A recent report by the U.S. Government Accountability Office (“GAO”) recommends that the federal banking regulators add new triggers to the prompt corrective action (“PCA”) framework for depository institutions that would require early and forceful regulatory action to address unsafe banking practices. The June 23 report, required by the Dodd-Frank Act, examines the outcomes of the use of PCA on the Deposit Insurance Fund (“DIF”) of the FDIC, the extent to which PCA thresholds, regulatory action and other financial indicators help address possible bank failure, and options for making PCA a more effective tool. The GAO’s analysis suggests that, although PCA has provided a mechanism to address financial deterioration in banks, the PCA framework did not prevent widespread losses to the DIF, which is a key goal of PCA. According to the report, every bank that underwent PCA because of capital deficiencies and failed since 2008 produced a loss to the DIF. The report also found that those losses were comparable as a percentage of assets to the losses caused by failed banks that did not undergo PCA. The GAO concluded that the PCA framework’s current triggers limit its ability to promptly address bank problems. To improve the effectiveness of the PCA framework, the report recommends that the Federal Reserve, FDIC and OCC consider additional triggers that would require “early and forceful regulatory actions tied to specific unsafe banking practices” and suggests adding a measure of risk to the capital category thresholds and modifying the capital ratios that place banks into PCA capital categories.

Nutter NotesThe GAO noted that the effectiveness of the current PCA framework is limited because of its reliance on capital, which can lag behind other indicators of a bank’s health. The report indicates that problems with a bank’s assets, earnings or management typically are present and visible before such problems affect bank capital. The GAO argued that, once a bank falls below the PCA capital thresholds, it may not be able to recover regardless of the regulatory action imposed. The report suggests that other financial indicators, including measures of asset quality and liquidity, may be better suited to predict future bank failure. In terms of adding one or more additional trigger mechanisms to PCA, the report suggests that a measure of asset quality or asset concentration would improve the likelihood that the PCA framework would reduce losses to the DIF because noncapital triggers were shown to be more effective in identifying those banks that failed without undergoing PCA. Another option – incorporating an institution’s risk profile into PCA capital categories – would add a measure of risk to the capital category thresholds beyond the existing risk-weighted asset component. The report also suggests that regulators consider changing accounting rules used to measure capital levels to enhance the effectiveness of PCA.