Academic journal article Federal Reserve Bank of St. Louis Review

The Effects of Legislating Prompt Corrective Action on the Bank Insurance Fund

Academic journal article Federal Reserve Bank of St. Louis Review

The Effects of Legislating Prompt Corrective Action on the Bank Insurance Fund

Article excerpt

1 See Walter (1991) for a thorough discussion of the allowance for loan losses.

2 When the FDIC liquidates a bank, it becomes a creditor of the failed bank for the amount of its payment to the insured depositors. The claim of the FDIC against the assets of the failed bank has equal priority to the claims of the uninsured depositors.

R. Alton Gilbert is an assistant vice president at the Federal Reserve Bank of St. Louis. Richard I. Jako provided research THE FEDERAL DEPOSIT Insurance Corporation Improvement Act of 1991 (hereafter, FDICIA) authorized more federal government funds for the Federal Deposit Insurance Corporation and made major changes in the supervision and regulation of depository institutions. One section of FDICIA requires supervisors to take prompt corrective action when an institution's capital ratio falls below the required level.(1) Banks that are classified as well-capitalized or adequately capitalized are subject to the fewest constraints on their activities. Supervisors are required to impose limits on the activities of banks with relatively low capital ratios and to close them promptly if their capital ratios fall below some critical level. Some examples of the constraints on poorly capitalized banks include limits on their asset growth, dividends and various insider transactions.

As FDICIA states, the purpose of prompt corrective action is "to resolve the problems of insured depository institutions at the least possible long-term loss to the deposit insurance fund." The legislation is based on the assumption that losses to the Bank Insurance Fund (BIF) would have been lower in recent years if supervisors had acted as required by FDICIA. This paper investigates whether the evidence is consistent with the assumptions that underlie the case for this legislation.


A few years ago, as part of a program to reform the supervision and regulation of depository institutions, several economists began promoting proposals for prompt corrective action (PCA) by supervisors.(2) The report on financial reform by the Treasury Department in February 1991 included a version of these early proposals.(3) The General Accounting Office recommended a supervisory TABULAR DATA OMITTED system in which supervisors would be required to act based on certain indicators of the performance and behavior of depository institutions, as well as capital ratios.(4)

Proponents of legislating PCA, including the Treasury and others, have based their case for PCA largely on the incentive for banks to assume risk, not on evidence of the behavior of poorly capitalized banks. The recent behavior of savings and loan associations provided most of the evidence that depository institutions assumed greater risk as their capital ratios declined.(5) The following quote illustrates the thinking of PCA advocates:

As banks approach the point of economic insolvency, they have less and less to lose from pursuing aggressive, high-risk investment strategies in an attempt to return to profitability. The supervisory free rein given undercapitalized thrifts during the 1980s is widely recognized as a leading factor contributing to the cost of resolving insolvent thrifts. Some argue that commercial bank supervision has been far from perfect, too. In this view, banks are allowed to carry assets on their books at unrealistically optimistic values and are not appropriately restrained from high-risk behavior and irresponsible dividend policy.(6)


The direct method of determining whether PCA legislation will reduce the BIF's losses is to enact the legislation, then observe BIF losses for several years. Waiting several years to form an opinion about the effectiveness of PCA legislation, however, does not seem the best way. If PCA legislation turns out to be ineffective, we will have wasted valuable time during which more effective reforms could have been doing their job. …

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