Summary

Regulatory and legislative changes, along with market forces, have expanded the range of activities undertaken by insured banking institutions, particularly the largest ones, and the risks that they assume. These institutions, which now deal in a host of nontraditional bank products, such as mutual funds, securities, derivatives, and other off-balance sheet products, pose major supervisory and regulatory challenges. Federal bank and thrift regulators recently announced that bank examinations will assess how effectively banks manage risk and will rate their sensitivity to risks posed by various market factors. Although GAO has not fully evaluated the implementation of the recent changes to supervisory and examination policy, these changes appear to address some of GAO's concerns about examinations in the aftermath of bank failures in the 1980s and early 1990s. Perhaps the most important--yet unanswered--question is to what extent improvements in the detection of problems can help ensure that regulators take timely and forceful corrective measures to prevent or minimize losses to the deposit insurance funds. This testimony (1) describes the history of the bank and thrift crises of the late 1980s and early 1990s and the legislative response to them, (2) highlights supervisory and regulatory weaknesses that GAO has noted in the past and improvements that have been made or are under way, and (3) identifies continuing issues.

GAO noted that: (1) bank supervision and examination today show evidence of lessons learned from the bank and thrift crises of the 1980s and early 1990s; (2) these procedures are the primary basis for federal regulatory agencies to assess the risks that banks and thrifts assume and to take actions to maintain a safe and sound banking system and protect deposit insurance funds; (3) one critical lesson of the earlier crises was that excessive regulatory forbearance contributed to the extent of the crises; (4) the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) based regulatory practices on a simple principle: if a depository institution fails to operate in a safe and sound manner, it should be subject to timely and forceful supervisory response, including, if necessary, prompt closure; (5) FDICIA also required that banks reform their corporate governance and accounting practices and that the regulatory agencies improve their supervision of insured banks and thrifts; (6) in a November 1996 report, however, GAO noted that questions remain about the effectiveness of FDICIA's trip-wire provisions which are intended to limit regulatory discretion; (7) as implemented, the trip-wire that enables regulatory action at the early stage of problems in a bank does little to limit regulatory discretion; (8) in several reports in the early 1990s, GAO also noted limitations in the safety and soundness examinations conducted by the regulatory agencies; (9) the limitations included a lack of comprehensive internal control assessments, insufficient review of loan quality and loan loss reserves, weaknesses related to insider lending, and insufficient assessment of bank subsidiaries; (10) regulators have made a number of changes in an effort to improve their examinations; (11) the changes respond, in part, to the dynamic banking environment in which institutions can rapidly reposition risk exposures; (12) to ensure that banks and thrifts have the managerial ability and internal control structure to effectively manage risk, the examination process is evolving to put greater emphasis on risk management and internal controls; and (13) in its recent report on foreign banking organizations operating in the United States, GAO noted that regulators have begun to put greater emphasis on risk management processes and operational controls in examinations of these organizations.