Immediate Measures That Can Be Taken to Strengthen the Bank Insurance Fund

Published by the Government Accountability Office on 1990-09-26.

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

                       United States General Accounting OfWe / #s”          7 0

For Release            Immediate    Measures That Can Be Taken       to
on Delivery            Strengthen    the Bank Insurance Fund
Expected at
1O:OO a.m.
September 26,   1990

                       Statement of
                       Donald H. Chapin
                       Assistant  Comptroller    General
                       Accounting  and Financial    Management Division
                       Before the
                       Committee on Banking,     Housing,   and Urban Affairs
                       United States Senate


GAO/T-AFMD-90-33                                                      GAO Form 160 <12/87)
Mr. Chairman            and Members of                   the Committee:

        We are      pleased             to be here          today       to provide           comments on your
proposal       to allow           the Federal              Deposit        Insurance          Corporation               (FDIC)
flexibility         in setting              deposit         insurance            premiums.            In recent
testimony        before          this     Committee,1              we stressed          the need for
immediate        actions          to protect              the Bank Insurance                 Fund until             long-
term deposit            insurance           reforms         can be considered                  as required              by the
Financial        Institutions               Reform,         Recovery,             and Enforcement                Act of
1989 (FIRREA).                 At that       time,         the Committee             asked us to provide                       a
list    of    actions          the Congress               and the administration                      could
immediately         implement             to protect           the nation's             system of deposit
insurance        and,         ultimately,           the     taxpayers.              We provided            this        list        in
a letter       to the Committee                   which      contained             11 recommendations                    and
draft      legislation.                 I ask that          this       letter,       dated        September            13,
1990,      and a follow-up                letter,          dated     September          14,       1990,       be
introduced         into        the      record      at this         time.          I will      discuss           the
specific       recommendations                   later      in my statement.

        We are encouraged                   by the Committee's                     recognition            that      action
must be taken             quickly         to strengthen              the Bank Insurance                    Fund.          The
Committee's         proposed             amendment to the Federal                       Deposit           Insurance            Act
maintains        the designated                  reserve       ratio        but     eliminates            the
restrictive         caps on assessment                      rate       increases        that       FDIC may charge
member banks            for     deposit          insurance          coverage.           It     also       allows        the

lAdditiona1        Reserves and Reforms are Needed to Strengthen                                                   the Bank
  Insurance       Fund (GAO/T-AFMD-90-28,  September 11, 1990).
FDIC Board of Directors                            to determine                 the     appropriate                 assessment
rate        to be charged.                  This        is an important                      first         step     toward
strengthening                 the Fund and is similar                            to our proposed                     amendment
which        iie ~gf@~fd           for      considefati9n                     19 fhe         first         of our 11

            Both      our projections                   of    the Bank Insurance                           Fund balance               and
FDIC's           show that         with      the        restrictions              currently                 imposed by FIRREA
on setting             assessment            rates           the Fund will               not          achieve        the FIRREA
designated             minimum reserve                   ratio           of    1.25     percent             by 1995.               As we
previously             testified           before            this        Committee,             and as we discuss                      in
our        recently       issued          report,        2 the           Fund is too thinly                       capitalized
for        the    exposures         it     currently                faces.        The Fund ended 1989 with                                   its
second           consecutive             loss,      $852 million,                 which              reduced        the Fund's
ratio        to     insured        deposits             to    .7 percent,               the          lowest       this        ratio      has
ever        been.       FDIC now expects                      the Fund to lose                        as much as $2 billion
in 1990,            and our own projections                              show the        Fund's             ratio        to    insured
deposits            decreasing            to as low as .58 percent                                   by year-end              1990.          The
allowable             assessment            increases               designated           by FIRREA will                       be
insufficient              to protect              the Fund in the                     event           of a recession                  that
results           in significant                 bank failures.                   The Fund's                  reserves             need to
be increased              to ensure              that        a recession              will           not   deplete            the Fund
and result             in costs           to the         taxpayer.

2Bank Insurance   Fund:  Additional  Reserves and Reforms Needed to
 Strengthen   the Fund (GAO/AFMD-90-100, September 11, 19901,
        Although              we support            the Committee's               proposal           to allow            FDIC
flexibility              in setting            assessments            to maintain                 the designated
reserve         ratio,         we believe            the proposal               could      be further
strengthened              by (1) specifying                     in the     amendment a target                          date      by
which        the Fund balance                  should        achieve       the designated                     minimum
reserve        ratio          to     insured        deposits,         (2) providing                 that        in setting
assessment             rate        increases,         consideration               be given           to the            economic
conditions             affecting          the       financial         health        of     the banking                 industry,
and (3)        removing             the ceiling          on the         reserve           ratio      set        by FIRREA at

        While         your         amendment is a necessary                       first       step,            the other
steps        we have recommended are also                             vital,            We believe              that     this
first        step      should          be implemented               in conjunction                with        other      measures
discussed            in detail           in our       letters         to this           Committee.               These short-
term measures                 can be taken             in this        session           of Congress               to protect
the Fund and can largely                            be implemented               administratively.                       Thus,
the Committee                 should      request        that:

        --     the       Department            of    the Treasury               include       in its            study       of
               deposit             insurance         reform         (1) an assessment                    of     the
               reasonableness                  of    the minimum and maximum reserve                                    ratios
               designated               by FIRREA in light                 of     the banking                  industry's
               present             condition         and the Fund's               exposure,              (2)     a reserve
               ratio          target      that       would      protect          taxpayers           in a recession,
               and (3) means,                  in addition            to premium            assessments,                 such as

     increased           capital          levels          in banks,           that     would      reduce           the
     Fund’s          potential           liabilities;

--   the Chairman,               Federal            Deposit        Insurance           Corporation;                the
     Chairman,           Federal          Reserve          Board;        and the Comptroller                       of     the
     Currency           immediately             implement           a policy           to conduct          annual
     on-site,          full      scope examinations                      of    large      banks and
     problem          banks      and obtain               such staffing               levels      as are needed
     to perform           these          examinations;

--   the bank regulatory                      agencies            immediately           require         that        large
     banks       whose failure               would         cause a significant                   cost      to the
     Fund have their                quarterly              call     reports           reviewed      by an
     independent              public        accountant;

--   the Chairman,               Federal         Deposit           Insurance           Corporation,                (1)
     closely         monitor        the Fund’s              cash resources                and promptly
     advise          the Committee             of       any projected                cash shortages                so
     that       the Congress              can consider              other       means to ensure                    that
     necessary           regulatory            action         is not delayed               because        of        a
     lack       of    cash resources,                   and (2)      immediately               revise     FDIC’s
     guidelines           for      recorded             values      of    assets        to include             a
     critical          review       of      the appraisers’                   underlying         assumptions
     in valuing           assets          acquired          from failed               banks     and adjust
     recorded          values       to reflect              these        assets’        realistic         values

     in light          of     their         historical         experience                  and current

--   the Committee               itself         reaffirm,           through            a Senate            resolution
     or other          means,         its      intent       that         bank regulators                   use the
     regulatory             authority           conferred           in FIRREA and elsewhere                                   to
     minimize          losses         to the Bank Insurance                          Fund and to ensure
     the     stability          of      the banking            system,              specifying             its
     expectation              that      the     regulators               act    promptly            to enforce
     safe     and sound banking                    operations              and protect               the Fund;

--   the     Financial          Accounting               Standards             Board        (FASB) and the
     American          Institute             of Certified                Public        Accountants                (AICPA)
     together          take     prompt          action       to clarify                the authoritative
     accounting             rules       regarding           loss         recognition               and
     determination              of      loss      amounts          for     nonperforming                   loans         and
     other      real        estate          owned that        was acquired                   through
     foreclosure.               This         clarifying            guidance            should        be made
     available           to the banking                  industry          in       time     for     use         in the
     1990 reporting                  cycle;

--   the Securities                  and Exchange            Commission                (SEC) monitor                    the
     progress          of     the FASB and AICPA in developing                                     guidance              on
     loss     recognition              and determination                       of    loss     amounts             for
     nonperforming              loans          and other           real        estate        owned that                 was
     acquired          through         foreclosure,                and issue               guidance         on

                interpreting              these         accounting           rules        if    the accounting
                authorities          are unable               to meet the December timetable,                                    All
                banking        institutions,                including             those        reporting         to other
                regulatory          bodies,             should      then         be required            to follow         this

The measures             outlined          above can,             and should,              be implemented               before
the Congress             recesses.            Another            issue       which       Congress          should       address
before         the end of         this      calendar             year‘ is         the need to enact
legislation             that     requires          comprehensive                  internal         control,         auditing,
reporting,           and management                reforms          for      financial           institutions.               such
reforms         are needed          to help             prevent          these     institutions             from getting
into      trouble,         to provide             regulators              with     an early          warning        when
institutions             begin      to get          into     trouble,             and to protect              against        the
kind      of    fraud      and other          illegal            acts      that      occurred           in the      savings
and loan         industry.           The government                     needs to take              responsibility                for
these      areas        that     up until          now have been largely                         left      to the private
sector         to better         protect          its      interests             as insurer         of deposits.                 The
government,             because      of     its         insurance          commitments,              has at       least      as
much right           to protection                as shareholders                  of    financial          institutions.

          Our past         and ongoing             work has disclosed                      serious         internal
control         weaknesses          in financial                 institutions.                 Before       enactment            of
FIRREA, we reported                  that         serious         internal           control         weaknesses           cited
by federal           regulators            contributed              significantly                to the       failure       of
virtually            all      of     the     184 banks which               failed        in 1987.3             We also
reported            that      regulators'             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            At that           time,       we
recommended                that      FIRREA       include         requirements             for     insured
institutions                to undergo            annual       financial            audits        and to issue
management            reports          on the        effectiveness              of      their      internal           controls
and on 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         included          by the Congress                in FIRREA.

           Our ongoing               work has disclosed                  that      weak internal               controls
continue            to be a serious                 problem          in financial              institutions            and
continue            to contribute                significantly            to failures.                  Our review              of
examination                reports         for    39 of     the       largest        banks of           the 406 banks
that       failed          in 1988 or 1989 disclosed                        that      many of           the
institutions                had serious             internal          control        weaknesses.

3Bank Failures:   Independent Audits Needed to Strengthen  Internal
 Control  and Bank Management (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).

          Management            and the boards                  of directors             of     financial
institutions              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   institution,                  but     also
to establishing                 and maintaining                  an effective               internal           control
structure.              Such a structure                  increases             an institution’s                   ability            to
protect        its      assets        and deal           with        economic        adversity               in an effective
manner.         The internal                 control        structure              should       ensure          that         (1)
transactions              are executed               and access            to assets            is permitted                 only        in
accordance            with     management’s               authorization,                 (2) transactions                      are
recorded        to permit             preparation               of     financial         statements              in
conformity            with     sound accounting                      principles          and to maintain
accountability                for     assets,          and (3)          the     institution             complies             with
all   applicable              laws and regulations,                        especially            those         relating             to
safety       and soundness.

          The accounting               profession               also     plays       a significant                 role        in
ensuring        corporate             accountability.                    Unfortunately,                 not      all      banks
receive        an annual             audit      by independent                  public        accountants.
Additionally,                there     are deficiencies                    in the        audits         of     some
financial            institution             which       are audited              by independent                 public
accountants.                 In recent         years,           the accounting                profession               has acted
to strengthen                some of         the auditing               procedures            vital      to determining
the true        condition             of     financial           institutions.                  In our view,
however,        the      guidance            provided           by the profession                     has not          been
sufficiently             specific            and substantive                  to ensure          that        audits          are

    c o n d u c te d       in a n e ffective                    manner.            M o s t i m p o r ta n tly,          th e p r o fession
    h a s n o t a g r e e d to              include             a review           o f compliance               with         safe ty     and
    s o u n d n e s s laws a n d regulatio n s                              as p a r t        o f a financial                institutions
    a n n u a l a u d i t.

              T h e p r o b l e m s disclosed                         by internal              c o n trol      reviews          a n d a u d i ts
    d o n o t always               receive           th e a tte n tio n              th e y      should by m a n a g e r s o f
    financial             institutions                    w h o , p a r ticularly                in tim e s         o f stress,          may
    a tte m p t        to cover          u p p r o b l e m s or p r o tect                     their        o w n actio n s          from
    scrutiny.               A d d i tio n a l        m e a s u r e s to shore u p th e corporate                                 governance
    process           n e e d to b e ta k e n .                     C o m m u n i c a tio n     b e tween th e          independent
    public          a c c o u n ta n t     a n d regulators                    n e e d s to b e i m p r o v e d ,             with     th e
    a u d i tor       reportin g           violations                  of    laws        a n d regulatio n s            to th e
    regulators              o n a tim e ly                basis,         a n d th e regulators                  providing
    inform a tio n            o n th e conditio n                      o f th e      institution               to th e a u d i tor.
    T h e a u d i tor’s           work also n e e d s to b e subject                                   to strict         p e e r review.
    Truly         independent              audit           c o m m i tte e s       th a t      include         lawyers         must be
    established               to e n s u r e th a t                 b o th m a n a g e r s o f financial                 institutions
    a n d a u d i tors          p e r fo r m       their            roles      a n d d u ties          in a responsible
    manner.            We     believe            th a t       all      th e m a jor financial                   institutions
    players--managers,                          directors,               a u d i tors,         a n d regulators--must                   work
    to g e th e r      a n d work e ffectively                           to p r o tect          th e taxpayer.

              W e a r e convinced                    th a t         legislation             dealing          with     th e     internal
    c o n trol,        a u d i tin g ,          reportin g ,             and management problems we have
    m e n tio n e d       is critical                to reducing                 th e risk          o f loss         to th e         insurance
funds.        Therefore,            as stated            in our       recent         letters       to the
Committee,          we recommend that                   legislation                be enacted           requiring           that:

         --   financial            institutions            prepare        annual            financial           statements
              in accordance                with      generally         accepted             accounting

              financial            institutions            establish               adequate       internal            controls
              and annually               assess        and report         on whether              such controls
              provide           reasonable           assurance         that         (1)     transactions              are
              executed           and access            to assets         is permitted              only         in
              accordance            with       management's            authorization,
              (2)   transactions                  are recorded           to permit             preparation             of
              financial            statements           in conformity                with      sound accounting
              principles            and to maintain               accountability                  for     assets,           and
              (3)   the         institution            complies        with         applicable           laws and
              regulations               including         those       related         to safety           and

         --   independent             public        accountants           annually             audit      the
              institution's                financial         statements              and examine            and report
              on the       institution's                assessment            of     its     internal        controls;

         --   audits       of      financial           institutions             be performed              only        by
              independent             public        accountants           who have received                      an
              adequate           peer      review;

--   independent                public       accountants                 identify           all     signif        icant
     related            party      transactions               and review                 their       financial

--   independent                public       accountants                 use specific               procedures              to
     determine            compliance            with         applicable                 laws and regulations,
     including            those          relating         to safety              and soundness;

--   independent                public       accountants                 review          risks      and
     uncertainties                 and evaluate               the        institution’s                ability          to
     continue            in business            over         the        next     year;

--   independent                public       accountants                 pursue          indications             of
     illegality             by the          institution,                 inform          the management                and
     directors            of     the      institution              if     it     is determined                that        an
     illegality             has likely              occurred             and,      if     the      institution              does
     not     take        corrective            action         on a substantial                      illegality,
     report         to FDIC,           resign        from the             audit,          or both;           and

--   institutions                establish           truly         independent               audit        committees
     that     include            lawyers        whose duties                    include           reviewing           the
     basis        for     the     reports           issued         by an institution’s                        management
     and accountants.

             Our initial                 letter       dated      September              13,        1990,          included                proposed
legislation                  for     the Committee               to consider                  which            would      implement                our
proposed                 recommendations                by amending               the Securities                       Exchange             Act of
1934.              This      proposal             was offered             because        of        consideration                     being
given          in the House of Representatives                                     to a proposal                       that      would
repeal             the     1934 Act's              section       12(i)          exemption                for      financial
institutions                     and address            some of the              reforms            needed.               Our proposed
legislation                  would        have strengthened                     the House bill.                         Our follow-up
letter             included         proposed            legislation              with         respect             to financial
institutions                     by amending            the Federal              Deposit            Insurance                 Act.          We are
satisfied                 that     this      legislation              contains               the measures                 necessary                to
reduce             the     risk     of      loss      to the Bank Insurance                          Fund.              We urge             that
this         legislation              be enacted              before        the     end of           the calendar                         year     so
that         its     provisions              can be fully               effective              in 1991.


             We believe             that          the measures            we have outlined                            today,         if
promptly             addressed,              will      assist         in reducing                  the         risk     of a major
crisis             in the banking                  industry,            Our goal              is    to ensure                 a sound
system of deposit                         insurance           that      continues              to maintain                    public
confidence                 and can withstand                   adverse          economic             conditions                 without
costing             the     nation's              taxpayers          billions           of     dollars,                 The amendment
you have proposed                         to allow          FDIC more flexibility                               in setting
premiums             is a critical                  first      step       to protect                the Bank Insurance

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