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Central Banker | Fall 2008

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Prompt Corrective Action: What Does It Mean for a Bank’s Liquidity?

Allen North's article, "Arkansas Bank Failure Teaches Lessons in Missed Fundamentals," in this issue of Central Banker points out the challenges of managing bank liquidity when asset quality issues arise.

Section 38 of the Federal Deposit Insurance Act requires insured depository institutions and federal banking regulators to take "prompt corrective action" to resolve capital deficiencies at insured depository institutions. What are the relevant prompt corrective action provisions that can affect liquidity, and what should a bank's board of directors consider when setting a bank's liquidity tolerances? Key provisions for different capital categories include the following:

Adequately capitalized institutions

Such institutions must receive a waiver from the FDIC to accept, renew or roll over brokered deposits (banks sell these large-denomination deposits to brokerages). A waiver is granted on a case-by-case basis, upon a finding that acceptance of such deposits does not constitute an unsafe and unsound practice.

If granted, an institution may not pay an effective yield that exceeds by more than 75 basis points the effective yield paid on deposits of comparable size and maturity.

Institutions that are undercapitalized to varying degrees must take additional actions and have additional requirements:

Undercapitalized institutions

  • must file an acceptable capital restoration plan;
  • cannot pay dividends or management fees;
  • may not accept, renew or roll over any brokered deposit; and
  • may not solicit any other deposits by offering an effective yield that exceeds by more than 75 basis points the effective yield paid on deposits of comparable size and maturity.

Significantly undercapitalized institutions

  • are subject to the same actions as an undercapitalized bank;
  • cannot pay bonuses to, or increase compensation of, senior executive officers without prior regulator approval; and
  • are subject to other restrictions and actions as noted in the Federal Deposit Insurance Corporation Improvement Act (FDICIA).

Critically undercapitalized institutions

  • are subject to the same provisions as an undercapitalized bank and a significantly undercapitalized bank; and
  • cannot pay interest or principal on subordinated debt (without FDIC waiver) after 60 days of becoming critically undercapitalized.

In addition, within 90 days of the bank becoming critically undercapitalized the chartering authority must:

  • appoint a receiver; or
  • take other such actions that the primary regulator, with the concurrence of the FDIC, determines would better serve the purposes of prompt corrective action (and review such determination every 90 days).

What does this all mean? As capital ratios deteriorate, the ability to generate high-rate deposits can become restricted. Moreover, Section 142 of the Federal Deposit Insurance Act places limits on Federal Reserve discount window lending in these situations.

The best solution to liquidity strains during times of financial stress is to prevent them. Therefore, boards of directors should consider:

  • setting liquidity risk tolerances for the bank and maintaining diversified funding sources;
  • establishing policies, procedures, limits and internal controls;
  • maintaining standards to identify, measure, monitor, control and report liquidity risk; and
  • periodically conducting scenario analysis and contingency planning exercises.

Capital Categories for Financial Institutions

Capital Category Total Risk-based Tier 1 Risk-based Leverage Other
Well-capitalized 10% or more 6% or more 5% or more not subject to formal action to maintain a specific capital level
Adequately capitalized 8% or more 4% or more 4% or more leverage ratio of 3% or more if bank is 1 rated and not growing
Undercapitalized less than 8% less than 4% less than 4% leverage ratio of 3% or more if bank is 1 rated and not growing
Significantly undercapitalized less than 6% less than 3% less than 3% N/A
Critically undercapitalized N/A N/A N/A tangible equity to total assets ratio of 2% or less

SOURCE: Section 38 of the Federal Deposit Insurance Act

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