Prompt corrective action and bank efforts to recover from undercapitalization

Abstract

This study empirically examines the likelihood and timing of bank recoveries from positions of undercapitalization. Our findings indicate that: (1) There appears to be only a limited capacity for banks to ‘correct’ positions of undercapitalization by growth limitations or dividend restrictions; (2) the impact of profitability on recovery is greater the longer a bank remains undercapitalized; and (3) equity infusions are the primary mechanism by which banks can recapitalize quickly. This evidence is relevant to regulators in their implementation of the FDIC Improvement Act of 1991, which requires that undercapitalized banks take ‘prompt corrective actions’ to recapitalize quickly under threat of early closure.