The Use of Capital Ratios to Trigger Intervention in Problem Banks: Too Little, Too Late

Abstract

A wave of depository institution failures and dramatic losses to deposit insurance funds occurred in the 1980s and continued into the 1990s. In response, the Congress passed a series of bank regulatory acts intended to address the problems that led to the crisis and prevent its recurrence. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was the capstone of this transformation of banking legislation, with two key provisions designed to reduce the cost of troubled banks to the deposit insurance fund: early closure of failing institutions, and early supervisory intervention in problem banks, referred to as prompt corrective action.> This article considers whether the capital ratio thresholds that trigger prompt corrective action intervention provide sufficient lead time for successful intervention at troubled banks. The study finds that because prompt corrective action is based on a lagging indicator of a bank's financial health, it is likely to trigger intervention in problem banks only after they have been identified by examiners, who rely on far more information that the capital ratio. The authors propose two simple measures to improve the current triggers for prompt corrective action.

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