Where were regulators when banks were failing?

The regulator in question, the Office of Thrift Supervision (OTS), worked with management to show more capital than they had in their books and appear more financially sound than they were, the Treasury report said. That helped the banks continue business as usual, even though the lower capital levels would have cost them a key rating and cut off their access to some deposits.

"Why assume that such supervisory failures apply only to these banks?" says Philip Wellons, a former deputy director of a program on international financial systems at Harvard Law School. "We do not know what would be found if the regulatory curtain were lifted on all banks."

These lapses are fueling questions about how effective new laws can be, especially if they aren't enforced properly.

"A fire alarm might go off and someone might run to see what's happening, but there's no one there to put out the fire," says Tyler Cowen, economics professor at George Mason University. Cowen also says that under former president George W. Bush's administration, the emphasis on de-regulation led to an environment in which there was "a greater willingness to look the other way."

Young banks vulnerable

Many banks that are failing are young and look to regulators for guidance. ANB, for instance, was 14 years old when it failed. Of the 62 banks that failed since January 2008, 43% were less than 15 years old.

Main Street Bank (MSB), of Northville, Mich., opened its doors on March 1, 2004, with the primary goal of offering traditional deposit and credit products to the local community. However, within nine months of opening, the bank pursued an aggressive-growth strategy, writing risky construction and home-equity loans.

It started relying on deposits that came from brokers who were looking for high yields. Known as "hot money" in the industry, these deposits are considered very volatile, because brokers usually stay at a bank for about six months and then move the money to another institution that offers a higher yield.

MSB's primary regulator, the FDIC, saw the riskier strategy and in March 2005 required the bank to provide monthly reports. However, the FDIC's inspector general noted that the FDIC didn't ask relevant questions on why the bank was relying so heavily on unstable brokered deposits.

In fact, the FDIC waived the monthly reporting requirement in May 2006, when brokered deposits made up two-thirds of the bank's total deposits.

The inspector general's report said "more aggressive or timelier supervisory actions could have been taken to address risks" of the bank's "plans, operations and financial condition." The FDIC didn't take any enforcement action until right before the bank failed in October 2008, just four years after it was established.

The FDIC won't comment on any specific bank, but acknowledges that it could have done more at such banks. Sandra Thompson, its director of the division of supervision and consumer protection, says, "There are things we could have done and acted on more quickly."

Lax enforcement

In many cases enforcement is a key issue. Regulators would discover weaknesses and risky lending practices and recommend specific actions, but then they would not check back to see if the banks had followed their directions. Other times they ran into resistance from management.

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