Where were regulators when banks were failing?

When ANB Bank of Arkansas failed last year, it was easy to blame executives whose pursuit of high-adrenaline growth led to the bank's demise. But now other key culprits have emerged in ANB's collapse: the government officials who were supposed to be policing the bank.

The inspectors general at the U.S. Treasury and the Federal Deposit Insurance Corp. (FDIC) have both issued reports saying that bank failures surged because regulators in some cases didn't step in and prevent hazardous behavior, and in others actively helped banks hide their growing problems.

As early as Wednesday, the Obama administration is set to release details of a new regulatory framework for the vast and complex financial system of commercial and investment banks and brokers that has evolved in the last few years. However, the recent reports from the inspectors general highlight that bank regulators failed to do their job properly even when supervising far simpler banking institutions, showcasing the difficulty the administration faces in ensuring the new supervisory system will work effectively.

Banks are closing at a faster clip than has been seen in 15 years. Already in 2009, 37 banks have failed, after 25 failures in 2008. Expectations are for a fourfold jump for the rest of the year. That has come at a high cost. The FDIC, which today insures deposits at banks for up to $250,000, has paid out $28.5 billion in just the last two years. Some of the failures might have been prevented.

At ANB, for instance, management suddenly started writing high-risk loans in a bid to grow. Half of the bank's loan portfolio in 2005 was concentrated in risky construction and land-development loans — a 300% increase from 2004. That same year, the bank had the highest loan losses in its history, and earnings plunged as its loan delinquency rate hit twice the national average. But rather than flagging those missteps, the bank's top cop, the Office of the Comptroller of the Currency (OCC), condoned ANB's behavior by awarding it the top overall safety rating.

"You can get into a comfort zone by looking at the rating from our primary regulator that says everything's OK," says Debra Jackson, who was chief operating officer of ANB and worked at the bank from its inception in 1994 until it failed. Conditions got worse after 2005, but it wasn't until the end of 2007 that the OCC conducted an on-site examination of the bank.

Months later, in May 2008, the FDIC seized ANB. "If OCC had acted more aggressively and sooner," the inspector general's report said, "ANB might have acted earlier or differently to address its problems."

That type of regulatory failure was repeated at several institutions that the FDIC has had to seize. In at least six banks examined by the Treasury's inspector general and at seven more scrutinized by the FDIC's inspector general, regulators were incompetent or indifferent — willing to look the other way as bank executives took their banks down destructive paths. The Federal Reserve's inspector general is conducting its own reviews on at least three institutions that failed under its supervision.

Perhaps the most extreme examples were two banks where the Treasury found "inappropriate" backdating of capital, which contributed to "misleading financial reporting."

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.

That came into play in the failure of three related banks — First National Bank of Arizona, First National Bank of Nevada, and First Heritage Bank, which together had $3.65 billion in assets and were seized by the FDIC in July 2008. Thethree shared common boards and some centralized functions.

As early as 2002, the OCC identified problems at the First National Banks of Arizona and Nevada (which merged in June 2008) and said they were "adversely impacted by the significant concentration in high-risk mortgage products and weak risk management controls." Yet the OCC still gave both banks the same high rating as in 2001 when there were few problems.

All three banks were controlled by the First National Bank Holding Co., whose chairman was Raymond Lamb. The inspector general characterizes Lamb as "very dominant and influential," and says he "emphasized growth and profits over appropriate risk management."

His son, Patrick Lamb, ran the mortgage division at the First National banks, which had the most troubled real estate loans. The FDIC said, "The owner's son ran the mortgage division as a closed, separate operation and wanted no intervention from anyone." In July 2007 regulators seized the banks. Raymond Lamb didn't return phone calls seeking comment, and Patrick Lamb couldn't be reached.

OCC officials won't talk about specific cases, but they blame the economic downturn for most of their misses. "The economy and the financial system has gone through a severe disruption on a scale not seen since the Depression," says John Walsh, chief of staff at the OCC. "Nobody realized in looking at these bad real estate loans that a tsunami was coming, as opposed to just a tide."

Backdating capital

However, to the Treasury's inspector general the most "alarming" findings were that some senior officials at the OTS "either directed or authorized" two banks —IndyMac and BankUnited — to "inappropriately" book capital that wasn't there.

"We were alarmed by the risk such mischaracterizations can cause to good bank management and oversight. ... The banks' position and soundness were not accurately reported," says Rich Delmar, counsel to the Treasury's inspector general.

The OTS' director of the western region, Darrel Dochow, allowed the California bank IndyMac to show that it had more capital on its books than it actually did to avoid falling below its "well-capitalized" status. If banks fall below that status, regulators immediately cut off a bank's access to new brokered deposits.

IndyMac's holding company made a $50 million capital contribution on May 9, 2008, of which $18 million was recorded as capital on March 31, 2008. The FDIC seized IndyMac just four months later, on July 11. The government agency has incurred losses totaling $8.9 billion related to the bank. Dochow was removed from his job, and he has since left the agency. Dochow couldn't be reached for comment.

The inspector general also found that Florida's BankUnited was short of capital for the second quarter of 2008. When the OTS' senior deputy director found out in August about the shortfall, he directed the bank to infuse capital from its holding company. However, he advised that the funds be recognized as of June 30, at least two months before the infusion occurred.

Scott Polakoff, the officer who allowed the backdating, had been promoted to acting director of the OTS. Polakoff was removed from his job in March as the inspector general investigated this case. BankUnited failed on May 21, leading to a loss of $4.9 billion for the FDIC. BankUnited has since been taken over by a consortium of private equity and bank investors. Polakoff didn't return a call seeking comment.

John Bowman, acting director of the OTS, says capital transfers from a bank's holding company are appropriate, though he admitted that their timing went against accounting rules.

"The (capital backdating) had no impact on whether the particular institutions or series of institutions would fail," Bowman says. However, the regulator has since worked to ensure that the banks can book capital only if it comes in before the end of a specific period.