Monday, April 6, 2009

William K. Black on The Prompt Corrective Action Law: Section 1831o

William K. Black, associate professor of economics and law at the University of Missouri in Kansas City writes:

My comments in the Bill Moyers Journal interview about the “Prompt Corrective Action” (PCA) law (adopted in 1991) have sparked considerable comment in the blogsphere.

Here is the portion of the interview transcript that discusses the PCA law:

WILLIAM K. BLACK: Well, certainly in the financial sphere, I am. I think, first, the policies are substantively bad. Second, I think they completely lack integrity. Third, they violate the rule of law. This is being done just like Secretary Paulson did it. In violation of the law. We adopted a law after the Savings and Loan crisis, called the Prompt Corrective Action Law. And it requires them to close these institutions. And they're refusing to obey the law.

BILL MOYERS: In other words, they could have closed these banks without nationalizing them?

WILLIAM K. BLACK: Well, you do a receivership. No one -- Ronald Reagan did receiverships. Nobody called it nationalization.

BILL MOYERS: And that's a law?

WILLIAM K. BLACK: That's the law.

BILL MOYERS: So, Paulson could have done this? Geithner could do this?

WILLIAM K. BLACK: Not could. Was mandated-

BILL MOYERS: By the law.

WILLIAM K. BLACK: By the law.
I first published an article about the PCA law over a month ago entitled: “Why is Geithner Continuing Paulson’s Policy of Violating the Law?” (February 23, 2009).

I was the staff leader for Federal Home Loan Bank Board Chairman Ed Gray’s successful reregulation of the S&L industry. That reregulation provided the tools that allowed the agency to place in receivership many of the worst control frauds. Gray inherited (and for a time supported) a dominant strategy of covering up the scale of the S&L industry’s insolvency. He personally recruited vigorous senior regulators such as Michael Patriarca and Joe Selby to reverse that strategy. The PCA law was adopted largely in response to the enormous cost to the taxpayers of our predecessor’s failed strategy of not closing insolvent S&Ls.

The new law had an impressive start, thanks in great part to the transformed reregulatory spirit. How many readers recall the 1991-92 subprime crisis? It didn’t happen because we took prompt regulatory action against subprime S&L lenders that were following practices (e.g., qualifying borrowers at the teaser rate, offering “neg am” mortgages, etc) that we knew would lead to widespread failures.

The broadcast of Bill Moyers Journal interview has raised enormously the public’s awareness of the PCA. A commentator has responded by arguing that the PCA law does not mandate that the regulators place insolvent banks into receivership. I am delighted that the debate has turned to focus in part on the issue of why virtually all economists and white-collar criminologists believe that it is essential to take prompt regulatory action to resolve failed banks, particularly ones that are insolvent due to “control fraud”, i.e., where the person that controls a seemingly legitimate entity uses it as a “weapon” to defraud. In the financial world accounting fraud is the “weapon of choice.”

Banks owned by holding companies are fully subject to the law

The commentator’s primary concern can be answered briefly because it criticizes a claim I never made. S(he) notes that banking holding companies and insurance companies are not subject to PCA. I did not say that they were. As the interview excerpt shows, we were talking about “[savings] institutions” and “banks” that can be put into “receivership” (I’m going to use “bank” here to refer to any FDIC-insured depository institution.) The FDIC (and if it lacks the funds, the U.S. Treasury) is only legally obligated to pay depositors of FDIC-insured banks up to the deposit insurance limits. The federal banking regulators have receivership powers only over federally insured depository institutions. The FDIC and the U.S. Treasury have no obligation to pay the debts of bank holding companies or insurance companies – and shouldn’t be paying those debts.

The commentator uses this strawman argument (refuting a claim no one made) to imply that the fact that PCA doesn’t apply to bank holding companies means that the federal financial regulators did not have to comply with the PCA law. S(he) lists a series of companies, primarily large bank holding companies (BHCs) and declares that their existence means: “So, pretty much all of the really big players don't fall under the PCA in the first place.” Bank holding companies, of course, are called that because they own banks – and the U.S. banks they own are subject to PCA. The fact that a bank is owned by a holding company is irrelevant to the PCA’s requirements; it provides no immunity from the PCA. BHCs are “really big players” because they own massive banks subject to the PCA. The banks are the “really big players” and they are subject to the PCA law. When we put insolvent banks into receivership their BHCs and affiliates lose all control of the bank. The FDIC has sole control of it.

PCA does not apply to the corporate owners of banks or their non-bank affiliates.
However, the bank subsidiaries are the dominant assets of almost all holding companies that own banks. As such, the failure of the banking within the group is likely to trigger the failure of the holding company.

To sum up the first point: banks are the issue. U.S. banks have FDIC insurance and are subject to the PCA law, regardless of whether they are owned by a BHC. Deposit insurance covers only insured banks, not BHCs, so the FDIC, the Treasury and the taxpayers do not owe any obligation to pay their creditors. If the commentator is worried that BHCs will escape receivership, s(he) need not fear. BHCs and insurance companies such as AIG are subject to the bankruptcy laws, which can be used to block and even “claw back” excessive and fraudulent executive compensation. (Treasury is also requesting Congress to grant it authority to place BHCs and some insurers into receivership.)

The PCA law mandates receivership in these circumstances

The commentator’s secondary argument is that the PCA law does not mandate that deeply insolvent banks be placed in receivership. S(he) points to several discretionary exceptions in the law, but none of the exceptions apply to insolvent banks that cannot be promptly corrected (recapitalized). They must be placed in receivership to comport with the stated purpose and language of the law. Moreover, neither the Bush nor the Obama administration has purported to act in accordance with the inapplicable exceptions.

I will respond to the argument primarily by citing other scholars on the PCA that were writing at an earlier time and in an apolitical context. The scholarly literature on the PCA is fairly extensive and quite consistent. I’ve drawn on Nieto & Wall (2007) (see n. 2) for the quotations in the following discussion (other than statutory language), but other sources do not differ materially on the origins, singular purpose, and provisions of the PCA law.

The PCA law, as I noted in the interview, arose as a corrective to problems exposed during the S&L debacle. The consensus was that the central problem was that regulators, sometimes bowing to political or industry pressure (“regulatory capture”), were delaying placing failed banks into receivership and greatly raising the cost to taxpayers.

The US has a long history with the basics required to implement PCA: binding capital adequacy standards and the ability to take substantial actions against banks that failed to meet the standards. The supervisors had the authority to adopt many of the provisions of PCA using their pre-existing powers if they had so chosen. However, the experience of the 1980s had clearly indicated that US supervisors valued discretionary responses targeted at keeping some banks (especially thrifts and large banks) in operation after they had became financially distressed. (p. 12)

Economists and white-collar criminologists broadly agree that prompt receiverships of failed banks reduce taxpayer costs and systemic risk.

[A]llowing insolvent banks to continue in operation runs the risk that they will accumulate even larger losses leading to even greater market disruption when the bank’s continued operation is no longer tenable. In contrast, if a bank is required to be closed before its losses exceed the bank’s equity and subordinated debt then depositors and other creditors should not be exposed to any loss. Moreover, prompt resolution reduces the probability that more than one systemically important bank will be insolvent at the same time. In sum, a supervisory focus on limiting deposit insurance costs is unlikely to result in significantly higher expected losses due to systemic financial problems and may well result in lower expected costs. (p. 18)

Leaving the senior officers that caused bank failure in control creates particularly severe risks to the taxpayers.

Prompt corrective supervisory action seeks to minimize expected losses to the deposit insurer and taxpayer by limiting supervisors’ ability to engage in forbearance. Along with reducing taxpayer losses, PCA should also reduce banks’ incentive to engage in moral hazard behavior by reducing or eliminating the subsidy to risk-taking provided by mispriced deposit insurance. These potential benefits from PCA appear to have been recognized, as reflected in the increasing number of recommendations to policy makers to introduce PCA type of provisions in their national legislation. Japan, Korea and, more recently Mexico have adopted this prudential policy. (p. 31).

“Moral hazard” can lead to both “reactive” control fraud and wildly imprudent risks. Either can cause a dramatic increase in taxpayer losses. As I explained in the interview, leaving the managers in place that caused the failure also prevents us from obtaining honest evaluation of assets and the criminal referrals that are essential to resolve this crisis.

The PCA law states its sole, express purpose:

(1) Purpose

The purpose of this section is to resolve the problems of insured depository institutions at the least possible long-term loss to the Deposit Insurance Fund. (1831o (a) (1)).

The administration’s duty, under the rule of law, is to administer the law to achieve that purpose. Prompt receiverships “resolve the problems” of insolvent and failing banks “at the least possible long-term loss.”

Because the problem prompting passage of the PCA law was supervisory delay in closing insolvent banks, the law mandated “prompt corrective action.” This, of course, need not mean receivership for troubled banks that can promptly recapitalize themselves by raising equity. The mandate to the regulators is that either the bank or the regulator must promptly correct the capital inadequacy.

In 1991 the Congress moved to limit taxpayer exposure to losses at failed banks with the passage of FDICIA. The PCA provisions of FDICIA create a structured system of supervisory responses to declines in bank capital, culminating in the bank being forced into receivership within 90 days after its tangible equity capital dropped below two percent of total assets. (pp. 11-12)

Note that two percent tangible capital (the point below which a bank is “critically undercapitalized”) is a much higher number than it may appear, for many banks have large amounts of “goodwill” (an intangible) on their books as an asset. The authors emphasize the regulators “forc[ing]” the bank into receivership if it does not promptly restore its capital. They expressly tie these provisions to the PCA law’s intent to combat regulatory forbearance through “mandatory” supervisory intervention.

The key innovation of PCA is that it recommends a reduction of supervisory discretion to exercise forbearance by proposing a series of capital adequacy tranches with a set of mandatory supervisory actions for each of the undercapitalized tranches. Mandatory supervisory actions are intended to override the incentives supervisors would otherwise have to engage in forbearance. (p. 19)

The authors also explain that the PCA law was intended to protect the regulators “independence” from the common political pressures to keep failing banks open by “requir[ing] them to intervene.

The US supervisors did not need political or judicial approval prior to PCA to intervene at a troubled bank or to force an insolvent bank into resolution. The major change in supervisory practice resulting from PCA is that after PCA the supervisors were required to intervene as a bank’s supervisory capital ratios deteriorated. The independence of supervisory action provided to supervisors before PCA is critical to the effective operation of PCA. A system that requires the prior approval of political authorities creates the potential for delay and forbearance in supervisory intervention to the extent that the political authorities do not follow the supervisors´ recommendations. Moreover, if this condition is not met, the requirement of prior political approval reduces the effectiveness of PCA in discouraging banks from taking excessive risk. (p. 22)

If the bank cannot promptly raise capital on its own to return to health it must be placed in receivership. Nieto & Wall explain that such receiverships are the normal U.S. means of dealing with failed banks, lead to the removal of the bank officers that caused the failure, are not remotely akin to “nationalization”, and substantially reduce the cost to the taxpayers.

2.3 Should banks be closed with positive regulatory capital?
Both SEIR [the academic proposal of Drs. Kaufman and Benston that led to the adoption of the PCA law] and PCA call for timely resolution, which is a policy where banks with sufficiently low, but still positive, equity capital are forced into resolution. In the US context, resolution is understood to include: (1) the government assuming control of the failed bank, firing the senior managers and removing equity holders from any governance role, and (2) the government returning the bank’s assets to private control through some combination of sale to a healthy bank or banks, new equity issue, or liquidation. Timely resolution provides two important benefits. First, forcing a bank into resolution while it still has positive regulatory capital truncates if not eliminates the value of the deposit insurance put option, reducing the incentive of the bank’s shareholders to support excess risk taking. Second, timely resolution is critical to limiting deposit insurance losses. If insolvent banks are allowed to continue in operation then the potential losses from failure can be very large. (pp. 20-21)

These mandatory provisions of the PCA law are “critical” to its effectiveness. Note the scholars’ emphasis on the provisions that “require minimum and automatic supervisory action” and subject banks to “mandatory closure” before they become insolvent.

Three aspects of the philosophy underlying SEIR/PCA are critical to its effective operation. First, the primary goal of prudential supervisors should be to minimize deposit insurance losses, a goal which is also likely to result in a reduction in the expected social costs of systemic financial problems.

The PCA policy applied in the US goes beyond those three principles of Basle II in that it limits even further supervisory discretion as to when to forbear from intervening by specifying capital/asset ratios that require minimum and automatic supervisory action.

The third critical part of PCA follows from the first two parts, banks should be subject to mandatory closure at positive levels of regulatory capital ratio. This provides an incentive to banks’ managers to recapitalize the bank or look for a healthy merger partner and, ultimately, contribute to reduce the cost of deposit insurance. (p. 31)

The authors also explain provisions of the PCA law that make its requirements anathema to the bankers that caused the failures (i.e., firing managers and restricting management “bonuses and raises”) and the regulators whose laxity permitted widespread frauds.

No bank may make a capital distribution (dividend or stock repurchase) if after the payment the bank would fall in any of the three undercapitalized categories unless the bank has prior supervisory approval. All undercapitalized banks must submit a capital restoration plan and that plan must be approved by the bank’s supervisor. All undercapitalized banks also face growth restrictions. Significantly undercapitalized banks must restrict bonuses and raises to management. Critically undercapitalized banks must be placed in receivership within 90 days unless some other action would better minimize the long-run losses to the deposit insurance fund. Supervisors are also given a variety of discretionary actions they may take. For example, the supervisors may dismiss any director or senior officer at a significantly undercapitalized bank and may further require that their successor be approved by the supervisory agency. (p. 13)

PCA requires that the inspector general of the appropriate supervisory agency prepare a report whenever a bank failure results in material losses. The report addresses why the loss occurred and what should be done to prevent such losses in the future. A copy of the report is to be provided to the Comptroller General and to any member of Congress requesting the report.21 FDICIA also provides for public release of the reports upon request…. (p. 14)

Recent IG reports of this nature have led to the removal of two of the most senior Office of Thrift Supervision (OTS) leaders. Regulators that place fraudulent banks that they have failed to supervise properly into receivership risk their reputations and careers. One can well understand why senior regulators are so hostile to complying with the PCA law. (As Treasury Secretary, and as a leading colleague of then Secretary Paulson, I have concentrated on Mr. Geithner’s role, but each of the top federal banking regulators is complicit in failing to comply with the PCA law.)

Before the legal minutia, let’s not lose sight of the policy issue

To review the bidding to date: there is a consensus among economists and white-collar criminologists (and senior regulators that have successfully resolved prior crises such as William Seidman, Edwin Gray, and Paul Volcker) that failing banks should be placed promptly into receivership if they cannot recapitalize. So the fundamental question, even if the PCA law was never passed, is what can the nation do to end the disastrous Paulson/Geithner policy of covering up the largest banks’ losses and leaving the CEOs and senior officers that caused their failures, often through fraud, in power? How many of those of us that voted for Mr. Obama believed that they were voting for a continuation of Bush’s failed financial regulatory policies? Given the terrible cost to taxpayers during the early years of the S&L debacle of “forbearance” for failed S&Ls, the horrific failure of Japan’s embrace of the cover up of its bank losses, and the great success of the vigorous reregulation of the S&L industry why would we adopt the failed strategy instead of the proven success? The way we reregulated the S&L industry was not simply an economic success, it was vital to restoring at least some integrity. We insisted on honest accounting, used prompt receiverships, and rooted out the control frauds. This led to over 1000 felony convictions related to the debacle – the greatest criminal justice success in history against elite white-collar criminals.

On to the legal specifics

The commentator argues that the PCA law does not mandate receiverships, citing exceptions to the mandatory language. None of the exceptions apply in the circumstances we are discussing and neither the Bush nor the Obama administration purports to be following such exceptions. Instead, what is occurring is a coverup designed to evade the PCA that relies on abusive accounting to hide the banks’ losses that arose due to mortgage and accounting fraud. There is a certain awful symmetry to thinking that the cure for accounting fraud is greater accounting fraud countenanced, even arguably mandated, by the government. Governmental abuse of accounting makes it far harder to prosecute bank officials that enriched themselves through accounting fraud.

To begin, we need to review the context of the discussion during the interview. Here’s the relevant portion of interview that led to the discussion about the PCA law:
BILL MOYERS: Why are they firing the president of G.M. and not firing the head of all these banks that are involved?

WILLIAM K. BLACK: There are two reasons. One, they're much closer to the bankers. These are people from the banking industry. And they have a lot more sympathy. In fact, they're outright hostile to autoworkers, as you can see. They want to bash all of their contracts. But when they get to banking, they say, ‘contracts, sacred.' But the other element of your question is we don't want to change the bankers, because if we do, if we put honest people in, who didn't cause the problem, their first job would be to find the scope of the problem. And that would destroy the cover up.

BILL MOYERS: The cover up?

WILLIAM K. BLACK: Sure. The cover up.

BILL MOYERS: That's a serious charge.

WILLIAM K. BLACK: Of course.

BILL MOYERS: Who's covering up?

WILLIAM K. BLACK: Geithner is charging, is covering up. Just like Paulson did before him. Geithner is publicly saying that it's going to take $2 trillion — a trillion is a thousand billion — $2 trillion taxpayer dollars to deal with this problem. But they're allowing all the banks to report that they're not only solvent, but fully capitalized. Both statements can't be true. It can't be that they need $2 trillion, because they have masses losses, and that they're fine.
These are all people who have failed. Paulson failed, Geithner failed. They were all promoted because they failed, not because...

BILL MOYERS: What do you mean?

WILLIAM K. BLACK: Well, Geithner has, was one of our nation's top regulators, during the entire subprime scandal, that I just described. He took absolutely no effective action. He gave no warning. He did nothing in response to the FBI warning that there was an epidemic of fraud. All this pig in the poke stuff happened under him. So, in his phrase about legacy assets. Well he's a failed legacy regulator.

BILL MOYERS: But he denies that he was a regulator. Let me show you some of his testimony before Congress. Take a look at this:

| TIMOTHY GEITHNER:I've never been a regulator, for better or worse. And I think | you're right to say that we have to be very skeptical that regulation can solve | all of these problems. We have parts of our system that are overwhelmed by
| regulation.

Overwhelmed by regulation! It wasn't the absence of regulation that was the problem, it was despite the presence of regulation you've got huge risks that build up.

WILLIAM K. BLACK: Well, he may be right that he never regulated, but his job was to regulate. That was his mission statement.


WILLIAM K. BLACK: As president of the Federal Reserve Bank of New York, which is responsible for regulating most of the largest bank holding companies in America. And he's completely wrong that we had too much regulation in some of these areas. I mean, he gives no details, obviously. But that's just plain wrong.

BILL MOYERS: How is this happening? I mean why is it happening?

WILLIAM K. BLACK: Until you get the facts, it's harder to blow all this up. And, of course, the entire strategy is to keep people from getting the facts.

BILL MOYERS: What facts?

WILLIAM K. BLACK: The facts about how bad the condition of the banks is. So, as long as I keep the old CEO who caused the problems, is he going to go vigorously around finding the problems? Finding the frauds?
The context then is Geithner saying that it would cost the taxpayers $2 trillion to bail out the insolvent banks, yet virtually all the banks are reporting they are solvent and “well capitalized.” I noted that both statements could not be true. Geithner has every incentive to understate, not overstate, the cost of bailing out the banks and his $2 trillion estimate is materially lower than most analysts, so there is every reason to believe that the banks are not recognizing at least $2 trillion in losses. We know that the big banks hold a greatly disproportionate share of the worst assets. That means that many, probably most, of the big banks are massively insolvent (because $2 trillion far exceeds what they claim to hold as capital). We know that many large bank stocks (before the announcement of the huge TARP II subsidy for banks) were trading at prices that indicated market expectations that they had suffered massive capital losses and were essentially high risk options capitalizing the value of moral hazard. (Remember, the worst thing we can do is to maximize moral hazard. We are maximizing moral hazard by leaving open insolvent banks under the control of managers that caused the failure, often through fraud.)

If Geithner is right about the scale of the banks’ insolvency many of the large banks have to be hopelessly insolvent, but engaging in accounting fraud to hide that insolvency. That was the context for our PCA discussion. These large banks have not been able to recapitalize. They have been deeply insolvent since, at the latest, March 2007 when the secondary market in nonprime assets collapsed. (If we are fortunate it will never be restored because it was inherently dangerous. If it is it will cause future crises.)

The PCA law is characterized by mandates that the regulators ensure that a bank, well before, insolvency, is recapitalized – promptly. Failing that action, the PCA law requires the regulators to act to correct the problem by selling the bank or putting it in receivership. In the context we are discussing – the deep insolvency of many large banks that means that the law mandates receivership.

Here are the specifics:

Immediately after the “purpose” clause quoted above comes the mandate (“shall”) to act in accordance with that purpose to achieve prompt corrective action:

(2) Prompt corrective action required
Each appropriate Federal banking agency and the Corporation (acting in the Corporation’s capacity as the insurer of depository institutions under this chapter) shall carry out the purpose of this section by taking prompt corrective action to resolve the problems of insured depository institutions.

Well before insolvency, as soon as a bank becomes “undercapitalized”, it must (“shall”) file a plan to promptly restore its capital adequacy and that plan must meet strict standards.

(IV) Capital restoration plan required
(IV) In general
Any undercapitalized insured depository institution shall submit an acceptable capital restoration plan to the appropriate Federal banking agency within the time allowed by the agency under subparagraph (D).
(B) Contents of plan
The capital restoration plan shall—
(IV) specify—
(IV) the steps the insured depository institution will take to become adequately capitalized;
(II) the levels of capital to be attained during each year in which the plan will be in effect;
(III) how the institution will comply with the restrictions or requirements then in effect under this section; and
(IV) the types and levels of activities in which the institution will engage; and

Subsection (C) (1) of the law mandates (“shall not accept … unless”) tough standards on the agency in terms of capital restoration plans it is permitted to approve.

(C) Criteria for accepting plan
The appropriate Federal banking agency shall not accept a capital restoration plan unless the agency determines that—
(i) the plan—
(I) complies with subparagraph (B);
(II) is based on realistic assumptions, and is likely to succeed in restoring the institution’s capital; and
(III) would not appreciably increase the risk (including credit risk, interest-rate risk, and other types of risk) to which the institution is exposed; and
(ii) if the insured depository institution is undercapitalized, each company having control of the institution has—
(I) guaranteed that the institution will comply with the plan until the institution has been adequately capitalized on average during each of 4 consecutive calendar quarters; and
(II) provided appropriate assurances of performance

No deeply insolvent large U.S. bank could provide, “based on realistic assumptions” a plan to return itself to adequate capitalization. That means that the bank is prohibited to pay any bonus or give any raise to any senior executive official.

(4) Senior executive officers’ compensation restricted
(A) In general
The insured depository institution shall not do any of the following without the prior written approval of the appropriate Federal banking agency:
(i) Pay any bonus to any senior executive officer.
(ii) Provide compensation to any senior executive officer at a rate exceeding that officer’s average rate of compensation (excluding bonuses, stock options, and profit-sharing) during the 12 calendar months preceding the calendar month in which the institution became undercapitalized.
(B) Failing to submit plan
The appropriate Federal banking agency shall not grant any approval under subparagraph (A) with respect to an institution that has failed to submit an acceptable capital restoration plan.

Deeply insolvent banks, however, fall into a more severe category under the PCA law. They are “severely undercapitalized,” and the law mandates that the bank or the regulators promptly restore them to adequate capital or place them in conservatorship or receivership (and prohibit a wide range of business activities).

(h) Provisions applicable to critically undercapitalized institutions
(1) Activities restricted
Any critically undercapitalized insured depository institution shall comply with restrictions prescribed by the Corporation under subsection (i) of this section.
(2) Payments on subordinated debt prohibited
(A) In general
A critically undercapitalized insured depository institution shall not, beginning 60 days after becoming critically undercapitalized, make any payment of principal or interest on the institution’s subordinated debt.
(B) Exceptions
The Corporation may make exceptions to subparagraph (A) if—
(i) the appropriate Federal banking agency has taken action with respect to the insured depository institution under paragraph (3)(A)(ii); and
(ii) the Corporation determines that the exception would further the purpose of this section.

(3) Conservatorship, receivership, or other action required
(A) In general
The appropriate Federal banking agency shall, not later than 90 days after an insured depository institution becomes critically undercapitalized—
(i) appoint a receiver (or, with the concurrence of the Corporation, a conservator) for the institution; or
(ii) take such other action as the agency determines, with the concurrence of the Corporation, would better achieve the purpose of this section, after documenting why the action would better achieve that purpose.
(B) Periodic redeterminations required
Any determination by an appropriate Federal banking agency under subparagraph (A)(ii) to take any action with respect to an insured depository institution in lieu of appointing a conservator or receiver shall cease to be effective not later than the end of the 90-day period beginning on the date that the determination is made and a conservator or receiver shall be appointed for that institution under subparagraph (A)(i) unless the agency makes a new determination under subparagraph (A)(ii) at the end of the effective period of the prior determination.
(C) Appointment of receiver required if other action fails to restore capital
(i) In general Notwithstanding subparagraphs (A) and (B), the appropriate Federal banking agency shall appoint a receiver for the insured depository institution if the institution is critically undercapitalized on average during the calendar quarter beginning 270 days after the date on which the institution became critically undercapitalized.
(ii) Exception Notwithstanding clause (i), the appropriate Federal banking agency may continue to take such other action as the agency determines to be appropriate in lieu of such appointment if—
(I) the agency determines, with the concurrence of the Corporation, that (aa) the insured depository institution has positive net worth, (bb) the insured depository institution has been in substantial compliance with an approved capital restoration plan which requires consistent improvement in the institution’s capital since the date of the approval of the plan, (cc) the insured depository institution is profitable or has an upward trend in earnings the agency projects as sustainable, and (dd) the insured depository institution is reducing the ratio of nonperforming loans to total loans; and
(II) the head of the appropriate Federal banking agency and the Chairperson of the Board of Directors both certify that the institution is viable and not expected to fail.
(i) Restricting activities of critically undercapitalized institutions
To carry out the purpose of this section, the Corporation shall, by regulation or order—
(1) restrict the activities of any critically undercapitalized insured depository institution; and
(2) at a minimum, prohibit any such institution from doing any of the following without the Corporation’s prior written approval:
(A) Entering into any material transaction other than in the usual course of business, including any investment, expansion, acquisition, sale of assets, or other similar action with respect to which the depository institution is required to provide notice to the appropriate Federal banking agency.
(B) Extending credit for any highly leveraged transaction.
(C) Amending the institution’s charter or bylaws, except to the extent necessary to carry out any other requirement of any law, regulation, or order.
(D) Making any material change in accounting methods.
(E) Engaging in any covered transaction (as defined in section 371c (b) of this title).
(F) Paying excessive compensation or bonuses.
(G) Paying interest on new or renewed liabilities at a rate that would increase the institution’s weighted average cost of funds to a level significantly exceeding the prevailing rates of interest on insured deposits in the institution’s normal market areas.

Parsing through this legalese yields the following:
• The regulators must place an insolvent bank into receivership or conservatorship
• Normally, this should be done no later than 90 days after becoming “critically undercapitalized”, i.e., well before the bank became insolvent.
• The 90 day limit can only be pushed back if the FDIC and the primary regulator agree in writing that doing so would best serve the purposes of the Act – which is to minimize the cost of resolving the insolvent bank – and “document” that the delay would reduce that cost. To our knowledge, the FDIC and the OCC (the primary regulator of most of the largest banks) have not made such joint determinations for any of the large, deeply insolvent banks. Given the fact that delaying receiverships of deeply insolvent banks typically increases the cost of resolving the failure, it is unlikely that the regulators could provide honest documentation to support a failure to act.
• Even if we were to assume, counterfactually, that they provided such documentation, they would have to place the big insolvent banks in receivership or conservatorship. After being insolvent for 270 days (and many of the big banks will have been insolvent for roughly two years), the regulators can no longer extend the clock. They cannot extend the clock for an insolvent bank beyond 270 days. A “critically undercapitalized” bank’s clock extension can only be extended if it meets each of four criteria:

(I) the agency determines, with the concurrence of the Corporation, that (aa) the insured depository institution has positive net worth, (bb) the insured depository institution has been in substantial compliance with an approved capital restoration plan which requires consistent improvement in the institution’s capital since the date of the approval of the plan, (cc) the insured depository institution is profitable or has an upward trend in earnings the agency projects as sustainable, and (dd) the insured depository institution is reducing the ratio of nonperforming loans to total loans; and

A deeply insolvent bank (recall, that is what we were discussing) has negative net worth. It will also typically fail the other minimum requirements. The bank must meet all four of the requirements. To sum it all up, the interview explained why Geithner’s statements about a $2 trillion bailout cost means that many large banks have to be deeply insolvent. The PCA law mandates that deeply insolvent banks be placed in receivership or conservatorship. The exceptions to PCA’s mandatory closure directives do not apply to insolvent banks. Indeed, it does not appear that the regulators have complied with the provision that delays the requirement to appoint a receiver. The regulators could not, in good faith, invoke that delay provision for a deeply insolvent bank.

The PCA’s Achilles’ heel has always been accounting fraud

Nieto & Wall note the vulnerability of the PCA law to accounting fraud by banks and regulators.

3.4 Accurate and timely financial information
Arguably, the biggest weakness of PCA is its reliance on regulatory capital measures of a bank’s capital, measures which may significantly deviate from the bank’s economic capital. Banks that are threatened by PCA mandated supervisory actions have a strong incentive to report inflated estimates of the value of their portfolios. The extent to which banks are allowed to overestimate their capital under PCA depends in part on the accounting rules and in part on the enforcement of the rules. Thus, if bank prudential supervisors want to preserve their discretion despite the requirements for mandatory actions in PCA, supervisors need only accept a troubled bank’s inflated estimates of its regulatory capital adequacy ratio. In the US, PCA is vulnerable to problems both in the accounting principles and their enforcement. (p. 27)

To the extent that outside auditors are unable or unwilling to force banks to recognize losses in their asset portfolios, PCA depends on the effectiveness of bank examinations by the supervisory agencies. Yet relying on the supervisors to enforce honest accounting creates a contradiction in PCA. PCA is designed to limit supervisory discretion in enforcing capital adequacy, yet PCA will only be fully effective if the bank supervisors use their discretion in conducting on-site examinations to force timely recognition of declines in portfolio value. The vulnerability in enforcement is highlighted by Eisenbeis and Wall’s (2002) finding that deposit insurance losses at failed banks in the US did not decrease as a proportion of the failed bank’s assets after the adoption of PCA as should have happened if the supervisors were following timely resolution. (p. 28)

These are the points I was making in the interview. We need honest accounting and honest asset values. We will not get them if we allow the failed bankers and regulators to remain in charge. They have strong incentives to inflate asset values in order to escape the consequences of PCA. The people of America, however, have a compelling interest in demanding that the government comply with that law and resolve cases at the least cost to the taxpayers.

Secretary Geithner is not simply writing the PCA law effectively out of existence; he is creating an unprecedented (and unauthorized) rival system in place that will maximize fraudulent bank CEOs’ perverse incentives. The transcript of his press conference rolling out the TARP II bill contains two separate references to his creation of “capital insurance” for favored banks.


U.S. Department of Treasury
Washington, D.C.

8:56 A.M. EDT
But the critical part of that program is to make it clear that they will be able to raise capital from the government if they can't raise in the markets so that they can get through a deeper recession. That will help reduce the odds of a deeper recession, help make sure, again, they can provide a level of lending that will be necessary to support recovery.
And a program of insurance -- you could call it capital insurance for the banking system so that banks have the cushion of capital necessary to lend and expand even if the economy goes through a broader -- a deeper recession.
This program is dangerous because it optimizes moral hazard, but it also violates the express purpose of the PCA law to resolve bank problems at the lowest cost to the FDIC and the taxpayers. Providing taxpayer “capital insurance” subsidies to insolvent or troubled banks increases the taxpayers’ costs. TARP II is designed to provide a federal subsidy to insolvent and failing banks.

Additional reading on this subject:

"How to Clean a Dirty Bank", by Andrew Rosenfield, The New York Times, April 5, 2009.