      the         Northeast                    economy              similar                to     what
    occurred              in      the        Southwest                   could          result             in      additional                       large             banks
    failing             beyond              those           included              in        our         estimates.                       Also,            the         banking
    industry’s                  increased                   dependence                  on riskier                     assets              could            result            in
    additional                  losses             and bank                failures.                     For       example,                    based           on FDIC’s
    historical                  loss          rates,           a $13            billion                 Fund       balance                 could           be
    eliminated                  by the             costs            related             to        the      failure                 of      one or              more
    large          money         center              banks              with      total            assets              of      $130            billion.                    While

              Y
                                                                                       11
I am not                  saying            that-        any money                center            banks            are     currently                in     danger
of      failing,                   this      example                 demonstrates                   the        vulnerability                of         the          Fund
at      its            current            level        of       reserves.


              We did               not      identify                 any     study           done         to    set        the     minimum                 (1.25)
and maximum                        (1.50)          reserve             ratios            prescribed                   by FIRREA.                 For         this
reason,                 and        because          of         our     concerns               about            the     potential            exposure
facing             the        Bank          Insurance                 Fund,        we believe                   the        Secretary             of         the
Treasury’s                     study         of     deposit                insurance                reform            required            by FIRREA
needs             to     examine             the       reasonableness                         of     these            minimum         and maximum
reserve                 ratios.              We believe                    this        study         needs            to propose            a reserve
ratio             target            that       regulators                   believe             would           protect            taxpayers                  in     the
event             of     a recession.


          We recognize                        the         concern             that           raising            assessments                to     build              a
more          adequately                   capitalized                     Fund        could         significantly                     impact               the
profitability                         and competitiveness                               of      banks.               Also,         achieving
adequate                 protection                 for         the        Fund        and ultimately                        the    taxpayer                 solely
through                 assessment                premiums                 may not            be feasible.                       Therefore,                  as
part      of            the      deposit            insurance                 reform            study,            we believe               the
Department                    of     Treasury               should            assess            banks’            ability           to pay             higher
premiums                 and        estimate              at      what        point           such         higher            premiums           may become
counter                productive,in                      their            benefit            to     the        Fund.            Treasury’s                  study
should             also          consider            other             means           for      reducing               the       Fund’s          exposure
such          as bank              capital             levels              required             to be maintained                         and other


              Y

                                                                                  12
options              that         would           further          protect                the         Fund        and         ultimately                      the
taxpayers.
                                                                                                       ,

          While             the        studies            of deposit                     insurance                reform                  are      being
completed,                  we believe                that         FIRREA                should            be amended                      to give              FDIC
authority                  to     raise           rates       beyond            those             provided                   in FIRREA.                       FDIC
should             use      this         authority                to     achieve                the        minimum              reserve                 ratio            of
1.25      percent                designated                  in    FIRREA             by 1995.

                                                                                                                   .
COMMERCIAL BANKING INDUSTRY CONDITIONS
THAT COULD LEAD TO MORE BANK FAILURES


          The commercial                           banking              industry’s                 performance                            in     1989         and
outlook             add         to our            concerns             for     the         safety            of         the         Bank           Insurance
Fund.          Industry                 earnings              declined                $8.5         billion                   from          their         1988
level         of     $24.8             billion,              to $16.3               billion.                 The             large             decline              in
earnings              in        1989       is      attributable                     to     banks            in         the     Northeast                      and        the
large         commercial                   banks          with         assets             in     excess            of $10                  billion.


          Real           estate            lending,               which        has             increased                significantly                           as a
percentage                  of     total           industry              lending                activity,                has          experienced
increasing                  loan         performance                   difficulties.                         The Northeast                              in
particular                  has        experienced                 significant                     growth               in      nonperforming                            real
estate             loans.           While           total          outstanding                     real          estate               loans             in      the
Northeast                  increased               12 percent,                 from             $232        billion                  in         1988         to $259
billion             in      1989,          the       level         of        these             loans        that             were          nonperforming
          Y
                                                                               13
 increased                     from        $4 billion                     in     1988              to $10        billion                 in       1989.        This
trend           in         the         Northeast                is        reminiscent                     of     the        growth                in     noncurrent
real           estate               loans         in     the         Southwest                      during           the      early               1980s       that
eventually                       led       to     the         high         level              of     bank        failures                    in     that      region
from           the         late           1980s         to     the         present.                    These           failures                   caused        the
dramatic                  deterioration                        of         the         Fund         over        the         last          2 years.


               I am also                   concerned                 about              the         impact           LDC loan                 difficulties                    are
continuing                      to have               on the              industry.                    The level                  of         U.S.        commercial
bank        exposure                    on troubled                       foreign              loans           has declined                         from     $91
billion               in        1982,           the      beginning                     of      the        international                           debt      crisis,               to
$54       billion                 at year-end                    1989.                 The         remaining                exposure,                    however,             is
heavily               concentrated                       in      nine            money             center            banks.                  These         banks           held
$43       billion                   (80     percent)                 of         the         nation’s            troubled                     foreign          loans           at
December                  31,        1989.             These          banks              currently                have            reserves                 averaging
49 percent                     of       their          foreign                  loan         exposure.                  We are                concerned               that
continued                   high          LDC losses                  could              make          some of              these             banks         more
susceptible                       to       failure.


           The            industry               also          faces             growing               risks          from             its        increasing
levels           of         loans           considered                     highly              leveraged                transactions                        (HLTs).
During              the         198Os,           HLT loans                     experienced                     signif         icant               growth       with           the
advent           of         the        junk        bond         market                 in      the        investment                    banking             industry.
The       high         debt             to equity                ratio                typically                present                 in companies
involved                  in      HLTs reduces                       the         banks’              likelihood                   of         recovering               in      the
event          of      default.                   The commercial                               banking               industry’s                     exposure           on

           Y
                                                                                        14
HLTs           is generally                   in     the        form         of         secured,            senior            debt,          with          minimal
junk       bond         exposure.                    The        impact             of      loans          categorized                   as HLTs on the
cost       of      future              bank         failures             is        unknown.                 However,               recent
bankruptcy                   filings           of      companies                   involved               in    junk          bond          offerings
demonstrate                    that         there          is      a risk               that        the     secured,               senior            debt
portion           of         the       original              financing                   package            may not             be fully                  repaid.
This       could             result           in     losses            for         commercial                  banks          because               the
related            loan         collateral                   value           may be significantly                                    less      than          the
outstanding                    loan         balance             remaining                  to be repaid.


RELIANCE               ON BANK FINANCIAL
REPORTS MAY HINDER EARLY
WARNING OF PROBLEM BANKS


          Another                  factor           affecting                the         Fund’s           estimated                exposure                for
future           bank          failures              is      the       quality                 of    quarterly                call          reports              the
banks          prepare              for       the      regulators.                         These          reports,             which           are

unaudited,                are          used        by the           bank           regulators                  in     their           off-site
monitoring                of        banks’           financial                condition                   and       performance                  between
on-site           examinations.                            The reports                     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.


          Although                  we did           not        review             the         overall          quality               of     call
reports,               we have              found          examples                in      reviewing                certain             problem              banks
that       suggest              call          report            accuracy                 often        depends            on whether                       there

           Y
                                                                                  15
has       been       a recent                 examination                       by the        bank        regulators.                       Generally,
we found             that         the         regulators                    reported            that         these            institutions                      had
understated                 the         level           of      nonperforming                     loans           in        their          call         report
submissions,                  and            thus       had         established                 inadequate                   levels           of        loss
reserves             and      had overstated                               interest           income          and net                 income.


               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’s                    problem         bank        list.                 Because             a bank’s
financial                condition                  does        not         deteriorate                overnight,                    the         regulatory
supervision                 process                 should               detect        an emerging                  problem                bank         prior           to
its       imminent            failure.                   Of the                 406    banks         that         failed              in    the         last       2
years,           however,               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 absence                     or     limited            presence                 of         these
banks           on the       problem                 bank           list          suggests           that         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.                 .


           The Fund’s                   potential                   exposure             from        large         banks             and      known
problem            banks          is     so great                   that          accurate,            up-to-date                    information                  on
their           financial              condition                    is      essential.                 Additionally,                        the         accuracy
of      call       report          data , particularly                                 for      troubled               or      near         troubled
banks           where       the        effect            of misstatement                          is more              critical,                  is     a
           Y)                                                   .

                                                                                  16
      .
* ,


          concern              for      effective                 off-site              monitoring.                       Therefore,                 we believe
          that         the      Chairman             of        the       Federal             Deposit              Insurance               Corporation,                    the
          Chairman              of      the      Federal                Reserve          Board,             and         the      Comptroller                 of     the
          Currency              should           ensure              that         annual           full       scope,             on-site             examinations
          of     all         large       banks         and known                   problem                banks         are      performed.                  We are
          currently                  reviewing            the           regulators’                 enforcement                   of      bank        capital
          standards.                   Further,                because             of    our        concerns,                  we plan           to     review            the
          regulators’                  entire          examination                      and     supervision                      program             beginning
          this         fall.


          ACCOUNTING AND AUDITING                                     REFORMS
          NEEDED TO PROVIDE EARLY WARNING
          OF TROUBLED DEPOSITORY INSTITUTIONS


                       Regulators               need         more           timely           and      reliable                 data     on the
          financial              condition                of       depository                  institutions                      to more             effectively
          work         with      management                  to       restore            the        health           of        troubled              institutions
          and     to minimize                   losses             to       the      insurance               fund.              There           is    a concern
          that         financial              data        prepared                 in’accordance                        with      generally               accepted
          accounting                  principles                are         inadequate                for         this         purpose.               Call        report
          data         are      accounted              for         and       reported               in      accordance                 with          generally
          accepted             accounting                 principles.                        Banking              regulations                   require           that
          call         reports           be prepared                     on that             basis.


                       Generally              accepted                accounting                principles                     call       for        a writedown
          from         cost      to market                value             and      recognition                   of      a loss          when         an asset
                   u
                                                                                        17
value          has been             diminished.                            But,        there        are         major           problems               with             the
timing          of     the         recognition                      of      loss         and the           determination                         of         the
amount          of     the         writedown.


 w-
              The requirement                         that          a loss             be “probable”                     before            it         is
              recognized.                      “Probable”                   is     frequently                   interpreted                     in     practice
          as “virtually                         certain.”                     The        “probable”                requirement                       unduly
          delays             the       writedown                    of      problem              assets          to      fair           market             value

          and        thus        defers            recognizing                         the       loss      in      the          financial
              statements.


 Be
          The definition                         of         fair           market          value          used        in     determining                          the
              amount        of      the         loss          to be recognized.                                 The definition                         assumes
          that         the         asset         can be held                       until          market           conditions                    are         good
          and        that        the       seller              has          a good             bargaining                position.                     This
          frequently                   results                in      higher            fair        market            values             than          are
          justifiable                     in     the         circumstances.


                  These          generally                   accepted                  concepts            for        recognition                      of         loss
 and      the        determination                      of          fair          market          value          frequently                     result             in
 sudden           dramatic                losses             when           banks          get      into         trouble                and the
 regulators                  require             loss          recognition                       on a realistic                         basis.               These
 losses           could          have           been         reflected                  earlier            in     bank           call       reports
 under          more        stringent                  accounting                      rules        and     thus           provided                  a more
 timely           early          warning               of      bank           failures.                 We are             currently                   reviewing
whether              limited            changes                in        present             cost       based           generally                    accepted

          w
                                                                                  18
  accounting                 principles                  would            be sufficient,                        or     whether           some form                    of
  market            value          accounting                  is    necessary                     to provide               more       reliable                call
  report            data.                                                                             .


           Our       present              view         is     that         generally                 accepted               accounting
principles                 pertaining                  to     the      probability                        of    collection              of     a
troubled             loan          allow         bank         management                     too     much leeway                 to defer                the
recognition                  of         losses         in     financial                 statements.                     In our          current                work
on bank             failures              we found                a number              of         examples            where          examiners
identified                 loans          where         collection                    was doubtful                     and     in      hindsight
bank       management                    should         have         recorded                 reserves               to writedown                  the
loans        and          recognize              the        losses.              These              loans        were        carried           at
historical                 cost          because,             based         on bank                 management’s                 judgment,                the
potential                 losses          on these                loans         did          not     meet        the        accounting
criteria             of     “probable”                  that         would            have          required            writedowns                 to     fair
value.


           Similarly,                   our      present             view         is         that         generally            accepted
accounting                 principles                  relating             to        fair          market           value      do not
sufficiently                   recognize                the         need        for      banks             to    realize            collateral
values         in      a short                period         of      time.             The traditional                         fair      market
value        concept              establishes                  values            in      a hypothetical                       market          where             the
seller         is      under            no compulsion                      to    sell              and has           time      to negotiate                     a
sale.          Assets              in     troubled             banks            and      separate                asset         banks,         or        even
nonperforming                     assets          in        any bank,                 may have                 to be and are                 often
disposed               of         in     a market               when conditions                             require             that       the         assets          be
disposed               of         within           a short              time           frame.


          Conceptually,                            accounting                    for         bank         failures              and the              related
loss      recognition                         has        some of              the        same inherent                      weaknesses                  as
accounting                   for         loan          losses.                The Bank                   Insurance              Fund’s          December               31,

1989,           financial                    statements                 are         fairly           presented                  in     accordance                   with
generally                  accepted                accounting                   principles.                        However,             the          estimated
costs           of     $4 billion                      to $6 billion                         from         the      banks         we believe                   are
likely           to        fail          in      the         near       future            unless                recapitalized                   do not              meet

the      degree             of         certainty                for       loss           recognition                  established                     by

accounting                   principles.                        Accordingly,                        these          estimated               losses             are      not
recognized                   in        the       Fund’s              financial                statements.


          The Financial                           Accounting                    Standards                  Board           is    currently                   studying
certain              market             value           accounting                     and disclosure                       issues             for      financial
institutions.                           We encourage                      the        Board           to      address             market              value       based
accounting                  for         financial                    institutions.                         Based        on our            ongoing              study
of     these          issues               our         preliminary                   view           is     that       market            value           based
accounting                  or,         in       the         alternative,                    comprehensive                       market              value
disclosure,                       is    preferable                    to present                accounting                      and disclosure
standards                  for         financial                institutions.


          In         the          interim,              it      is      important               that             certain             limited            changes
be made to                  existing                generally                   accepted                  accounting                 principles                for
nonperforming                          loans           and other                real         estate             owned           acquired              through

            Y

                                                                                    20
        ,
.   *

            foreclosure.                      The accounting                      profession                    should             promptly           consider
            amending             accounting              rules          to        require


                      --        recording              losses         when             occurrence                of     loss          is     likely          (more
                                than       a 50 percent                 chance)                 rather           than         “probable”                as
                                required           under         existing                    rules,        and


                      --     valuing             the     underlying                     collateral                on the             assumption                that
                             near         term       disposition                   of         the      asset          will          be required.


            We believe                 this      interim             step         is         needed        to        improve           the      early
            warning          system            and      thereby             help             protect           the      Bank         Insurance               Fund.


                      I would             now like              to    talk         about              auditing               reforms          that       are
            needed         to     provide            regulators                   an early               warning              of     troubled            banks.
            Before         FIRREA             was enacted,                  we reported                   that          serious              internal
            control          weaknesses                cited          by federal                      regulators               contributed
            significantly                     to virtually                  all         of      the      184 banks                 which        failed          in
            1987.3           We also             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     cause             of      their           failure.4                  We recommended
            then      that        FIRREA          include             requirements                       for         insured           institutions                    to

            3Bank Failures:     Independent                                       Audits   Needed to                          Strengthen               Internal
             Control   and Bank Manaqement                                          (GAO/AFMD-89-25,                           May 31,              1989).
            4Thrift     Failures:      Costly Failures                                          Resulted    from                     Regulatory
             Violations        and Unsafe Practices                                           (GAO/AFMD-89-62,                        June 16,               1989).
                     Y
                                                                                        21
undergo          annual          financial                   audits             and        issue            management                  reports           on the
effectiveness               of         internal                   controls                and     their            compliance                  with       safety
and     soundness               laws      and          regulations.                          To provide                      assurance             on the
validity          of      the     management                       reports,                we also                recommended                  that,          as
part       of    the      annual          audit,              auditors                 be required                          to    review        and       report
on management’s                   assertions                       contained                 in       its         reports.
Unfortunately,                   these          recommendations                              were           not         adopted          by Congress
in     FIRREA.


           Weak internal                  controls                     are      a serious                   problem                in   financial
institutions               which          have          recently                    failed            and have                   contributed
significantly               to         those           failures.                     In      studying                  the        accounting              and
reporting              issues          I just           discussed,                     we reviewed                       examination                   reports
of     39 banks          which          failed               in        1988         and 1989.                  Those              reports          showed
that       serious         internal               control                weaknesses                    existed                   in many of             the
institutions.                   Bank       management                         and      the        boards               of        directors            have         a
responsibility                   to operate                   their             institutions                       in        a safe          and       sound
manner.           Safety          and      soundness                         relates            not         only         to overseeing                    the
day-to-day             operations                 of      the           bank,          but        also            to     establishing                   and
maintaining              an effective .                      internal                control                structure.                   The
accounting             profession                 and,            of     course,                government                       regulators             also
play       a significant                 role           in         ensuring               corporate                    accountability.                         We
need       to ensure            that       these              major             players            work            well           and    that         they
work       together.




                                                                               22
          I believe                that         when Congress                         revisits           FIRREA,             there             should         be
amendments              to     include                 and      strengthen                 the      management                 and auditing
reporting             requirements                      we previously                      recommended.                      Also,             these
reporting             requirements                      should         be buttressed                         with         other          auditing
reforms         to provide                     regulators              more            timely           and     reliable                 information
on the         health         of         financial                institutions.                         These         additional                 auditing
reforms         include


          --    Strengthening                         auditing           procedures                     to     require             auditors              to
                assess             the         risks         and     uncertainties                       affecting                 the
                institution’s                         ability          to continue                      as a going                 concern             over
                the       next        year.


       --       Strengthening                         the       auditor’s                responsibility                      for         detecting
                illegal             acts          and to           ensure              that       these         illegal             acts         are
                reported              to        the         regulators                 when management                       has         not     dealt
                with         the     problem.


       --       Requiring                 the         regulators                 to      share          with        the      auditors               their
                knowledge                 of     potential               illegal                 acts        by institutions.
                Exceptions                     should           be made           for         situations                  involving
                litigation                     and ongoing               investigations.


       --       Requiring                 insured               depository                 institutions                    to have
                independent                     audit           committees,                   which          should          include             at     least


           u
                                                                            23
                 one          attorney           to help              assure             their             institutions                      comply          with
                 laws          and      regulations.


Finally,           I would              add that               the         stakes         are          just         too         high         for      the
regulators               to      be monitoring                       the     condition                     of      institutions                     using
unaudited              call          reports,               especially              when             the        quality               of    those
reports          for      problem               institutions                   is        suspect.                   We believe                     those
reports          should           be reviewed                      by auditors                   for        known              problem
institutions                   and      those          large          institutions                         that,          if      they        fail,          would
cause        a significant                      loss         to     the      insurance                     funds.


           Our     March          7,     1990,              response           to        the         Treasury's                   request             for
comments          on issues                  under           its      study         of         the      deposit                 insurance              system
and my August                   2,     1990,           testimony               before                the        House           Subcommittee                  on
Telecommunications                           and Finances                    contain                 a detailed                   discussion                 of     my
recommendations.                         I     would           request          that            copies              of         that        letter           and
testimony              be included                 in        the      hearing             record.


CONCLUSIONS


           All    of      the        concerns                we have          discussed                     today          paint            a troubled
picture          for      the         future           of     the      banking             industry                  and          the       Bank
Insurance              Fund,           They       are         all      serious             concerns.                       We have              presented

fprevention,         Detection,     and Reporting     of Financial       Irregularities,
  Statement      of Charles     A. Bowsher,      Comptroller     General      of the United
  States,     before     the Subcommittee      on Telecommunications            and Finance,
  House Committee          on Energy   and Commerce (GAO/T-AFMD-90-27,
  August     2, 1990).
          Y
                                            24
our    concerns                  to encourage            the    Congress,            regulators,               the     accounting
profession,                  and others            to    implement            the    changes           needed         to minimize
losses           to    the        Bank     Insurance           Fund.          We must           do everything                possible
to    ensure           that        the     banking        industry            avoids       the       debacle          that
consumed              the        savings        and loan          industry          and    is       now costing              the
nation’s              taxpayers            hundreds        of      billions          of    dollars.


           Mr.        Chairman,            this      concludes          my prepared                 statement.               I would
be pleased                  to    answer        any questions             you or          the       members      of      this
Committee              may have            at     this    time.                                 .




                                                                   25