The Region

Are Banking Regulators Tough Enough?

An Analysis of Recent Enforcement Actions

Karen Grandstrand | Assistant Vice President, Bank Supervision

Published September 1, 1992  | September 1992 issue

A recent House subcommittee investigative report accuses banking regulators of lax supervision and recommends that regulators more strongly enforce banking rules and regulations.

The banking industry contends that the opposite is true, that the regulators have become overzealous bloodthirsty bureaucrats.

The regulators, clearly feeling caught in the middle, contend that they are tough but fair and are taking strong measures consistent with their duty to the public.

These divergent views on how the regulators (bank and thrift) are using their powers are, of course, mere opinions related to the points of view of Congress, the industry and the regulators. But one question remains that can be answered without relative bias: Are regulators actively enforcing banking laws and, if so, what types of enforcement actions are being pursued and why?

Recent Trends ...

A review of enforcement actions later in this article reveals that the four federal regulators have been anything but lax. These four are the Federal Deposit Insurance Corp. (FDIC) and the Office of the Comptroller of the Currency (OCC), which regulate commercial banks; the Federal Reserve System, which regulates banks and bank holding companies; and the Office of Thrift Supervision (OTS), which regulates the savings and loan (S&L) industry. Since the S&L debacle inspired Congress to begin passing get- tough legislation in 1989, the following have occurred:

Enforcement actions have increased. Under congressional authority, regulators use enforcement actions to pursue financial institutions and individuals who violate laws, engage in unsafe and unsound banking practices, or engage in breaches of fiduciary duties (trust) related to financial institutions.

These enforcement actions can seek a range of remedies, including corrective action (an example is a cease and desist order that requires an institution or individual to follow a certain course of action); civil money penalties; or the removal of an individual from an institution or from the banking industry. Agency actions range from formal to informal. Formal actions are generally used to address matters of greatest regulatory concern.

  • Agencies are relying heavily on formal actions.
  • Actions against individuals are increasing. Historically, most enforcement actions tended to be directed at the entity in trouble—the bank, thrift or holding company. Now, the agencies are focusing more on officers, directors and other institution-affiliated parties, such as accountants and attorneys.
  • Regulators are aggressively using civil money penalty actions.
  • Criminal referrals are increasing.
  • Also, these trends are expected to continue into the near future.

... Reflect a Changing Regulatory Environment

To gain an appreciation for how the regulatory environment has changed, it is useful to step back to 1989. Far-reaching legislation, aggressive agency pronouncements and pro-regulator court decisions dating from that time have shaped and given rise to our current environment. A sampling of these events follows:

The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) was signed by President Bush in August 1989, and was Congress' response to the S&L debacle. Congress and the public believed that more than economic uncertainty had contributed to the failure of financial institutions in the 1980s; a fair number believed that abuse and misconduct by the insiders of these institutions had caused the failures and the resulting multi-billion dollar losses facing the U.S. government and its taxpayers.

New Powers For Regulators In Increased Focus On Individuals

FIRREA was enacted to ensure that regulators had sufficient powers and enforcement tools to prevent an S&L-type crisis from ever recurring. When President Bush signed FIRREA, he said: "Beginning today, penalties for wrongdoing by officers and directors of insured institutions will be increased up to $1 million per day. And criminal penalties will be toughened from yesterday's slap on the wrist to the clang of a prison door. Those who try and loot the savings of their fellow citizens deserve, and will receive, swift and severe punishment."

FIRREA gave the federal banking regulators numerous new and enhanced enforcement powers over both financial institutions and individuals associated with them. For example, FIRREA:

  • Expanded the group of individuals subject to enforcement actions brought by the regulatory agencies. Historically, banking laws and the regulators focused on officers, directors and principal shareholders. FIRREA allows actions against all "institution- affiliated parties," which is defined to include attorneys, appraisers, accountants and other independent contractors.
  • Expanded the agencies' cease and desist authority so that, in addition to ordering an institution to cease and desist, an agency can order affirmative action, including restitution, restrictions on growth, the disposal of a loan or other asset, rescission of contracts and the employment of a qualified officer or employee.
  • Gave the federal banking agencies power to limit the activities or functions of an institution or institution-affiliated party.
  • Made it easier to remove an individual from an institution.
  • Expanded the statutory bases for the assessment of civil money penalties and increased the amounts of such penalties.
  • Made all new final enforcement orders public.

More Focus On Professionals

An August 1990 judicial opinion in the Lincoln Savings and Loan case was noteworthy because it specifically questioned why the nation was not focusing on the private sector individuals involved in the transactions that resulted in the looting of Lincoln. The opinion asked why none of the accountants, attorneys and other professionals had blown the whistle on the wrongdoing.

In the month following that judicial opinion, the chief counsel for the OTS gave a speech saying that the opinion must be taken to heart. Every fiduciary (a person in a position of trust) must know and honor his or her established legal obligations. He further said that under current law, such individuals owe fiduciary duties not only to their corporate entities and shareholders, but also to the federal insurer (that is, the OTS or FDIC).

More Regulatory Powers And Restrictions On Individuals

The Comprehensive Thrift and Bank Fraud Prosecution and Taxpayer Recovery Act of 1990 contained numerous provisions directed at individuals associated with financial institutions:

  • New crimes for violations of banking laws.
  • New powers for the regulators, including prejudgment attachment and restraining orders.
  • Restrictions on salary and legal expense prepayments.
  • Limitations on the ability of insured depository institutions and their holding companies to protect their officers and directors through parachutes, indemnification and insurance.

Calls For A "Tripwire" Approach To Enforcement and Prompt Intervention

A Government Accounting Office (GAO) report of March 1991 criticized federal supervision and enforcement practices. The GAO concluded that the banking agencies were not typically using the strongest enforcement actions available to them in dealing with regulatory problems. The agency recommended that the supervision and enforcement process be more predictable, more credible and less discretionary.

To accomplish this objective, the GAO recommended that Congress develop a regulatory "tripwire" system requiring prompt and forceful regulatory action tied to specific unsafe banking practices. The GAO envisioned an approach where the regulators would be required to take specific, increasingly more severe actions against an institution as its condition deteriorated.

Two months after the GAO report, the Court of Appeals for the Fifth Circuit issued an opinion that sent shock waves through the banking industry. In this case, the FDIC had issued a directive against a bank and its directors, requiring them to increase the bank's capital. Prior to issuance of this directive, the bank and its directors were not given a hearing but were given notice and 14 days to respond. The bank failed to comply and the FDIC sought and obtained an order from a federal district court requiring the bank, as well as its officers and directors, to restore the required capital levels.

The bank and directors appealed to the Fifth Circuit, arguing that the FDIC's action violated Fifth Amendment due process requirements and that issuance of capital directives is subject to court review. The Court of Appeals upheld the lower court's decision, holding that the FDIC's procedures (consisting of notice and an opportunity to respond) were sufficient, and that the issuance of a capital directive is solely committed to agency discretion and is not subject to further review.

Legislation Incorporating "Tripwire" Approach And Prompt Intervention—Less Due Process and Less Regulator Discretion

The industry has not yet felt the full effects of the most recent enforcement legislation—the Federal Deposit Insurance Corp. Improvement Act (FDICIA) of 1991. Its provisions are far-reaching and incorporate many of the enforcement themes running through the above-cited reports, speeches and court decisions.

First, FDICIA incorporates a "tripwire" approach to supervision and enforcement. The regulators have less discretion and are required to pursue certain prompt corrective action against institutions based primarily on five levels of capital adequacy. Second, the Act allows the regulators to take action without extensive prior notice and hearings (that is, due process).

Third, FDICIA increases the amount of regulator intervention in the affairs of financial institutions. The Act requires that the regulators issue operational and managerial standards; asset quality, earnings and stock valuation standards; and compensation standards. Fourth, FDICIA increases the role of the federal insurer—the FDIC.

New Enforcement Tools and Liability Standards

In March 1992, the OTS filed suit against the law firm of Kaye, Scholer, Fierman, Hayes & Handler seeking $275 million related to the firm's representation of Charles Keating's Lincoln Savings and Loan Association from 1988 to 1989. The OTS also sought a temporary cease and desist order to preserve the firm's assets and the assets of certain individual attorneys in the firm—an unprecedented move by a regulatory agency. The firm settled with the OTS for $41 million and sanctions against three of the firm's partners.

Finally, over the past couple of years there has been an ongoing debate in the courts over whether officers and directors of financial institutions are only liable for gross negligence or intentional misconduct, or whether they can be also liable for simple negligence. In February of this year, the Tenth Circuit Court of Appeals held that the FDIC could pursue an action based on simple negligence.

Regulatory Action Increases...

As noted earlier, a review of the data reveals that the regulators have answered Congress' call for increased enforcement. After a dramatic rise from 1989 to 1990—the first full year since the new wave of regulatory legislation—total initiated enforcement actions decreased among the four banking and thrift regulatory agencies, from 5,824 in 1990 to 5,671 last year. (Initiated actions are those begun within the calendar year, though not necessarily completed that same year.)

At first glance, it would appear that enforcement actions have been on the wane. However, while total actions decreased from 1990 to '91, formal actions increased 7.8 percent, from 2,630 to 2,836. Furthermore, if we eliminate consideration of one particular category of informal action—supervisory directives/letters, which are unilateral actions reported by only two agencies—then the remaining total of informal actions also increased, from 1,169 to 1,343, or 14.9 percent.

Of the formal actions, the four most common—cease and desist orders, formal written agreements, removal and prohibition orders, and civil money penalty orders—all increased between 1990 and 1991. Of those, cease and desist and civil money penalty actions showed the greatest increase. Cease and desist orders increased 70.4 percent and civil money penalty orders rose 87.9 percent. In total, in the two years since Congress has responded to the savings and loan crisis, the four most common formal actions rose dramatically.

Another important measure of regulatory enforcement is the number of actions completed (those begun earlier but ended during a particular year). By this measure also, formal actions have shown a marked increase in recent years, from 2,234 in 1990 to 2,453 in 1991, or 9.8 percent. Partial data for the first six months of 1992 suggests that formal actions are at least on par with last year, and may end up exceeding the 1991 total.

The number of removal and civil money penalty actions against individuals is also noteworthy. Removal actions initiated rose 17.8 percent; removal actions completed rose 41.8 percent. Civil money penalties assessed against individuals totaled 168 in 1990 and 319 in 1991 (an 89.9 percent increase).

As a final measure of regulatory action, we must note the increase in the number of referrals that the federal regulators made to the Department of Justice. In 1990, the agencies referred 31,360 cases, one year later they referred 40,061. These referrals are made by the agencies when banks or individuals are suspected of violating laws and regulations that result in criminal penalties. The agencies can pursue civil remedies (for example, civil money penalties) while the Department of Justice must pursue criminal penalties (for example, criminal fines, criminal restitution and imprisonment).

...As Agencies Take a more proactive Stance

In recent years the federal banking regulatory agencies have become increasingly proactive. In the early 1980s, enforcement actions were generally viewed as punitive measures to be employed after moral suasion and informal advice failed to work and an entity was in dire trouble. The mindset has changed. More actions are being pursued today against higher- rated institutions to address deteriorating trends. Further, the regulators are not relying exclusively on traditional rating systems. Actions are now pursued for such violations as the failure to timely file accurate regulatory reports, regardless of an institution's financial condition rating.

When it comes to actions against individuals, agencies are focusing not only on individuals that are shareholders, officers and directors, but other individuals affiliated with institutions such as attorneys, real estate appraisers and accountants. One case that has caught the attention of bankers, lawyers and the media is the Kaye, Scholer case discussed earlier. Indeed, the cover of the July 1992 issue of the American Bar Association's ABA Journal reads: "The Tremors Continue After Kaye Scholer." The OTS also recently announced its first case against a real estate appraiser.

Another sign of the times is that agencies are now devoting significant resources to the enforcement area. For example, the Minneapolis Fed started a separate Enforcement Actions Section within its Banking Supervision Department in 1989. The section was originally staffed with three examiners; now there are five. And, in 1991 the Federal Reserve System undertook the most extensive enforcement-related investigation ever conducted by the System to address the activities of the Bank of Credit and Commerce International S.A. (BCCI) in the United States and other countries. As a result of this investigation, the System (in 1991 alone) initiated 23 actions, including six actions seeking $257 million in civil money penalties.

Overall, the regulatory climate has changed dramatically. The regulators are more proactive, focusing on individuals and devoting additional resources to enforcement activities because of this changed environment. But this new environment is not entirely the making of the regulators. Large numbers of bank failures over the past decade, the S&L crisis and increasing calls for more consumer legislation have spurred Congress to pass laws that have broadened regulators' responsibilities. Federal agencies have been given many new and enhanced enforcement powers and are under ever-increasing pressure from Congress and the public to step up enforcement efforts.

The Future

The current regulatory climate is the result of the S&L debacle, the financial problems faced by the deposit insurance funds and the belief that these problems could have been minimized, if not avoided, by more aggressive enforcement laws and regulatory actions. This climate will continue until bank and thrift failures end, or at least decrease substantially, and the industry is perceived to be healthy again.

We will not see a decrease in enforcement actions or enforcement- related legislation in the near future. For example, Rep. Frank Annunzio of Illinois recently sponsored legislation that would force bank criminals to pay restitution more quickly, allow private citizens to act as "bounty hunters" to help recoup losses, and require government agencies to more closely coordinate their enforcement efforts.

Further, we have not yet seen the ramifications of the FDICIA legislation. Once the implementing regulations are in place, the banking industry will begin to feel the effects of "prompt intervention" —the regulators will be required to take quick, forceful action without providing extensive due process notice or hearings. Lawsuits will undoubtedly challenge the constitutionality of the regulators' new enforcement powers. Given the climate, courts will probably rule in favor of the regulators, allowing regulators to become even more aggressive.

Sheryl Britsch, Minneapolis Fed senior financial analyst, contributed to this article.

A Primer on Administrative Enforcement Actions

As discussed in the accompanying article, Congress has given each of the federal bank and thrift regulatory agencies the authority, responsibility and mandate to pursue enforcement actions to carry out their supervisory responsibilities. These actions can range from "informal" to "formal," depending on the nature of the supervisory concern.

Formal Actions Requiring Corrective Action

Cease and Desist Orders

Congress has given the agencies the power to issue cease and desist orders against financial institutions and individuals to address violations of laws, unsafe and unsound practices and breaches of fiduciary duties. Cease and desist orders can either require an entity or individual to cease certain actions or to take certain actions.

Common provisions in cease and desist orders prohibit dividend and other payments and transactions without prior regulatory approval; require the submission of acceptable plans, policies or procedures; and require restitution, reimbursements or other corrective action. Cease and desist orders are enforceable in court and the ramifications of violating such orders are severe—the individual or institution can be subject to civil money penalties.

In general, cease and desist orders are used for the most egregious situations—situations where an institution is in very poor financial condition and where violations of law and insider abuse are present.

Written Agreements

A written agreement is enforceable to the same extent as a cease and desist order. An agreement, however, is contractual in nature and signed by both the institution/individual and the agency. An agreement will usually contain the same types of provisions found in a cease and desist order.

Informal Actions Requiring Corrective Action

Memorandum of Understanding

A memorandum of understanding is also a contractual agreement between the institution/individual and the agency. In the Federal Reserve System, the primary distinction between a written agreement and a memorandum of understanding is that the local Federal Reserve bank is authorized to enter into a memorandum; staff of the Board of Governors of the Federal Reserve System must approve written agreements. Another important distinction is that cease and desist orders and written agreements must, by law, be made public; a memorandum of understanding is a private agreement.

Boards Resolutions or Commitments

Corrective action may also be in the form of board resolutions or commitments made unilaterally by the financial institution.

Civil Money Penalty Orders

Civil money penalty actions do not seek corrective activity, but assess a fine against an individual or institution. Penalties can be assessed for violating cease and desist orders or written agreements, violating laws, or engaging in unsafe or unsound practices or breaches of fiduciary duties.

The amount of the penalty that can be assessed by a regulator varies depending on whether the individual's or institution's conduct was knowing or reckless, caused a loss to a financial institution or resulted in gain to the wrongdoer.

Removals and Prohibition Orders

These orders may be used to remove parties from institutions or to prohibit their participation in the affairs of institutions in the future.

All of the orders discussed above (cease and desist, civil money penalty and removal/prohibition) can be on consent. In other words, the institution or individual can voluntarily agree to the action. If an institution or individual chooses not to consent to a formal or informal action, the agency has three choices: (1) issue a notice of charges (in essence, a complaint) and commence a formal enforcement proceeding that will result in a public order; (2) negotiate with the party and accept either a different type of action or different provisions within the action; or (3) drop the matter.

Criminal Referrals

One final type of enforcement activity that can be pursued by a regulator is a criminal referral. If a regulatory agency uncovers any known or suspected violations of criminal laws, the agency refers the matter to the Department of Justice for investigation and enforcement.

Ninth District Enforcement Actions on the Rise

The Minneapolis Fed has been tracking its enforcement actions since 1989 and, as the bottom chart [available in print version] on this page shows, after a drop in actions between 1989 and 1990, total actions increased dramatically the following year and the first six months of 1992. Following the national trend, formal actions rose significantly between 1990 and 1991.

The Minneapolis Fed, like some national regulators, also charts the number of actions that are in process in any particular year. This is useful data given that enforcement actions rarely begin and end within a calendar year.

Also, consistent with the national trend, the Minneapolis Fed is relying more on civil money penalty actions, removals and criminal referrals.