Using a secret enforcement tool, federal regulators in 2005 tried to limit the growth of Vineyard Bank, which was making commercial real estate loans in Southern California at almost double the rate of its peers.
The limit was a secret even to new regulators who took over the bank’s supervision in 2006 and never found out about it, according to a report prepared by the U.S. Treasury Department’s Office of Inspector General in July 2010. Vineyard, based in Corona, California, kept growing.
Its loans eventually soured and it failed in 2009, costing the fund that insures customers’ deposits an estimated $470 million. More than 400 such failures since 2007 have cost the fund, which is fed by banks and backstopped by taxpayers, an estimated $88 billion. That volume shows the need for more transparency in bank regulation, which is largely conducted in the dark, said Paul Atkins, a former Republican commissioner at the Securities and Exchange Commission.
“Transparency is vital,” said Atkins, the managing director at Patomak Partners LLC, a financial services consulting firm in Washington. “It helps make regulators accountable and helps taxpayers better judge what their liabilities might be.”
At least 1,400 times last year, federal examiners told a bank to fix a problem that could imperil its health, according to data from the three agencies that regulate banks. The agencies didn’t reveal the names of the troubled banks or the nature and severity of their concerns. That information is kept from investors, customers and the public unless securities laws force the bank itself to disclose.
Preventing Bank Runs
Such secrecy is needed to prevent panic that might result in bank runs or investor sell-offs, making problems far worse, said representatives of the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., all of which regulate banks and financial institutions.
“Ninety-five percent of the corrective action we want to get from an institution, we get seamlessly and efficiently, and sometimes it involves nothing more than a bank examiner whispering in the ear of a compliance officer,” said Dan Stipano, deputy chief counsel at the OCC. “That kind of thing unfortunately for us is invisible and not necessarily measurable. You don’t see scalps on the wall.”
Informal regulatory approaches also mean the public can’t see when regulators do a poor job, said Viral Acharya, an author of several books on financial regulation who teaches at New York University’s Stern School of Business.
“The regulators should be accountable, and they should at least face some risk of disrepute in case of mistakes and oversights in the process,” Acharya said.
Not as Forceful
Examiners weren’t always as tough as they needed to be from 2006 through the third quarter of 2010, according to a June report by the Government Accountability Office, an investigative arm of Congress. “Regulators generally were successful in identifying early warning signs of bank distress, but the presence and timeliness of subsequent enforcement actions were often inconsistent,” according to the report.
Enforcement has gotten tougher since the 2008 credit crisis, said Ralph “Chip” MacDonald III, a partner at the Jones Day law firm in Atlanta who represents banks.
“Regulators are doing a good job, they are pretty much on top of their game,” MacDonald said. “The bias is toward acting quicker, as opposed to holding off.”
Most public oversight of bank examiners takes the form of post-mortem reviews: Inspectors general for the three regulatory agencies are required by law to audit any bank failure that costs the FDIC’s insurance fund more than $200 million. While that fund has a $100 billion line of credit with the U.S. Treasury, the FDIC can increase assessments on banks to keep it solvent.
Regulators’ main job is to ensure lenders’ safety and soundness through on-site examinations that involve looking through their books, assessing the risk they’ve taken on and monitoring their capital reserves. Examiners also gauge the acumen of the firms’ management teams. The largest banks have examiners on premises full time. Some banks are also reviewed by state authorities.
The Fed supervised 829 state member banks last year, along with more than 5,000 bank holding companies. The OCC oversees about 1,400 national banks, 631 federal savings associations and 48 branches of foreign banks. The FDIC regulates 4,715 institutions.
Public Enforcement Tools
All three generally employ the same enforcement tools. Public options include cease-and-desist orders, settlements in which banks agree to make changes. If banks don’t agree, regulators can file administrative charges. More urgent cases get a “Prompt Corrective Action” directive, a notice that a bank is likely to fail unless it takes immediate steps to fix problems. Banks can also face civil fines or have their charters revoked, among other public actions.
Non-public enforcement methods include so-called commitment letters, in which the firm agrees to make changes at the regulator’s request and “memorandums of understanding” between banks and their supervisors. Examiners can also require a bank’s board of directors to adopt resolutions detailing problems to be fixed. Each of these agreements is secret, voluntary and not enforceable through a judicial process or with sanctions.
In Vineyard Bank’s case, the FDIC and California state regulators required its board to adopt a 2005 resolution capping the bank’s growth at 25 percent a year, according to the Treasury inspector general’s report on Vineyard’s failure.
New Business Plan
That December, the bank applied for a national charter, and then went under the OCC’s jurisdiction in May 2006. The new regulators approved a Vineyard business plan that allowed for total asset growth of 33 percent growth in the first year. They also gave Vineyard the second-highest health rating.
The OCC examiners never found the board resolution capping growth at 25 percent, according to the report.
“It was surprising to us” that they didn’t find the resolution, said Donald Benson, an audit director at the inspector general’s office. The resolution was mentioned at least three times in minutes of Vineyard board meetings, and the OCC had access to those documents, according to the report.
OCC regulators took no formal or informal action against Vineyard until July 2008, when they required the bank to increase its capital levels in a public order, according to the July 2010 inspector general’s review.
“By then, the bank’s problems had become too large and too severe to resolve,” the report said. In 2007, commercial real estate loans represented 626 percent of Vineyard’s total capital, while the median for its peer banks was 381 percent, according to the report.
OCC spokesman Robert Garsson and FDIC spokesman David Barr declined to comment on Vineyard.
Norman Morales, who was president of Vineyard Bank until 2008, couldn’t be reached for comment. In June, he agreed to pay a $25,000 fine to settle the OCC’s allegations that he’d had the bank pay for some of his personal expenses. Morales didn’t admit or deny wrongdoing. Glen Terry, who was appointed Vineyard’s president less than a year before the bank closed, declined to comment.
In most cases, informal actions succeed in getting banks to comply with regulators’ directives, said Serena Owens, an associate director for risk management and supervision at the FDIC.
“By definition, the problems addressed by an informal action do not pose a serious risk warranting a formal, enforceable order containing a corrective program,” Owens said.
Discretion on Disclosure
Regulators have discretion on whether to disclose informal enforcement actions, said Thomas Vartanian, a partner at the law firm Dechert LLP in Washington who advises financial-services companies on regulatory and enforcement matters.
“Federal banking agencies can disclose pretty much what they want, subject to trade secret and other narrow supervisory exclusions,” Vartanian said.
The 2010 Dodd-Frank Act required the Fed to impose enhanced standards for capital, liquidity and risk management for banks with assets of more than $50 billion and non-bank financial companies deemed systemically important. While the law also empowered the Fed to require “enhanced public disclosures” from financial institutions, officials haven’t yet described any plans for doing so on enforcement matters.
Regulators for all three federal agencies gauge the health of banks with ratings known as CAMELS -- for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. Typically, these ratings, which range from 1, the best, to 5, aren’t disclosed, since downgrades might spur panic among depositors and investors.
In the absence of transparency, the agencies’ standards for setting CAMELS ratings can diverge. During an FDIC board meeting called at 10 p.m. on Nov. 23, 2008, members were told that unless they helped rescue Citigroup Inc. (C), its national banks might not have enough cash to do business the next morning, according to FDIC documents obtained through the Freedom of Information Act by the public interest group Judicial Watch.
At the time, the OCC gave Citigroup’s banking subsidiary a liquidity rating of 3, according to minutes of the meeting.
Then-FDIC Chairman Sheila Bair asked why the rating was that high “when the OCC was on the verge of having to close” Citigroup’s national banks. Then-Comptroller of the Currency John C. Dugan responded that the rating was already taking into account the government help that the board was discussing that night.
“Director Dugan said he thought the ability to contemplate government assistance enabling an institution to achieve adequate liquidity had been the standard,” according to the minutes. Bair said that wasn’t the standard for FDIC regulators, the minutes show.
Dugan, now head of law firm Covington & Burling’s financial institutions practice in Washington, said he stands by his remarks as reflected in the board minutes. Disclosing CAMELS ratings would risk increasing doubts about banks’ safety and soundness without increasing the quality of supervision, he said. Bair, now a senior adviser to the Pew Charitable Trusts, declined to comment.
“Citi is a fundamentally different company today than it was before the crisis,” said Jon Diat, a spokesman for the New York-based bank. It had $447 billion in cash and available-for- sale securities on Sept. 30, he said.
The largest banks, including Citigroup, retain “an implicit call on taxpayer-funded bailouts,” said NYU’s Acharya. For that reason, their health ratings ought to be published, after a delay, so taxpayers can judge regulators’ work, he said.
“What I find hard to accept is that currently we don’t make supervisory reports public, even with a lag,” he said. “I don’t see any good justification for that.”
Regulators are already held responsible when their supervision doesn’t work, said Scott Alvarez, the general counsel for the Fed’s Board of Governors.
“We will be accountable if one of these institutions gets in trouble,” he said. “But everything they do wrong isn’t leading them to failure.”
Lesser missteps don’t require formal action, and examiners need mechanisms for “informal give and take” with banks, Alvarez said.
That sort of approach didn’t work for Irwin Union Bank and Trust Co. of Columbus, Indiana, which received a series of informal enforcement orders from the Federal Reserve Bank of Chicago in 2001, 2002, 2003, 2005, 2007 and 2008, according to an inspector general’s report. Indiana state examiners closed Irwin Union on Sept. 18, 2009; the FDIC estimates the failure cost its insurance fund $872 million.
‘Early Warning Signs’
Fed examiners “identified key weaknesses, early warning signs and red flags” at the lender and “missed multiple opportunities to take more forceful supervisory action that may have reduced the loss,” the report said.
A chart in the report shows that Irwin Union’s reliance on brokered deposits, which are less stable than retail deposits, rose to about 35 percent of all deposits in 2008, up from less than 15 percent in 2003. The banking group’s total assets grew to $6.2 billion in 2005, up from $3 billion in 2001. As of Aug. 31, 2008, 84 percent of Irwin Union Bank’s total loan portfolio was in commercial real estate loans, according to the report.
William Miller, the former chairman and chief executive officer of Irwin Financial Corp., didn’t respond to telephone calls and an e-mail seeking comment.
“The report indicates that excessive risk-taking at IUBT was blatant, imprudent and risk-management capabilities did not keep pace,” said Mark Williams, an executive-in-residence at Boston University and a former Fed bank examiner. “These are obvious warning signs that early examinations should have picked up.”
While Fed regulators raised concerns about Irwin Union’s funding structure as early as 2003, they issued no formal orders until 2008, about a year before it failed. That agreement asked the financial group’s board to strengthen oversight, and sought plans to improve capital and liquidity. The Fed followed with a cease-and-desist order three days before Irwin Union closed.
The inspector general’s criticisms of individual cases in no way diminish the effectiveness of non-public enforcement, said Alvarez, the Fed board’s general counsel.
“A large amount of the time these informal actions are very successful in getting folks to remedy their problems,” he said.
One Irwin Union business offered loans of as much as 125 percent of a home’s value “regardless of whether Irwin Home Equity had the first or second lien position on the property,” the report said. Some of the loans were offered to subprime borrowers and applicants who weren’t asked for income verification, the report said.
Examiners found in 2002 that Irwin Union Bank and Trust was buying almost all of the loan production of Irwin Mortgage Corp., even though federal regulations restrict purchases to 50 percent -- another “red flag,” according to the report. The bank’s management “failed to comply” with a section of the Federal Reserve Act that limits such transactions, the inspector general’s report said. It’s unclear why the bank wasn’t cited.
“Violations of regulations do not necessarily result in enforcement actions,” said Vartanian, the lawyer with Dechert LLP. “There can be alternative remediation that satisfies regulators.”
Asked why there was no formal enforcement regarding that and other issues, Doug Tillett, a Chicago Fed spokesman, said “informal supervisory actions have proven to be successful in prompting a financial institution’s board of directors to address problems from within the organization.”
‘Formal and Informal’
“Supervisory authorities benefit from having both formal and informal methods to apply to various situations and enforcement actions,” Tillett said in an e-mailed statement.
Congress should keep regulators from ducking accountability, said U.S. Representative Kevin Brady, a Texas Republican who is vice chairman of the Joint Economic Committee.
“We shouldn’t give them a safe haven where they can hide these quasi-enforcement actions,” Brady said. “Given a choice, transparency is always better.”