Academic journal article Federal Reserve Bank of St. Louis Review

Implications of Annual Examinations for the Bank Insurance Fund

Academic journal article Federal Reserve Bank of St. Louis Review

Implications of Annual Examinations for the Bank Insurance Fund

Article excerpt

deposits and savings deposits.

26 See Brunner, Duca and McLaughlin (1991).

27 The 18-month exemption is canceled if a bank is sold.

REFERENCES

Benston, George J. "Bank Examination." The Bulletin of the Institute of Finance, Graduate School of Business Administration, New York University nos. 89-90 (May 1973).

The Federal Deposit Insurance Corporation Improvement Act of 1991 requires federal supervisors to examine insured depository institutions annually. This article investigates whether mandatory annual examinations will make supervisors more effective in limiting losses to the Bank Insurance Fund (BIF) that result from bank failure. Gilbert's findings, based on data for more than 800 banks that failed between 1985 and 1990, support the view that annual examinations are important for effective supervision of banks.

First, more than 90 percent of failed banks were classified as problem banks in examinations before their failure. Thus examiners can distinguish between sound and troubled banks when they examine them. Second, changes in balance sheets around the time of examinations indicate that examiners discovered bank problems that were not revealed in prior Call Reports.

Annual examinations are important if supervisors use the information in the examination reports to constrain problem bank behavior that would tend to increase exposure of BIF to losses. Gilbert reports sharp declines in dividends and in the growth rates of assets after banks were examined and downgraded to problem status. Finally Gilbert finds that losses to BIF were smaller in those bank failure cases in which banks were examined in their last 12 months of operation. The information derived from examination reports appears to be important to the efforts of supervisors to limit exposure of BIF to losses when banks get into serious trouble.

THE FEDERAL DEPOSIT Insurance Improvement Act of 1991 (FDICIA) requires many changes in bank supervision and regulation, including a requirement that the federal supervisory agencies conduct on-site examinations of all insured depository institutions at least once every 12 months.(1) Examinations of small (assets less than $100 million), well-capitalized banks are required only every 18 months. This legislation reduces the discretion that federal bank supervisors once had in scheduling bank examinations.(2)

Annual examinations are designed to reduce federal deposit insurance fund losses. More frequent examinations may reveal depository institution problems that can be corrected before they become more serious. In addition, more frequent examinations may permit supervisors to close seriously troubled institutions before their managers make new business decisions that increase the exposure of federal deposit insurance funds to losses. For example, institutions whose troubles have not been detected by their supervisors could increase exposure of the deposit insurance funds to losses by paying dividends or by increasing their assets in desperate gambles to regain solvency through favorable outcomes on new, risky investments.

This paper investigates whether there is a relationship between the frequency of bank examinations and losses to the Bank Insurance Fund (BIF).(3) Logically, such an association should be based on several links between the information gained during individual examinations, actions taken by supervisors on the basis of the information, and BIF losses associated with the failures of individual banks. First, supervisors must be able to identify the serious troubles of failing banks before they fail. Second, examinations of failing banks must help supervisors identify problems that had not been revealed in prior reports. Third, supervisors must be effective in changing the behavior of banks whose problems they identify through examinations. This paper investigates whether banks reduce their asset growth and dividends after supervisors classify them as problem banks. …

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