1
FDIC Banking Review
Differentiating Among Critically
Undercapitalized Banks and Thrifts*
by Lynn Shibut, Tim Critchfield, and Sarah Bohn**
The Prompt Corrective Action (PCA) provisions
in Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) require that
regulators set a threshold for critically undercapi
talized institutions, and that regulators promptly
close institutions that breach the threshold unless
they quickly recapitalize or merge with a healthier
institution. Many economists expected these pro
visions to result in dramatically reduced loss rates,
or even zero loss rates, for bank failures.
Bank regulators set the threshold for critically
undercapitalized institutions to 2 percent tangible
capital. There are a number of reasons why a
threshold above O percent is appropriate. Since
the value of many types of bank assets is opaque
and difficult to estimate, and since troubled banks
have an incentive to overstate asset values, it is
* Reprinted with minor edits from Prompt Corrective Action in Banking: 10
Years Later, edited by George G. Kaufman, pp. 143–202, © 2002, with per
mission of Elsevier.
not unusual for the capital levels of troubled banks
to be overstated.1 Thus a threshold slightly above
O percent may better approximate insolvency on a
marketvalue basis. In addition, a higher thresh
old may increase the likelihood that a privatesec
tor solution can be found for a failing institution.
Critics have complained that the 2 percent capital
threshold set by regulators is too low. For exam
ple, Benston and Kaufman (1997, p. 154) argued
that it appears to be "much too low" and should
be increased, citing as evidence the likelihood that
most banks with 2 percent tangible capital already
have negative marketvalue capital, the ability of
troubled banks to change risk exposure quickly by
using derivatives, and the loss rates of post
FDICIA failures.2
** Lynn Shibut is the Section Chief for Consulting Services in the Division of
Insurance and Research, FDIC. Tim Critchfield is a Senior Financial Analyst
in the Division of Insurance and Research, FDIC. Sarah Bohn is in graduate
school at the University of Maryland. The authors wish to thank Tyler Davis,
Heather Gratton, Toni Holloman-Spinner, Terry Kissinger, Jennifer Merrill, and
Katherine Samolyk for assistance, and Charles Collier, Robert Ferrer, Grovetta
Gardineer, Alton Gilbert, Herb Held, James Marino, Rae-Ann Miller, Larry Mote,
Dan Nuxoll, John O’Keefe, Bob Storch, Bob Walsh, and Jim Wigand for valu
able comments.
1 If troubled banks overstate asset values, their capital is artificially
increased: this may allow them to avoid or delay adverse consequences.
The U. S. General Accounting Office (1992) documented the problem. There
is also ample evidence that examinations of troubled banks often result in
increased reserve levels (which cause capital to fall). See for example Dahl
et al. (1998) and Gunther and Moore (2000).
2 Throughout the article, loss rates are defined as the FDIC loss divided by
total assets of the failed bank.
1 2003, VOLUME 15, NO. 2
FDIC Banking Review
Differentiating Among Critically
Undercapitalized Banks and Thrifts*
by Lynn Shibut, Tim Critchfield, and Sarah Bohn**
The Prompt Corrective Action (PCA) provisions
in Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) require that
regulators set a threshold for critically undercapi
talized institutions, and that regulators promptly
close institutions that breach the threshold unless
they quickly recapitalize or merge with a healthier
institution. Many economists expected these pro
visions to result in dramatically reduced loss rates,
or even zero loss rates, for bank failures.
Bank regulators set the threshold for critically
undercapitalized institutions to 2 percent tangible
capital. There are a number of reasons why a
threshold above O percent is appropriate. Since
the value of many types of bank assets is opaque
and difficult to estimate, and since troubled banks
have an incentive to overstate asset values, it is
* Reprinted with minor edits from Prompt Corrective Action in Banking: 10
Years Later, edited by George G. Kaufman, pp. 143–202, © 2002, with per
mission of Elsevier.
not unusual for the capital levels of troubled banks
to be overstated.1 Thus a threshold slightly above
O percent may better approximate insolvency on a
marketvalue basis. In addition, a higher thresh
old may increase the likelihood that a privatesec
tor solution can be found for a failing institution.
Critics have complained that the 2 percent capital
threshold set by regulators is too low. For exam
ple, Benston and Kaufman (1997, p. 154) argued
that it appears to be "much too low" and should
be increased, citing as evidence the likelihood that
most banks with 2 percent tangible capital already
have negative marketvalue capital, the ability of
troubled banks to change risk exposure quickly by
using derivatives, and the loss rates of post
FDICIA failures.2
** Lynn Shibut is the Section Chief for Consulting Services in the Division of
Insurance and Research, FDIC. Tim Critchfield is a Senior Financial Analyst
in the Division of Insurance and Research, FDIC. Sarah Bohn is in graduate
school at the University of Maryland. The authors wish to thank Tyler Davis,
Heather Gratton, Toni Holloman-Spinner, Terry Kissinger, Jennifer Merrill, and
Katherine Samolyk for assistance, and Charles Collier, Robert Ferrer, Grovetta
Gardineer, Alton Gilbert, Herb Held, James Marino, Rae-Ann Miller, Larry Mote,
Dan Nuxoll, John O’Keefe, Bob Storch, Bob Walsh, and Jim Wigand for valu
able comments.
1 If troubled banks overstate asset values, their capital is artificially
increased: this may allow them to avoid or delay adverse consequences.
The U. S. General Accounting Office (1992) documented the problem. There
is also ample evidence that examinations of troubled banks often result in
increased reserve levels (which cause capital to fall). See for example Dahl
et al. (1998) and Gunther and Moore (2000).
2 Throughout the article, loss rates are defined as the FDIC loss divided by
total assets of the failed bank.
1 2003, VOLUME 15, NO. 2
FDIC Banking Review
Setting the thresholds involves making tradeoffs.
Peek and Rosengren (1996, p. 5O) summarized
them as follows:
It is easy to identify a problem bank at the time of
its failure. The challenge is to identify a problem
bank in time to prevent its failure or at least in
time to alter its behavior in order to limit the loss
es to the deposit insurance fund. Thus an appro
priate slogan for early intervention might be "the
earlier the better." However, such an approach
must be tempered by giving appropriate weight to
the costs associated with supervisory intervention
in banks that are incorrectly identified as "trou
bled."
In this article, we studied institutions insured by
the Federal Deposit Insurance Corporation
(FDIC) that crossed the 2 percent tangible capital
threshold or failed between 1994 and 2OOO. We
separated these banks3 into four groups (lowcost
failures, highcost failures, nearfailures that sur
vived, and nearfailures that were purchased), and
we analyzed differences among the groups. If
there are consistent differences that separate failed
banks (and particularly highcost failed banks)
from other seriously troubled banks, there may be
opportunities to improve the regulatory treatment
of troubled banks-either through a change in the
PCA threshold for a critically undercapitalized
bank or by other means.
This article begins by providing background infor
mation, including a discussion of related literature
and the tradeoffs associated with setting the
threshold for critically undercapitalized banks.
The article then discusses the data and methodol
ogy and reports the results of various comparisons
across groups. The final sections provide conclud
ing remarks and make recommendations.
Background and Literature Review
The PCA provisions in FDICIA were motivated
by a desire to reduce supervisory forbearance and
failure costs in the banking industry. Many peo
3 Throughout this article, we use the term banks to mean all FDIC-insured
depository institutions.
ple, including members of Congress, believed that
regulators should have supervised banks and
thrifts differently in the 198Os. Appendix 1 pro
vides a summary of these provisions.
Carnell (1997b) concisely described the overarch
ing goal of PCA: "to resolve the problems of
insured depository institutions at the leastpossible
longterm loss to the deposit insurance fund (i.e.,
to avoid or minimize loss to the fund)." The
means for achieving the goal center on incentives.
For banks, PCA was designed to reduce the
"moral hazard" inherent in federal deposit insur
ance by giving the owners and managers of trou
bled banks an incentive to avoid taking excessive
risks by encouraging them to maintain enough
capital and by limiting their discretion if capital is
impaired. For regulators, PCA was designed to
encourage aggressive action against troubled banks
by limiting their ability to practice forbearance
and by requiring audits after failures. PCA also
clarified the rules of the game for both bankers
and regulators.
Technically, the goal of PCA can be accomplished
by reducing either the loss rate of failed banks or
the failure rate of banks (or both). The limits trig
gered by the thresholds for an undercapitalized
bank focus largely on avoiding failure and thus
reducing the failure rate. In contrast, the closure
rules triggered by the threshold for a critically
undercapitalized bank focus more heavily on
reducing the loss rate by ensuring prompt closure
of nonviable banks. But the closure rules could
also reduce the failure rate by encouraging banks
to seek capital earlier than they would if closure
occurred when banks become insolvent on a book
value basis.4
4 Since the 2 percent threshold allows the bank only 90 days to improve its
condition before closure, the bank’s viability at this point is almost entirely
determined by events that occurred before it reached the threshold. If banks
have not begun seeking capital well before reaching the 2 percent threshold,
the 90-day time limit is tantamount to closure. However, regulators are
allowed to delay closure for up to 270 days (inclusive of the first 90-day peri
od) if the primary supervisor determines, and the FDIC concurs, that the delay
would better achieve the purpose of FDICIA. The act also prescribes extreme
ly narrow and explicit conditions for a delay beyond 270 days.
2003, VOLUME 15, NO. 2 2
Setting the thresholds involves making tradeoffs.
Peek and Rosengren (1996, p. 5O) summarized
them as follows:
It is easy to identify a problem bank at the time of
its failure. The challenge is to identify a problem
bank in time to prevent its failure or at least in
time to alter its behavior in order to limit the loss
es to the deposit insurance fund. Thus an appro
priate slogan for early intervention might be "the
earlier the better." However, such an approach
must be tempered by giving appropriate weight to
the costs associated with supervisory intervention
in banks that are incorrectly identified as "trou
bled."
In this article, we studied institutions insured by
the Federal Deposit Insurance Corporation
(FDIC) that crossed the 2 percent tangible capital
threshold or failed between 1994 and 2OOO. We
separated these banks3 into four groups (lowcost
failures, highcost failures, nearfailures that sur
vived, and nearfailures that were purchased), and
we analyzed differences among the groups. If
there are consistent differences that separate failed
banks (and particularly highcost failed banks)
from other seriously troubled banks, there may be
opportunities to improve the regulatory treatment
of troubled banks-either through a change in the
PCA threshold for a critically undercapitalized
bank or by other means.
This article begins by providing background infor
mation, including a discussion of related literature
and the tradeoffs associated with setting the
threshold for critically undercapitalized banks.
The article then discusses the data and methodol
ogy and reports the results of various comparisons
across groups. The final sections provide conclud
ing remarks and make recommendations.
Background and Literature Review
The PCA provisions in FDICIA were motivated
by a desire to reduce supervisory forbearance and
failure costs in the banking industry. Many peo
3 Throughout this article, we use the term banks to mean all FDIC-insured
depository institutions.
ple, including members of Congress, believed that
regulators should have supervised banks and
thrifts differently in the 198Os. Appendix 1 pro
vides a summary of these provisions.
Carnell (1997b) concisely described the overarch
ing goal of PCA: "to resolve the problems of
insured depository institutions at the leastpossible
longterm loss to the deposit insurance fund (i.e.,
to avoid or minimize loss to the fund)." The
means for achieving the goal center on incentives.
For banks, PCA was designed to reduce the
"moral hazard" inherent in federal deposit insur
ance by giving the owners and managers of trou
bled banks an incentive to avoid taking excessive
risks by encouraging them to maintain enough
capital and by limiting their discretion if capital is
impaired. For regulators, PCA was designed to
encourage aggressive action against troubled banks
by limiting their ability to practice forbearance
and by requiring audits after failures. PCA also
clarified the rules of the game for both bankers
and regulators.
Technically, the goal of PCA can be accomplished
by reducing either the loss rate of failed banks or
the failure rate of banks (or both). The limits trig
gered by the thresholds for an undercapitalized
bank focus largely on avoiding failure and thus
reducing the failure rate. In contrast, the closure
rules triggered by the threshold for a critically
undercapitalized bank focus more heavily on
reducing the loss rate by ensuring prompt closure
of nonviable banks. But the closure rules could
also reduce the failure rate by encouraging banks
to seek capital earlier than they would if closure
occurred when banks become insolvent on a book
value basis.4
4 Since the 2 percent threshold allows the bank only 90 days to improve its
condition before closure, the bank’s viability at this point is almost entirely
determined by events that occurred before it reached the threshold. If banks
have not begun seeking capital well before reaching the 2 percent threshold,
the 90-day time limit is tantamount to closure. However, regulators are
allowed to delay closure for up to 270 days (inclusive of the first 90-day peri
od) if the primary supervisor determines, and the FDIC concurs, that the delay
would better achieve the purpose of FDICIA. The act also prescribes extreme
ly narrow and explicit conditions for a delay beyond 270 days.
2003, VOLUME 15, NO. 2 2