Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

DATE: January 22, 2004

MEMORANDUM TO: Michael J. Zamorski, Director, Division of Supervision and Consumer Protection

FROM: Russell A. Rau [Electronically produced version; original signed by Stephen M. Beard for Russell Rau], Assistant Inspector General for Audits

SUBJECT:Observations from FDIC OIG Material Loss Reviews Conducted 1993 through 2003 (Report No. 04-004)

This report presents summary observations from previously issued Federal Deposit Insurance Corporation (FDIC) Office of Inspector General (OIG) material loss review reports. In this report, we address the recurring and root causes for the failure of 10 FDIC-supervised institutions subject to the material loss review provisions of Federal Deposit Insurance Act (FDI Act) section 38(k), Review Required When Deposit Insurance Fund Incurs Material Loss. Section 38(k) provides that if a deposit insurance fund incurs a material loss with respect to an insured depository institution on or after July 1, 1993, the Inspector General of the appropriate federal banking agency shall prepare a report to the banking agency. The 10 failed banks had combined assets of $3.2 billion at the time they failed. The combined estimated loss to the BIF totaled about $584 million.

In accordance with the Act, our audit objectives for each material loss review were to: (1) review the agency's supervision of the institution, including the agency's implementation of FDI Act section 38, Prompt Corrective Action; (2) ascertain why the institution's problems resulted in a material loss to the insurance fund; and (3) make recommendations for preventing future material losses.

The scope of this review included an analysis of the 10 statutorily-required material loss reviews performed by the OIG since 1993. We reviewed each material loss review report to determine the root causes of failure and to ascertain whether there were any indicators of problems before the financial condition of the bank deteriorated. We then aggregated the information to determine whether there were any trends or common characteristics among the failed institutions. Based on the objective of this audit, we did not conduct any new audit procedures related to compliance with laws and regulations, internal control, or performance measures and did not rely on computer-generated data. We performed this audit from May through November 2003 in accordance with generally accepted government auditing standards.

SUMMARY

Our material loss reviews disclosed that the major causes of failure were inadequate corporate governance, poor risk management, and lack of risk diversification. Bank management took risks that were not mitigated by systems to adequately identify, measure, monitor, and most importantly, control the risks. As a result, bank management did not adequately fulfill its responsibility to ensure that the banks operated in a safe and sound manner. Although economic conditions may have contributed to failure and the resulting material loss, the economy was not the sole cause of failure. In fact, the financial condition of the majority of the banks became dependent on the economy as a result of bank management decisions.

The failed banks typically went through four stages:

1. Strategy the banks typically underwent a change in philosophy and developed aggressive business plans usually in a high-risk lending niche. Characteristics of a bank in this stage included emergence of a dominant person, lack of expertise in the niche area, and high-risk lending with liberal underwriting and weak internal controls.

2. Growth the banks appeared financially strong due to rapid growth in their niche area. High levels of fee income were reported, but bank portfolios were not sufficiently aged to show losses resulting from poor lending decisions and weak credit administration. Violations of laws and regulations and insider abuse occurred, and examiners concerns were not fully addressed. Poor risk management and inadequate diversification were evident.

3. Deterioration the banks overall financial condition declined. Characteristics of a bank in this stage included resistance to supervisory concerns, overvaluation of assets, plateau or decline in earnings, inadequate allowance for loan and lease losses (ALLL), impaired capital, significant concentrations of credit, and loan problems that were exacerbated when the economy declined.

4. Failing massive loan losses occurred, ALLL was severely deficient, significant capital depletion occurred, enforcement actions were issued by the FDIC, and key management officials departed. A massive capital infusion was needed for the bank to survive.

OBSERVATIONS

Our analysis led to the following observations that may be of value to Division of Supervision and Consumer Protection management and staff involved in planning and conducting bank examinations:

• Failed banks often exhibit warning signs when they appear financially strong.
• Financial condition is no guarantee of future performance.
• Failed banks frequently assume more risk than bank management is capable of handling.
• An inattentive or passive board of directors is a precursor to problems.
• Banks may reach a point at which problems become intractable and supervisory actions are of limited use.

The observations discussed in this report underscore one of the more difficult challenges facing bank regulators today - limiting risk assumed by banks when their profits and capital ratios make them appear financially strong. A critical aspect of limiting risk is early corrective action by bank regulators in response to bank examinations that identify potential problems and effects on a banks condition. For example, if a bank is experiencing rapid growth, the effects of poor underwriting in commercial real estate loans may not appear on the banks financial statements until several months or even years after the loans are made. Left uncorrected, poor underwriting could result in the serious and intractable problems experienced by the banks we reviewed.

The FDIC has taken a number of steps to address these challenges through risk-focused examination programs and risk-based capital requirements. Nevertheless, we recognize that bank failures may never be eliminated and, in a free economy, might even be necessary to cull the industry of marginal performers and excess capacity.

CORPORATION COMMENTS AND OIG EVALUATION

On January 14, 2004, the DSC Director provided a written response to the draft report. Prior to receiving the response, we made some changes to the report to add perspective based on conversations we had with DSC officials. The response is presented in Part III of this report. In its written response, DSC management generally concurred with the reports observations and conclusions. Since the report contains no formal recommendations, no further action is necessary on the part of management.