Nov. 10 (Bloomberg) -- At least three U.S. banks failed in the past year after the Federal Deposit Insurance Corp. deemed them healthy enough to qualify for a program that reduced the time examiners spent on reviews by at least 20 percent.

The three lenders -- FirstCity Bank in Stockbridge, Georgia, Security Pacific Bank in Los Angeles and 1st Centennial Bank in Redlands, California -- were among the banks included in the agency’s Merit program, designed to increase efficiency by focusing examiners’ attention on weaker firms. The program, launched in 2002, was terminated in March 2008 after examiners complained that the guidelines usurped their judgment.

“The program was misconceived from the beginning,” said Colleen Kelley, president of the National Treasury Employees Union, which represents the examiners. “Employees believed the procedures were directed more at reducing examination hours than at ensuring proper supervision.”

Participation in the program by the three banks was mentioned in reports that the FDIC’s Office of Inspector General issues on most institutions it closes. More banks subject to Merit exams may have been among the 120 institutions closed by the FDIC this year, the most since 1992, according to Deputy Inspector General Fred W. Gibson. Some reports may not have mentioned that the failed banks were included in the program and others haven’t been released yet, he said.

‘Missed a Lot’

More than 40 percent of all bank examinations conducted by the FDIC between 2004 and 2007 were shorter Merit reviews, according to Greg Hernandez, a spokesman for the agency.

“It’s a reasonable supposition that a lot more of the banks that failed were in the program if you just look at the percentages,” said Bert Ely, a banking consultant and chief executive of Alexandria, Virginia-based Bert Ely & Co. “It’s also clear that they missed a lot of things at the Merit banks if you look at how much those banks lost.”

The three banks that failed caused losses to the agency’s insurance fund of $535 million.

FDIC officials said the bank failures were the result of a decline in real estate prices rather than lax supervision.

“Economic conditions are the driver of banking conditions, not the examination process,” said Steven Fritts, associate director for risk management and policy at the agency.

Merit Program

The Merit program -- the name is an acronym for Maximum Efficiency, Risk-focused, Institution Targeted -- initially covered banks with $250 million or less in assets, high ratings from regulators and capital ratios of at least 10 percent. The program was expanded in 2004 to include banks with as much as $1 billion in assets. Examiners were told to reduce the time spent reviewing banks and to scrutinize fewer loan documents.

The 2005 audit by the FDIC’s watchdog found that examiners spent 27 percent fewer hours reviewing the 818 banks that qualified the previous year than they did before the program began. They also examined fewer loans and loan documents -- between 21 percent and 25 percent of the total, down from 36 percent to 50 percent -- according to a paper by Christopher Straw published in New York University Law School’s Journal of Legislation and Public Policy in 2007 citing FDIC data.

“Over the last 10 years, the FDIC’s ability to ensure the safety and soundness of the U.S. banking industry has once again been significantly undermined,” wrote Straw, at the time a law clerk to Maine Supreme Judicial Court Judge Jon D. Levy. “Bowing to pressure from the banking industry, Congress and the FDIC have instituted high-risk policies that threaten the integrity of the U.S. financial system.”

Straw, now an attorney at Wilmer Cutler Pickering Hale & Dorr in Boston, declined to comment.

Dodd’s Proposal

Concern about rising bank failures and the cost have spurred a debate in Congress over ways to improve bank supervision. Christopher Dodd, chairman of the Senate Banking Committee, proposed legislation today to create a single regulator that would strip the FDIC and Federal Reserve of their supervision authority, which the agencies are resisting. Dodd has said the system lets lenders choose among multiple charters and shop for the most lenient supervisor, while agencies are engaged in a “race to the bottom” to win oversight of banks and thrifts.

Edward Kane, a professor of finance at Boston College, said that reduced supervision allowed some banks to build dangerous concentrations of real estate and construction loans.

“A lot of what went on in those good years was called deregulation,” said Kane, who consults for the World Bank and is a senior fellow at the FDIC’s Center for Financial Research. “That was not really correct. It was de-supervision.”

FirstCity Bank

FirstCity Bank, with four branches in Georgia, had real estate construction and development loans equal to 711 percent of its capital at the end of 2006, compared with 101 percent at its peers. The bank qualified for a Merit exam in January 2007, according to the inspector general’s report about the lender.

Examiners reviewed 18 percent of the bank’s loans that year compared with 37 percent in 2005, before it qualified for the Merit program, the report said. Exam hours fell to 457 from 776. When FirstCity failed on March 20 with $297 million in assets, it cost the FDIC’s insurance fund $100 million.

Regulators should be concerned any time real estate development loans surpass 100 percent of a bank’s capital, said Walter J. Mix III, a managing director at Emeryville, California-based LECG LLC, a financial services advisory company, and a former commissioner of the California Department of Financial Institutions.

“That’s the stuff that goes first when the cycle turns,” Mix said.

Security Pacific

Security Pacific Bank, which qualified for a Merit review in 2006, was closed on Nov. 7, 2008. Substandard and non-current loans at the bank, which had four branches in or near Los Angeles, went from none in 2006, the year of the Merit exam, to $133 million in August 2008, according to an inspector general’s report, which said the agency had failed to take “timely supervisory action” after identifying problems at the lender. Security Pacific had assets of $540 million and caused $208 million in losses to the FDIC’s insurance fund.

At 1st Centennial Bank, which underwent Merit exams in 2004 and 2006, construction and development loans were more than 600 percent of its capital, according to the agency’s watchdog. Non- current loans soared to $110 million in 2008 from $2.2 million in 2004. The bank, owned by 1st Centennial Bancorp., had six branches in southern California. When it was closed on Jan. 23, it had assets of $784 million. Losses to the insurance fund were $227 million. The parent company filed for bankruptcy protection on March 25.

Executives at the three banks couldn’t be reached for comment.

‘Shortcuts’

“If you take shortcuts during the good times, you’re going to pay for it in the bad times,” said Nicholas Ketcha, a former director of the FDIC’s division of supervision and now a managing director with FinPro Inc., a bank consulting company in Liberty Corner, New Jersey. “I don’t think there’s any substitute for the examiners doing full-scope exams regularly. You build up a framework of knowledge so that when you have these problem situations you know how to respond.”

Kelley, the union president, voiced a similar concern.

“Substituting Merit exams for full-scope examinations made it less likely that FDIC employees would be in a position to see if a previously strong bank was beginning to slide in the wrong direction,” Kelley said in an e-mail.

Shrinking Staff

When the Merit program began in 2002, the FDIC staff had shrunk to 5,430 people from 6,452 in 2000 and 22,586 in 1991, near the end of the savings and loan crisis. After bottoming at 4,500 in 2007, the number has been increased to more than 6,000.

The decision to reduce examination hours for some banks “was independent” of staffing levels, the FDIC’s Fritts said.

Instead, the program was designed to improve efficiency by focusing reviews on banks and bank functions that posed the greatest risk, according to the 2005 inspector general’s report.

Examiners were told they needed to justify doing more loan reviews than specified by the Merit program, according to a Jan. 27, 2004, memo to regional directors from Michael Zamorski, the agency’s director of bank supervision. They were also encouraged to reduce scrutiny of banks that didn’t qualify for the program when appropriate, the memo said.

The program was halted because of declining staff morale and because the guidelines were no longer needed, according to Fritts.

‘Box-Checkers’

“The primary reason was that the examiners feel that the holy grail of supervision is using their judgment,” said Fritts. “They felt they were being turned into rigid box- checkers. It was a morale issue.”

While other bank regulators focus more on weak institutions than stronger ones, they haven’t codified reductions in examination hours, officials at the agencies said.

Kevin Mukri, a spokesman for the Office of the Comptroller of the Currency, which oversees about 1,650 nationally chartered banks, and William Ruberry, a spokesman for the Office of Thrift Supervision, which supervises about 800 thrifts, said that examiners can exercise their judgment on how much attention each institution requires.

The Merit program still has supporters.

“I can understand why it was suspended last year, but I hope they reinstate it,” said Christopher Cole, a lawyer for the Independent Community Bankers of America, an organization that represents smaller banks and pressed for the program as a way of easing regulatory burdens. “We were a strong proponent of Merit, and we argued for it. Let’s give a pass to more well- capitalized banks.”

That view is shared by Robert Clarke, comptroller of the currency from December 1985 to February 1992 and now a senior partner at Bracewell & Giuliani, a New York law firm.

‘Public Policy Failure’

“Risk-based supervision is exactly the way it ought to be done,” Clarke said. “Ninety-five percent of the banks could fix their problems on their own, and they should be allowed to do that.”

The FDIC’s division of research and statistics reached a different conclusion in a 1997 book titled “History of the Eighties -- Lessons for the Future.” The study examined the causes of the financial crisis that led to the collapse of more than 1,600 banks and 1,300 thrifts between 1980 and 1994.

Before 1976, the FDIC gave all banks a full exam every year. By the mid-1980s, as a result of deregulation, some highly rated banks were examined every five years, and lower-rated banks could go as long as three years between exams. By the end of 1986, more than 1,800 commercial banks under the agency’s supervision hadn’t been examined in three years, the study said.

“The decisions that caused examiner levels to be reduced during the first half of the 1980s were a public policy failure,” the book said. “It is reasonable to assume, although impossible to demonstrate empirically, that if examination frequency had not been reduced, problems would have been detected earlier and losses to the insurer reduced.”

To contact the reporter on this story: James Sterngold in New York at jsterngold2@bloomberg.net

Last Updated: November 10, 2009 12:57 EST