Federal Deposit Insurance Corporation Improvement Research Articles

THE EFFECTS OF REGULATORY COMPLIANCE FOR SMALL BANKS AROUND CRISIS‐BASED REGULATION

AbstractIn this article I investigate the regulatory burden for small U.S. banks around major crisis‐based regulatory programs using measures of profit, cost, and productivity from 1991 to 2014. After the passage of the Federal Deposit Insurance Corporation Improvement Act, there is little evidence consistent with increased regulatory burden. After the passage of the USA PATRIOT Act, the percentage change in employees was positive, and average pay was higher for small banks. After the passage of the Dodd–Frank Act, five of six regime‐shift indicators were consistent with increased regulatory burden, with lower pretax return on assets, lower loans per employee, lower technology and fixed‐asset expenditures, and higher percentage change in employees and salaries‐to‐assets in panel regressions.

New evidence on the impact of economic conditions and banking legislation on the bank failure rate in the US, 1970 to 2014

Purpose This study aims to identify factors influencing the bank failure rate in the USA over the period from 1970 to 2014 with an emphasis on economic/financial factors on the one hand and on banking legislation on the other hand. Regarding the latter, this study empirically investigates four major banking statutes: the Community Reinvestment Act of 1977; the Depository Institutions Deregulation and Monetary Control Act of 1980; the Federal Deposit Insurance Corporation Improvement Act of 1991; and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. After adopting the technique of generalized method of moments (GMM), a robustness check in the form of autoregressive conditional heteroskedasticity (ARCH) is undertaken. Overall, the estimations imply that the bank failure rate was a decreasing function of the percentage growth rate of real gross domestic product (GDP) and the real interest rate yields on both three-month US Treasury bills and 30-year fixed-rate mortgages and an increasing function of the real cost of funds. In addition, there is strong evidence that the bank failure rate was increased by provisions in the Community Reinvestment Act of 1977 and the Depository Institutions Deregulation and Monetary Control Act of 1980, whereas the bank failure rate was decreased as a result of provisions in the Federal Deposit Insurance Corporation Improvement Act of 1991 and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Finally, there also is evidence that higher federal budget deficits elevated the bank failure rate. Design/methodology/approach After modeling the bank failure rate as a function of financial/economic variables and banking legislation, the times series from 1970 to 2014 is estimated by GMM and then by the ARCH techniques. Findings The results of the GMM and ARCH estimations imply that the bank failure rate in the US was a decreasing function of the percentage growth rate of real GDP as well as the real interest rate yields on both three-month US Treasury bills and 30-year fixed-rate mortgages and an increasing function of the real cost of funds. Furthermore, there is strong empirical support indicating that the bank failure rate was elevated by various provisions in the Community Reinvestment Act of 1977 and in the Depository Institutions Deregulation and Monetary Control Act of 1980, while the bank failure rate was reduced by certain provisions in the Federal Deposit Insurance Corporation Improvement Act of 1991 and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. There also is evidence that higher federal budget deficits increased the bank failure rate. Originality/value This study is the most contemporary (1970-2014) analysis of potential causes of the bank failure rate in the USA. The study also may be the first to apply the GMM and GARCH models to the problem. Also, some interesting policy implications are provided in the Conclusion.

The Reach and Effectiveness of FDICIA: Internal Controls and Audit Committee Regulation in Banking

Complex and overlapping regulations governing the conduct of audits in the banking industry are dominated by the internal controls and audit committee requirements of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). Empirical tests using confidential supervisory data show that banks subject to these requirements under FDICIA are capable of conferring benefits that are useful to regulators in monitoring their financial condition. These benefits, however, are not evident uniformly across time nor across banks that vary by inherent accounting risk.

Did the Financial Reforms of the Early 1990s Fail? A Comparison of Bank Failures and FDIC Losses in the 1986-92 and 2007-13 Periods

Two of the most significant banking reforms to come out of the banking problems in the late 1980s and early 1990s were the increase in capital requirements from Basel 1 and the prompt corrective action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The PCA provisions require regulators to shut down banks before book capital becomes negative. We compare failures and FDIC losses on commercial banks in the pre-FDICIA commercial bank crisis of the mid-1980s to early 1990s with that in the recent financial crisis. Using a sample of community and mid-sized banks, we find that almost all the same bank characteristics predict failure and high losses in the two crises. Our results imply that for these classes of banks, the two crises were very similar. We find that the failure rate in the recent period was driven more by severe economic conditions than by the increased concentrations in real estate lending. The analysis suggests that the combination of PCA with higher capital levels helped reduce failure rates in the recent period. In contrast, the analysis suggests that the reforms did not help with FDIC losses. FDIC losses on failed commercial banks were approximately 14% of failed bank assets over the 1986-92 period but increased to approximately 24% over the 2007-13 period. We find that the increased losses are not explained by variations in bank balance sheets or local economic conditions. Finally, we find that a discretionary accounting variable, interest accrued but not yet received, is predictive of both failure and higher FDIC losses.

Did the Financial Reforms of the Early 1990s Fail? A Comparison of Bank Failures and FDIC Losses in the 1986-92 and 2007-13 Periods

Two of the most significant banking reforms to come out of the banking problems in the late 1980s and early 1990s were the increase in capital requirements from Basel 1 and the prompt corrective action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The PCA provisions require regulators to shut down banks before book capital becomes negative. We compare failures and FDIC losses on commercial banks in the pre-FDICIA commercial bank crisis of the mid-1980s to early 1990s with that in the recent financial crisis. Using a sample of community and mid-sized banks, we find that almost all the same bank characteristics predict failure and high losses in the two crises. Our results imply that for these classes of banks, the two crises were very similar. We find that the failure rate in the recent period was driven more by severe economic conditions than by the increased concentrations in real estate lending. The analysis suggests that the combination of PCA with higher capital levels helped reduce failure rates in the recent period. In contrast, the analysis suggests that the reforms did not help with FDIC losses. FDIC losses on failed commercial banks were approximately 14% of failed bank assets over the 1986-92 period but increased to approximately 24% over the 2007-13 period. We find that the increased losses are not explained by variations in bank balance sheets or local economic conditions. Finally, we find that a discretionary accounting variable, interest accrued but not yet received, is predictive of both failure and higher FDIC losses.

Determinants of audit report lag in the banking industry: updated evidence

This study examines the determinants of audit report lag (ARL) in the banking industry. Using data from 2001–2010 and models developed from prior research for banks, the pooled sample results show that bank size measured by market capitalisation and profitability measured by return on assets are associated with shorter ARL. Extraordinary items and higher abnormal audit fees are associated with longer ARL. We find that these results are driven by large banks that are subject to internal control requirements under the Federal Deposit Insurance Corporation Improvement Act and Sarbanes-Oxley Act. We find that the audit of internal controls over financial reporting and the presence of material weaknesses in internal controls are associated with longer ARL in the large bank subsample. The study provides updated evidence on the determinants of audit report lag in the banking industry and finds that the determinants of ARL have changed over a period of regulatory and economic changes in the last decade.

Unintended consequences of the increased asset threshold for FDICIA internal controls: Evidence from U.S. private banks

We examine the unintended consequences of the 2005 increase from $500 million to $1 billion in the asset threshold for the Federal Deposit Insurance Corporation Improvement Act (FDICIA) internal control reporting requirements. We focus on a test sample of banks that increased their total assets from between $100 million and $500 million prior to the change in regulation to between $500 million and $1 billion within two years following the change. These “affected” banks are no longer subject to the internal control requirements but would have been had the regulation not been changed. We hypothesize that these affected banks are likely to make riskier loans, which will increase the likelihood of failure during the crisis period. We find evidence consistent with this hypothesis. Affected banks have higher likelihood of failure during the crisis period than banks from two different control samples. We also find that auditor reputation (i.e., whether the bank is audited by a Big 4 auditor or an industry specialist auditor) has a moderating effect on the likelihood of failure for these affected banks.

Impact of FDICIA Internal Controls on Bank Risk Taking

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was designed, among other things, to introduce risk-based deposit insurance, increase capital requirements, and improve banks’ internal controls. Of particular interest in this study are the requirements for annual audit and reporting of management’s and auditor’s assessment of the effectiveness of internal control for banks with $500 million or more in total assets (raised to $1 billion in 2005) for bank risk taking prior to the recent financial crisis and its consequent implications for bank failure and financial trouble during the crisis period. Using a sample of 1,138 banks, we provide evidence that banks required to comply with the FDICIA internal control requirements have lower risk taking in the pre-crisis period. Specifically, the volatility of net interest margin, the volatility of earnings, and Z score show less risk-taking behavior. Furthermore, these banks are less likely to experience failure and financial trouble during the crisis period.

Unintended Consequences of the Increased Asset Threshold for FDICIA Internal Controls: Evidence from U.S. Private Banks

We examine the unintended consequences of the 2005 increase from $500 million to $1 billion in the asset threshold for the Federal Deposit Insurance Corporation Improvement Act (FDICIA) internal control reporting requirements. We focus on a test sample of banks that increased their total assets from between $100 million and $500 million prior to the change in regulation to between $500 million and $1 billion within two years following the change. These “affected” banks are no longer subject to the internal control requirements but would have been had the regulation not been changed. We hypothesize that these affected banks are likely to make riskier loans, which will increase the likelihood of failure during the crisis period. We find evidence consistent with this hypothesis. Affected banks have higher likelihood of failure during the crisis period than banks from two different control samples. We also find that auditor reputation (i.e., whether the bank is audited by a Big 4 auditor or an industry specialist auditor) has a moderating effect on the likelihood of failure for these affected banks.

Impact of FDICIA internal controls on bank risk taking

The Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 was designed, among other things, to introduce risk-based deposit insurance, increase capital requirements, and improve banks’ internal controls. Of particular interest in this study are the requirements for annual audit and reporting of management’s and auditor’s assessment of the effectiveness of internal control for banks with $500 million or more in total assets (raised to $1 billion in 2005). We study the impact of these requirements on banks’ risk-taking behavior prior to the recent financial crisis and the consequent implications for bank failure and financial trouble during the crisis period. Using a sample of 1138 banks, we provide evidence that banks required to comply with the FDICIA internal control requirements have lower risk taking in the pre-crisis period. Specifically, the volatility of net interest margin, the volatility of earnings, and Z score show less risk-taking behavior. Furthermore, these banks are less likely to experience failure and financial trouble during the crisis period.

Federal Reserve Lending to Troubled Banks During the Financial Crisis, 2007-10

Numerous commentaries have questioned both the legality and appropriateness of Federal Reserve lending to banks during the recent financial crisis. This article addresses two questions motivated by such commentary: 1) Did the Federal Reserve violate either the letter or spirit of the law by lending to undercapitalized banks? 2) Did Federal Reserve credit constitute a large fraction of the deposit liabilities of failed banks during their last year prior to failure? The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) imposed limits on the number of days that the Federal Reserve may lend to undercapitalized or critically undercapitalized depository institutions. We find no evidence that the Federal Reserve ever exceeded statutory limits during the recent financial crisis, recession and recovery periods. In most cases, the number of days that Federal Reserve credit was extended to an undercapitalized or critically undercapitalized depository institution was appreciably less than the number of days permitted under law. Furthermore, compared with patterns of Fed lending during 1985-90, we find that few banks that failed during 2008-10 borrowed from the Fed during their last year prior to failure, and only a few had outstanding Fed loans when they failed. Moreover, Federal Reserve loans averaged less than 1 percent of total deposit liabilities among nearly all banks that did borrow from the Fed during their last year. It is impossible to know whether the enactment of FDICIA explains differences in Federal Reserve lending practices during 2007-10 and the previous period of financial distress in the 1980s. However, it does seem clear that Federal Reserve lending to depository institutions during the recent episode was consistent with the Congressional intent of this legislation.

Impact of Banking Statutes, Housing-Market, Economic, and Financial Conditions on Bank Failures in the U.S, 1970-2008: GARCH Estimates

Bank solvency questions and bank failures in the U.S. have become issues of renewed concern in recent years. Given the significance of bank solvency and bank failures for the health and stability of the U.S. economy, it is imperative to have insights into those factors that systematically influence bank failures. Accordingly, this empirical study seeks to identify those factors influencing the bank failure rate in the U.S. over the period 1970 through 2008, with emphasis on: (1) recent major banking statutes, including: the Community Reinvestment Act of 1977, CRA, the Federal Deposit Insurance Corporation Improvement Act of 1991, FDICIA, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, RNIBA, and the Gramm-Leach-Bliley Act, GLB Act; (2) the health of the housing market; and (3) general economic and financial market conditions. The GARCH estimates indicate that FDICIA acted to reduce bank failures, whereas (presumably by increasing competition and/or increasing costs through branch bank expansion) RNIBA induced a net increase in bank failures in the U.S. The GARCH evidence implies that the CRA also led to increased bank failures in the U.S., arguably by exposing banks to greater credit risk. The evidence also indicates that the GLB Act may also have acted to induce more bank failures. Furthermore, a stronger housing market was found to reduce bank failures, whereas a stronger economy as well as more favorable interest rate conditions reduced bank failures.

The Bank Failure Rate, Economic Conditions and Banking Statutes in the U.S., 1970–2009

Given the significance of bank failures for the economic health and stability of the U.S., it is imperative to have insights into factors that systematically influence bank failures, including major federal government banking statutes that are implemented. Accordingly, this exploratory study investigates factors influencing the bank failure rate in the U.S. over the period 1970 through 2009, with emphasis on two major banking statutes, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) and the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (RNIBA). After allowing for a variety of economic and financial variables in the U.S. over the study period, the evidence strongly implies also that FDICIA acted to reduce bank failures whereas RNIBA (presumably by increasing competition and/or increasing costs through branch bank expansion) induced a net increase in bank failures in the U.S.

Determinants of bank failures in the US revisited

This study investigates factors influencing the bank failure rate in the United States over the period 1970 to 2007. The bank failure rate was found to be an increasing function of the unemployment rate, the average cost of funds, volatility of the S&P 500 Stock Index, and charge-offs as a percentage of outstanding loans and a decreasing function of the mortgage rate on new 30-year fixed-rate mortgages. The evidence implies also that the Federal Deposit Insurance Corporation Improvement Act acted to reduce bank failures whereas the Riegle–Neal Interstate Banking Act of 1994 may inadvertently have (by increasing competition and/or increasing costs through branch bank expansion) induced increased bank failures.

An Empirical Analysis of Auditor Independence in the Banking Industry

ABSTRACT: We examine auditor independence in the banking industry by analyzing the relation between fees paid to auditors and the extent of earnings management through loan loss provisions (LLP). We also examine whether this relation differs across large banks whose managements are required under the Federal Deposit Insurance Corporation Improvement Act to evaluate internal control over financial reporting and whose auditors must attest to the effectiveness of such internal controls, and small banks that are not subject to those requirements. We find that unexpected auditor fees are unrelated to earnings management for large banks. For small banks, we find greater earnings management via under-provisioning of LLP by banks that pay higher unexpected total and nonaudit fees to the auditor. These results suggest that auditor fee dependence on the audit client is associated with earnings management via abnormal LLP and is a potential threat to auditor independence for small banks. Our findings are relevant to policymakers contemplating new regulations in light of the recent banking crisis.

The Cost Effectiveness of the Private-Sector Resolution of Failed Bank Assets

In this paper, we examine how the cost of resolving bank failures differs between an FDIC liquidation and a private-sector resolution where the assets remain in the banking system. Our findings show that private-sector resolutions do not deliver the expected cost-savings prior to the passage of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. We obtain this result when we control for the selection bias that arises from the resolution process. In contrast, during the post-FDICIA period, we observe that private-sector resolutions yield significant cost savings over FDIC liquidations. We also find that the direct costs are lower for private-sector resolutions over the sample period. We derive these results from a sample that spans all failures between 1986 and 2007.

The federal deposit insurance corporation improvement act, bank internal controls and financial reporting quality

Altamuro and Beatty (2009) examine financial reporting quality before and after the Federal Deposit Insurance Corporation Improvement Act (FDICIA). They document increases in the validity of the loan-loss provision, earnings persistence, predictability of future cash flows and reductions in benchmark-beating for banks complying with FDIC's internal control regulations relative to non-complying banks. Our discussion focuses on Altamuro and Beatty's interpretation of the results, specifically that the internal control provision of FDICIA improved financial reporting quality. In this paper, we provide a brief overview of FDICIA in an attempt to assess the importance of FDIC's internal control regulations. We then review the findings of other studies on internal control regulations with the goal of evaluating what new insights we gain from Altamuro and Beatty. Next, we report new evidence relating to the sub-groups driving the changes in financial reporting quality surrounding the FDICIA. Finally, we discuss the results in the context of the current financial crisis and suggest avenues for future research.

The Federal Deposit Insurance Corporation Improvement Act, Bank Internal Controls and Financial Reporting Quality

Altamuro and Beatty (2009) examine financial reporting quality before and after the Federal Deposit Insurance Corporation Improvement Act (FDICIA). They document increases in the validity of the loan loss provision, earnings persistence, predictability of future cash flows and reductions in benchmark-beating for banks complying with FDIC’s internal control regulations relative to non-complying banks. Our discussion focuses on Altamuro and Beatty’s interpretation of the results, specifically that the internal control provision of FDICIA improved financial reporting quality. In this paper, we provide a brief overview of FDICIA in an attempt to assess the importance of FDIC’s internal control regulations. We then review the findings of other studies on internal control regulations with the goal of evaluating what new insights we gain from Altamuro and Beatty. Next, we report new evidence relating to the subgroups driving the changes in financial reporting quality surrounding FDICIA. Finally, we discuss the results in the context of the current financial crisis and suggest avenues for future research.

The Sarbanes-Oxley Act of 2002 (SOX): A redundant regulation for the banking industry

The aim of the paper is to show that, for banking institutions, Sarbanes-Oxley (SOX) regulation is redundant, and imposes additional unnecessary compliance costs. The banking industry in the United States is heavily regulated. Each of the regulations that banks must follow was developed in isolation by various governing bodies, causing many regulatory provisions to be redundant, overlapping or contradictory. In the wake of the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 was the Securities and Exchange Commission's answer to restoring investor confidence. However, the enactment of SOX was done hastily, and its effects on industries like the banking sector were largely ignored. SOX overlaps with previously enacted banking regulations such as the Federal Deposit Insurance Corporation Improvement Act, Bank Secrecy Act (BSA)/Anti-Money Laundering Directive (AML) and Basel II, among others. The redundant nature of SOX is costing banking institutions large sums of time and money. It is essential that banks strive to achieve a single compliance framework that can manage all of the regulations to which the bank is subject in order to mitigate the costs of redundancy.

Evidence of Improved Monitoring and Insolvency Resolution after FDICIA

To realign supervisory and market incentives, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) adjusts two principal features of federal banking supervision. First, it requires regulators to examine insured institutions more frequently and makes them accountable for exercising their supervisory powers. Second, the Act empowers regulators to wind up the affairs of troubled institutions before their accounting net worth is exhausted. Using 1984-2003 data on the outcome of individual bank examinations, this paper documents that the frequency of rating transitions and the character of insolvency resolutions have changed substantially under FDICIA. The average interval between bank examinations has dropped for low-rated banks in the post-FDICIA era. Examiner upgrades have become significantly more likely in the post-FDICIA era even after controlling for the state of the economy. However, in recessions managers are slower to correct problems that examiners identify. As a result, during downturns upgrades become less likely and absorptions become more likely. Giving the FDIC authority to wind up troubled banks before their tangible net worth is exhausted has reduced the role of government in the insolvency-resolution process. Consistent with an hypothesis that FDICIA has improved incentives, our data show that a markedly larger percentage of troubled banks now search for a merger partner rather than trying to stay in business until the regulators force them to fail. This greater reliance on quasi-voluntary mergers is observable both within and across various stages of the business cycle. These findings suggest that supervisory interventions became more effective at banks during the post-FDICIA era.