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DECEMBER 10, 1982
Printed for the use of the
Committee on Banking, Housing, and Urban Affairs


13-540 O


J A K E GARN, Utah, Chairman
DONALD W. RIEGLE, J R . , Michigan
J O H N TOWER, Texas
J O H N HEINZ, Pennsylvania
ALAN J. DIXON, Illinois
J O H N H. CHAFEE, Rhode Island
M. DANNY WALL, Staff Director
ROBERT W. RUSSELL, Minority Staff Director
J O H N T. COLLINS, General Counsel






Opening statement of Chairman Garn
Statement of Senator Tower



C. T. Conover, Comptroller of the Currency
Why did Penn Square Bank fail?
Should bank supervision and regulation be changed?
Prepared statement
Overview of the failure
OCC supervisory actions
Limits of Federal bank supervision
The lessons of Penn Square
I. Summary of OCC supervisory policies and procedures
A. Uniform financial institutions rating system
B. OCC on-site examinations
C. OCC remote monitoring devices
D. OCC administrative actions
History of OCC supervision of Penn Square
A. 1960-79
B. The events of 1980
C. The events of 1981
D. The events of 1982
Response to written questions from the committee concerning Penn
Square and related issues
Response to additional written questions from:
Senator Garn
Senator Riegle
Senator Tower
William M. Isaac, Chairman, Federal Deposit Insurance Corporation
Failure confirms lessons of the past
Possible criminal violations
FDIC report on receivership of Penn Square Bank, N.A., and operations
of the Deposit Insurance National Bank of Oklahoma City:
Status of the Penn Square receivership
Receivership income and expenses
Litigation by and against the receivership estate
Bond claims and directors liability matters
Criminal irregularity
Receivers' certificates
Status of DINB's operations
Supplemental information supplied for the record
Loan performance of commercial banks
Foreign loans
Response to written questions from the committee concerning Penn
Square and related issues
J. Charles Partee, Member, Board of Governors, Federal Reserve System
Federal Reserve's involvement with Penn Square Bank
Solution for uninsured depositors
First Penn Corp., summary fact sheet



J. Charles Partee, Member, Board of Governors, Federal Reserve System—
Response to written questions from the committee concerning Penn
Square and related issues
Wendell Sebastian, Executive Director, National Credit Union Administration:
Prepared statement
Response to written questions from the committee concerning Penn
Square and related issues
Thomas P. Vartanian, General Counsel, Federal Home Loan Bank Board
Regulatory structure remains safe and sound
Effects of Penn Square Bank problem
Prepared statement
Impact of Penn Square failure on savings and loans
Safety of the savings and loan system
Lessons of Penn Square
Response to written questions from the committee concerning Penn
Square and related issues
Panel discussion:
Huge loans accepted blindly
Disclosure requirements
Removal of bank officers
Cost of failure to Federal Government
Bank failure rate
Agencies complimented for handling difficult situation
How many more Penn Squares exist?
The bank problem list
Frequency of examinations
Disclosure problems of small town banks
Improvements in monitoring procedures
Dealing with doomsday scenarios
Nonperforming loans
Areas in need of improvement
Revolution in financial services industry
Discovering excessive assets or imprudent loans
Independent outside audit committee
Increase in foreign loans
Projected bank failures
Primary responsibility of Penn Square
Bank closed at precisely the right time




Washington, B.C.
The committee met at 9:30 a.m., in room 5302, Dirksen Senate
Office Building, Senator Jake Garn (chairman of the committee)
Present: Senators Garn and Riegle.
The CHAIRMAN. The Banking Committee will come to order.
By coincidence, the Banking Committee is coming in at the same
time as the Senate. If you notice the orange light is on and the
country is once again in danger. I always thought that orange light
should be red.
During the past year, there have been numerous supervisory
mergers and some failures of depository institutions, none of which
has been quite like the failure of the Penn Square Bank. From its
size and the unusual circumstances surrounding its deterioration
and failure, Penn Square Bank has been the subject of continuing
discussions here in Washington and throughout the country about
the condition of our financial system and the supervisory structure
designed to insure the system's safety and soundness.
Today's hearing on the failure of the Penn Square Bank provides
the members of this committee an opportunity to review for themselves the causes, effects, and implications of the bank's insolvency
and liquidation.
After being informed of the Penn Square Bank failure last July,
my initial reaction was to ask what the breadth of the problem was
and to ask about the ability of the Federal supervisory and insuring agencies to handle it. After being briefed by the regulators, I
was confident that the situation would be controlled. Fortunately,
that has been the result.
While I believed the Penn Square Bank situation was unique, it
certainly had the potential to affect adversely the stability of the
financial system.
I decided to conduct committee hearings on the matter but, due
to the volatility of the failure and the need to have the regulators
devote their initial efforts to contain the problem, I decided to conduct such hearings after the dust had settled and after the agencies
had finished establishing their salvage operation and their preliminary investigation. Now that these things have been accomplished,



we have an opportunity and a responsibility to examine more closely the demise of the Penn Square Bank.
The general circumstances regarding the failure read like a textbook case of how not to run a bank. The Comptroller's Office
became aware of management and loan problems at Penn Square
Bank as early as April 1980. In the following months, OCC officials
met repeatedly with officers of the bank and the bank's board of
directors. Further deterioration of the bank in 1980 resulted in a
formal written agreement between the Comptroller's Office and the
board of directors dated September 9, 1980, in which the board
agreed to make specific changes and improvements in its policies
and operations. By the close of 1981, the Comptroller's Office had
noted improvements in Penn Square's condition and the establishment of the programs and systems required of it under the 1980
But in the first 6 months of 1982, Penn Square went on a lending
spree amounting to approximately $1.1 billion in new energy related loans, many of which were apparently of dubious quality. By the
time the Comptroller's Office began its April 1982 general examination, Penn Square's fate was already sealed. As the examination
proceeded, writeoffs in the loan portfolio grew to the point that
Penn Square's capital was wiped out and the bank was declared insolvent.
With the benefit of 20/20 hindsight, it is easy to suggest how
things might have been done differently. Penn Square might have
been more vigorously supervised, the Comptroller might have required the removal of certain officers, and so forth. The fact remains, however, that bank regulators can do only so much to try
and help an institution save itself. If the officers of a particular
bank choose to ignore that advice and plunge recklessly ahead,
there may be no way that such an institution can be or should be
The strength of the system is that these failures can be effectively administered by the appropriate regulators and that insured accounts are paid off promptly without losses. It bears repeating the
well known fact that not a single dollar has ever been lost in a federally insured deposit since the advent of FDIC insurance nearly 50
years ago.
Having said this, we cannot overlook the disruption caused by a
bank failure such as Penn Square. Public confidence in the banking system is shaken, institutions with correspondent relationships
experience serious losses related to loan participations with the
failed bank, and uncertainty is generated in the markets. The seriousness of these effects requires that Federal regulators do all they
can to discover banks that are in trouble and to take necessary
steps to bring them back to health.
I am hopeful that these hearings will assist us in discovering
what lessons have been learned from the Penn Square Bank failure
and how those lessons may be applied to improve the health of our
Nation's financial system in the future and hopefully prevent repeats of Penn Squares.
Gentlemen, we are happy to have each of you with us today. We
have a very distinguished panel of regulators to testify on this particular issue: The Honorable Todd Conover, Comptroller of the Cur-


rency; the Honorable William Isaac, Chairman of the FDIC; the
Honorable J. Charles Partee, Member, Board of Governors, Federal
Reserve System; Mr. Wendell Sebastian, Executive Director, National Credit Union Administration; and Mr. Thomas P. Vartanian,
General Counsel, Federal Home Loan Bank Board.
Gentlemen, we are happy to have you with us and we will start
with Mr. Conover.
Mr. CONOVER. Thank you, Mr. Chairman. I have a rather lengthy
statement that I would like to have entered in the record and I
would like to make some brief introductory remarks that summarize and paraphrase that statement.
The CHAIRMAN. We would be happy to include your full statement in the record and I might take advantage at the same time
and say that Senator Tower would have liked to have been here
but was not able to, but he also has a statement for the record that
we would include at this point and he has some questions for you
gentlemen that he will submit to you in writing for your response
for the record.
[Senator Tower's statement follows as though read:]
Senator TOWER. Gentlemen, I have reflected on the testimony on
Penn Square Bank before the House Banking and Commerce Committees. I have read with interest the proceedings from the questioning on July 16, 1982, when Mr. Conover and Mr. Isaac were
before the committees. It is not my intention to ask you gentlemen
to be grilled again. Rather, I believe it should be the function of
these hearings today to place the Penn Square Bank experience in
perspective. That is, how it relates to the future role of our bank
regulatory framework, the continuation and size of deposit
insurance, and how another Penn Square Bank incident can be
In my own State of Texas, exactly 1 month after the Comptroller
closed Penn Square Bank on August 6, 1982, the Abilene National
Bank was closed. It was foreclosed upon by the holder of the outstanding bank stock loan, Mercantile National Bank of Dallas.
Then Abilene National was merged into the Mercantile of Texas
holding company. Thus, the depositors were spared the fact of a
Federal Deposit Insurance Corporation receivership. I would like to
compare and contrast the foreclosure of the Abilene National Bank
with the failure of Penn Square Bank in my brief questions today.
These are questions for the Comptroller of the Currency with comments from the FDIC where appropriate at a later date.
One, Penn Square Bank had been rated a 3 at the conclusion of
its September 30, 1981, examination with note of improvement
having been made. From then until its closing on July 5, 1982, 9
months passed. In fact, on May 11, 1982, the Washington Office of
the Comptroller was notified by the Dallas regional administrator
that "problems were being uncovered" at Penn Square. Still it was
not until June 30, 1982, that a temporary cease-and-desist order
was filed.
Sir, in light of this long incubation period for this Oklahoma
bank, I am curious how the process went from months of working


with the Penn Square Board and careful combing of the loan portfolio to a matter of just a few days in Abilene National's case. I understand about the now infamous article in the Dallas Morning
News on July 9, 1982, questioning Abilene National's loan quality
which resulted in a liquidity problem. This liquidity problem, I believe is explainable, but I ask why did this bank go from having
liquidity problems the week of July 19, 1982, to having the Comptroller declare on July 23, 1982, that Abilene National would have
to raise $30 million in new capital by July 30, 1982, due to potential loan losses estimated to between $20 and $30 million? Would
you comment please?
Two, then, explain please why Mr. Clifton A. Poole, Jr., the regional administrator in the 11th National Bank Region made the
following statement in July 13, 1982, just 10 days before Poole gave
his ultimatum to the board: "Abilene National Bank is not receivership and the Office of the Comptroller of the Currency has no
plans to place it in receivership."
Gentlemen, as a representative of Texas where 10 percent of the
Nation's banks operate and the spirit of community banking is
strong, I am interested in being assured that there is consistency in
bank regulation. It is incumbent on us as we move toward deregulation that fear and emotions not govern our actions. Observing the
chronology and transcripts from both Penn Square and Abilene
National, I must ask a final question.
Three, it appears that in our heavily regulated banking environment that our early warning systems have broken down. Tell me
what you believe to be bank regulators' role in a deregulated

Mr. CONOVER. Mr. Chairman and members of the committee, I
welcome this opportunity to discuss the actions of the Office of the
Comptroller concerning Penn Square Bank. Specifically, I want to
address two basic questions: First, why did the bank fail despite
our supervisory efforts? Second, should our bank supervisory procedures and regulations be changed in light of the failure and, if so,

Penn Square Bank failed because it made an extraordinary
number of poorly conceived, poorly administered loans that violated the basic principles of safe and sound banking. The loans were
made in total disregard of both the bank's own internal policies
and procedures and OCC's supervisory directives. In a flourishing
economy, many of those loans would have been marginal at best.
But when the downturn in the energy industry began to seriously
hurt many of Penn Square's major borrowers, the results were disastrous.
Let me briefly review OCC's supervisory actions concerning Penn
Square Bank. Following an examination in early 1980, the bank's
board of directors entered into a formal agreement with the OCC
that required the bank to take specific remedial actions. The direc-

tors individually signed that agreement. We monitored compliance
through monthly reports and periodic examinations. In addition,
we required the board of directors to travel to Dallas in August
1980 and July 1981 to discuss the bank's problems and necessary
remedial actions with our regional office.
When we conducted an examination in September 1981, the bank
appeared to have made substantial progress in complying with the
agreement. Bank management assured us they would continue
their compliance efforts.
When we returned to the bank in April 1982, however, we discovered that the bank had radically altered its course. At a time when
the energy industry experienced a sudden and severe decline, Penn
Square went on a binge of imprudent lending that virtually assured its own destruction. Some of the bank's actions even warranted referral for possible criminal prosecution.
Between September 1981 and April 1982, Penn Square generated
approximately $800 million in new loans—an amount nearly twice
the asset size of the bank. Of the $49.1 million in assets eventually
classified as loss, approximately $28.5 million had been booked
after September 1981. As rumors of the bank's difficulties began to
spread, Penn Square experienced a sharp increase in deposit withdrawals in early July. Consequently, on July 5, 1982, before we had
even concluded the examination then in progress, I declared Penn
Square insolvent when it became clear that loan losses exceeded
capital and the bank could no longer meet the demands of its depositors and creditors.

OCC's supervisory efforts were unsuccessful in Penn Square
largely because management chose to ignore them. In the final
analysis, we must depend on bank management and directors to
carry out our directives. Over the long term, OCC can detect and
overcome bank management resistance to supervisory requirements. In the short term, however, our efforts can be frustrated by
a bank management that promises one thing and does another.
That is what happened at Penn Square.
That raises the question of whether the failure of Penn Square
means there should be changes in bank supervision and regulation.
We believe that changes are warranted in two areas: Frequency of
full-scope bank examinations, and collection and public disclosure
of information about banks.
Well before the failure of Penn Square, OCC had planned to
change its onsite examination policies to focus more of its resources
on problem banks. After reviewing the rapid deterioration of Penn
Square, we increased the frequency of our full-scope examinations
of troubled banks.
We also believe that the adverse effects of the failure could have
been reduced if the public and bank regulators had been provided
with better and more timely information on the condition of the
bank. Both the market and the regulators can do a better job of
disciplining banks if they have more information about bank condition. There are several ways to obtain that information.


First, we are revising the call report. These revisions will, among
other things, require banks to report data on past-due loans, maturity structure, interest rate sensitivity, and commitments and contingencies. We are also requiring all banks to file income statements on a quarterly basis.
Second, we intend to make this information available to the
public. The OCC is also considering other disclosures, such as publication of income statements and making certain types of enforcement actions public.
Another question is whether we need legislation to address the
specific practices that led to the Penn Square failure. I believe the
answer is no. That failure was an aberration arising from unique
circumstances. Penn Square justifies neither increased regulation
nor a reduced pace of bank deregulation.
Bank failures are always regrettable, and we go to great lengths
to prevent them. But I do not believe our country needs or can
afford a fail-safe banking system. The possibility of failure imposes
an important discipline. It acts as an incentive for banks to avoid
unnecessary risk. A fail-safe banking system would eliminate this
incentive. It would also encourage regulators to reduce risk to the
system by limiting bank management's freedom to make business
decisions. Without risk, there is no reward, and without reward, it
is impossible to attract either capital or good managers. The public
interest would not be well served by a regulatory system that is so
restrictive or so protective as to eliminate the risk of failure altogether.
[Complete statement of Mr. Conover follows:]

DECEMBER 10, 1932

Mr. Chairman and Members of the Committee:
I welcome this opportunity to discuss the actions of tne Office
of the Comptroller of the Currency concerning the Penn Square
Banx of Oklahoma City, which was declared insolvent on July 5,
rfhile the failure of the Penn Square Bank raises many
questions, two are particularly pertinent to the agency:

Wny did tne bank fail despite our supervisory efforts?


Should our bank supervisory procedures and regulations be
changed in light of the failure and, if so, how?

1 will deal principally with these questions. To aid the
Committee in its review of tne Penn Square Bank failure, I have
also provided, as an appendix to my statement, a summary of OCC
policies and procedures affecting problem banKs and a more
detailed history of OCC's supervision of Penn Square Bank.

To understand why the Penn Square Bank failed despite our
regulatory actions, the direct cause of the failure must be

poorly conceived and poorly documented loans that

violated prudent banking policies and procedures.

The bank had

concentrated its loans in the Oklahoma oil and gas production

In late 1981 and early 1982, that industry suffered

a severe and unexpected decline.

Many of Penn Square's major

customers began to experience financial difficulties.


than reducing its exposure to these firms, Penn Square extended
more credit in an effort to "bail out" its customers.

In late

19dl and early 1982, the bank originated an extraordinary
volume - over $800 million - in new loans.

The vast majority

of those new loans were to energy-related borrowers.

When the decline in the oil and gas industry continued to
deepen, many of the new loans became non-performing.


losses greatly exceeded the bank's capital, thus, resulting in
a book insolvency.

Simultaneously, a severe decline in market

confidence in the bank led to a run-off of deposits and other
funding sources, thus causing a liquidity insolvency.
Accordingly, the combination of a large volume of poor quality
credits and a severe downturn in economic conditions directly
resulted in the failure of the bank.

A primary cause of the

insolvency was that the Penn Square management heedlessly
disregarded the principles of safe and sound banking and failed
to comply with OCC directives.

A Chronology of Events
In 1980 Penn Square Bank was assigned a "3" rating under the
Uniform Financial Institutions Rating System despite the
absence of many of the usual quantitative indicators for a bank
requiring special supervision. OCC was concerned about the
bank because of its poor liquidity and funds management,
deficient capitalization, and lack of staff expertise.
Essentially, we thougnt the bank's resources were stretched
very thin by its extremely rapid growth. In light of the
bank's strengths, however, a more severe "4" or "5" rating was
not warranted. At that time, the overall quality of the loan
portfolio was acceptable and its earnings exceeded those of its
..eers. See chart below:



Return on Assets


Because of its weaknesses, the bank was placed in OCC's Special
Projects Program to receive additional supervision. As part of
that program, we required, and the bank consented to implement,
remedial measures for the identified problems. Through a
formal agreement signed by each director under 12 U.S.C. §
1818(b), OCC required the bank, its board, and management to:
increase capital; formulate and implement a more stringent loan
policy, and establish improved internal review procedures to
enforce that policy; develop and implement acceptable policies
on liquidity, asset, and liability management; and evaluate and
strengthen its staff and management.
The formal agreement, signed in September 1980, was consistent
with our guidelines affecting problem banks. The Office
thereafter undertook to monitor implementation and compliance
by the bank with that agreement. The bank was examined with
the same scope and frequency accorded other "3" rated banks.
We expressed concern over the concentration of credits to oil
and gas interests and questioned whether such a concentration
was consistent with prudent risk diversification.
Nevertheless, we felt that the decision of whether the bank
should continue to make loans in the oil and gas industry,
provided such loans were of good quality, was within the
discretion of management and the board. The bank's strong
prior earnings record and the then favorable prospects of 1980
for the energy industry mitigated our concerns regarding those
loan concentrations. We did not feel that restrictions on the
growth of the bank were necessary or appropriate if such growth
conformed to the terms of the agreement, particularly the
requirement that capital be maintained at 7.5% of assets.

After initial resistance, the bank's management agreed to
implement OCC's proposed remedial measures. By September 1981,
the bank appeared to have substantially complied with most of
the OCC directives. More particularly, the bank had adopted an
adequate capital plan; had increased its capital to an
acceptable level; had hired experienced management and lending
officers; had adopted an adequate loan policy that required
approval by a committee, the Chairman, or the President of all
loans over $50,000; had created an internal loan review
procedure to assure compliance with the policy; had adopted
acceptable policies on liquidity, asset and liability
management; and had hired a new chief financial officer to
oversee that area. Most significantly, the bank had brought on
a new management team which appeared to be competent, in
control, and fully committed to improve the bank's condition in
a manner consistent with OCC directives.
In normal circumstances, such measures could be expected to
improve the oank's condition. Thus, the "3" rating was
continued through the September 1981 examination. However,
following tne September 1981 examination, largely in response
to difficulties in the energy industry, the bank engaged in
various transactions *?hicn were wholly inconsistent with
prudent banking practices and in wholesale disregard of agreed
upon lending policies and procedures. These actions made tne
failure of Penn Square Bank inevitable.
As previously noted, between the September 1981 examination and
the commencement of our examination in April 1982, the bank
originated approximately $800 million in new loans largely to
its oil and gas customers who were beginning to experience
financial difficulties due to a severe decline in their

industry. As indicated in the following chart, domestic
drilling activity (as represented by the number of active
drilling rigs) was substantial and growing until late 1981, at
wnich time the industry faltered. Penn Square's lending
continued to increase beyond that time in disregard of the
industry's decline.

-. 2.800M

Gross Loans

- 2.600M
- 2.400M
- i 2.00CM
- 1.800M
- 1.-00N*
- 1.000M











Source: Paine Webber Mitchell
Hutchins. Inc.
Oil Service Monthly

i4any of those loans were of poor quality and violated the
internal lending policies and review procedures mandated by
OCC. The extraordinary volume of loans generated was almost
twice the size of the Dank. It is virtually impossible to
prudently manage such explosive growth. By the bank's own
count, there were over 3,000 documentation exceptions in the
loan portfolio. Many liens were not filed, some had not been
taken, and some notes were even unsigned. A large percentage
of those loans eventually resulted in loss which caused the
banc's failure. Of the $49.1 million in assets eventually
classified as loss, approximately $28.5 million (or 58% of
losses) had been booked after the September 1981 examination.
Had the examination initiated in April 1982 been completed, the
bank's rating, would certainly nave been increased from a
composite "3" to a composite "5". The declaration of
insolvency, however, overtooK such a redesignation.
Reason for Failure Despite OCC Supervision
The bank failed despite OCC's supervision, in significant part,
because bank management acted imprudently and abandoned their
compliance with our remedial directives. If the bank had fully
implemented the terms of the agreement, its condition would not
have deteriorated so rapidly and, very probably, would have
improved. Indeed, OCC supervisory procedures and directives,
as we followed with respect to Penn Square Bank, have proven to
be overwhelmingly effective with u 3" rated banks.

13-540 0 - 8 3 - 2

The chart below summarizes the ratings, as of October 31, 1982,
of the 215 national oanks that were rated "3" in August 1980.

1980 "3" RATED BANKS

Still "3" Rated

Have Deteriorated^
to " 4 " or " 5 "
Have Merged into
Other Institutions and
No Longer A Problem 1°/°y

No Longer A Problem

Declared Insolvent and
Placed in Receivership

The management of Penn Square failed or refused to adhere fully
to tne agreement which likely would have prevented the
failure. We received repeated assurances from management and
the board of directors that the oank would fully comply with
the agreement. If Penn Square had ever openly refused to

cooperate with our supervisory efforts, OCC would have taken
stronger action.
By the time OCC returned to the bank in April 1982, the bank
had during the few months between examinations radically
altered its course and thereby assured its own failure.


the bank's extraordinary imprudence resulted in:

classified assets which were 352% of gross capital


delinquency in almost 13% of the loan portfolio
more than 3,000 credit and collateral documentation

The conduct of some bank officials was so egregious as to
warrant our referral of particular matters to the United States
Attorney for possiole criminal prosecution.
tfe followed established and generally successful examination
and supervisory procedures in addressing the problems of the
bank based upon the facts known to us at the time.


our experience with Penn Square demonstrates that the agency's
supervisory effectiveness is to some extent limited by the

(or unresponsiveness) of a bank's management and

board to our efforts.

Over the long term, OCC will usually

detect and overcome management resistance.

However, in the

short term, our supervisory efforts can be defeated by a bank
management that promises one thing and does another.
actions are irresponsible in the best of times.


They are

disastrous in an economic environment that changes very
quickly, as did the oil and gas industry.
what occurred at Penn Square.

Essentially, tnis is

The extent to wnich OCC can or should direct the affairs of
national banks is practically limited. Our banking system is a
private enterprise system. Consistent with our nation's
fundamental economic philosophy, the basic strategy of the
federal bank supervisory agencies is to work with bank
management to detect and control the risk exposure of their
institutions, and to assure a high level of bank compliance
with applicable laws and regulations. The role of OCC may be
defined as supervisory. We do not take over and manage
institutions; we do not substitute for private management.
However, if a bank refuses to cooperate, OCC vigorously
enforces laws and prudent banking standards within the limits
of due process.
In extreme cases, OCC can, consistent with statutory
requirements, remove or suspend an officer, or order that bank
management carry out or refrain from particular acts.
Generally, however, when a bank is experiencing problems and
requires special supervision, OCC will direct the bank
management to implement remedial measures and, where
appropriate, we will order such changes through formal and
informal administrative actions.
In the final analysis, the agency's ability to affect the
condition of a bank depends upon the execution of our
directives by the officers and directors of the bank. It is
not desirable for the regulator to substitute for bank
management. A necessary consequence of this properly limited

role of bank supervisors is that some banks can and will fail
despite our best efforts. In the short term, unless we
permanently assign a team of national bank examiners to review
all decisions made by a bank, management can deceive us as to
whether it is complying with our directives. Despite this
risk, the agency must presume the honesty and good faith of
management. The bank supervisory system could not operate
under a presumption of management dishonesty.
Penn Square's disregard of the agreement was not detectable by
OCC's remote monitors because the violations were basically
qualitative rather than quantitative in nature. The data in
current call reports does not readily reflect changes in the
quality of a loan portfolio between examinations. The recently
announced changes in call report data should help to alleviate
this problem.
More Stringent Action Was Not Warranted
Would the failure have been prevented if OCC had made more
extensive use of its formal administrative powers? In my
opinion, no.
OCC nad considered issuing and, indeed, had threatened to
issue a cease and desist order against the bank. However, in
practical terms, such an order would nave contained essentially
the same requirements as the agreement. Moreover, OCC monitors
day to day compliance with orders and agreements in essentially
the same way. Finally, in light of the apparent cooperation of
tne bank's management and directors, such an order did not seem

Neither removal of officers nor civil money penalies were
justified in light of the information known to us before the
April 1982 examination. tfhile OCC was concerned with the
lending activities of iAr. Patterson, Senior Executive Vice
President in charge of the energy department, prior to the
spring of 1982, we did not believe that his activities or those
of anyone else were sufficiently egregious to satisfy the
requirements for removal under 12 U.S.C. § 1818(e)(1). 3y the
time we became aware of information that would have justified
tne removal of any officer or director, the damage to the bank
had been incurred and its failure was all but inevitable.
Finally, we come to the other question: Should bank
supervision and regulation be changed in light of the failure?
As noted before, the primary reason for the bank's failure
despite OCC supervisory efforts was that imprudent banking
practices resulted in so rapid a deterioration that OCC had
insufficient time to implement effective remedial measures.
During the period between our examinations, and contrary to its
assurances, the bank went on a binge of imprudent lending.
Pushed on by unrealistic optimism for a recovery of the energy
industry or in an effort to hang on and minimize losses, the
bank went too far in extending new credit.
Our experience with Penn Square has confirmed certain
conclusions OCC had already reached. Under our recently
implemented policies, OCC will provide more frequent
examination of all "4" and "5" rated banks and of "3" rated
banks with assets of more than $100 million. OCC also will
assign more of its examining resources to such banks.
The rapid deterioration of Penn Square Bank between exams
underscores the need to increase the frequency of examination
of banks with composite ratings of "3" or higher.

Among the other specific issues that the OCC is further
reviewing in light of the Penn Square Bank experience are:

Whether OCC should provide more frequent examinations for
oanks engaged in large sales of loans and participations


Whether OCC can make additional improvements in its remote
monitoring system to increase our ability to detect rapid
changes in a bank's loan portfolio


How OCC might better use information obtained while
examining one bank in examining other banks


What additional information about banks should be publicly

These are not easy questions, but they must be answered. Some
preliminary conclusions can be drawn from the Penn Square Bank
The adverse effects of the failure could have been reduced if
the public and the bank regulators had been provided with
better and more timely information on the condition of the
bank. This suggests several remedial measures to increase the
quality of market discipline and supervisory oversight by
improving the amount and quality of information available,
particularly from non-registered oanks (like Penn Square Bank)
that are exempt from many disclosure requirements.
First, the federal bank regulators are changing the Report of
Condition and Income, commonly known as the "call report", to
provide the regulators with more information about banks. To

permit assessment of the quality of loans and leases, banks
will be required to report data on past due, non-accrual and
renegotiated loans and leases, and the amount of charge-offs
and recoveries during the reporting period. Other revisions
will require banks to report maturities of assets and
liabilities and interest rate repricing opportunities to aid in
the analysis of rate sensititivity and rate risk. Finally, to
provide improved reporting of income and expenses, all banKS
will eventually be required to report on a full accrual basis
of accounting.
Second, we intend to publicly disclose more information about
the condition of banks. Deregulation should result in shifting
some of the responsibilities for the discipline of banks from
the regulators to the marketplace. If the marketplace is to
function efficiently and provide adequate safeguards against
excessive risk, market participants must have adequate
information. For that reason, information on loans past-due
for 90 days will be made public beginning with the June 30,
1983 call report. The Office is also considering other
disclosures, sucn as publication of income statements and
making certain types of enforcement actions public.
New Legislation is Not Needed
There is, however, no need for enactment of legislation at this
time to address the specific practices that led to the Penn
Square Bank failure. That failure was, in large part, an
aberration arising from unique circumstances. Penn Square Bank
justifies neither increased regulation nor reduction in the
pace of deregulation of banking.

The bank's failure raises in stark terms a fundamental
regulatory question: Do we want and can we afford a failsafe
banking system? The answer must be no.
The possibility of a business failure plays an important role
in the free enterprise system. Failures remove inefficient
firms so that the resources tney consume may be allocated to
their more efficient competitors. Most importantly, the threat
of failure is essential if the discipline of the marketplace is
to function.
The lack of a credible threat of failure can have two adverse
effects upon businesses. First, any company may not operate as
efficiently if not faced with a risk of collapse. The threat
of failure motivates banks to be vibrant and responsive to
changing needs for financial services. Second, a business that
cannot fail may be inclined to imprudently engage in high risk
activities tnat offer potentially large profits. This second
effect has profound implications for banking. Indeed, such
thinking may have influenced some of the banks that purchased
large quantities of loans and participations from Penn Square
Bank. They, and we, have undoubtedly learned a valuable lesson
from the failure.
Tne risk of a failure motivates investors and depositors, not
directly involved in managing the bank but who still have a
stake in its soundness, to monitor carefully the performance of
the bank's management with regard to risk exposure.
A failsafe banking system would forfeit these important
benefits. It would also incur unacceptably high social and
financial costs. In order to eliminate the risk of serious

errors or transgressions tnat could result in a bank's failure,
the freedom of bank management to make business decisions would
be curtailed and supplanted by regulatory supervision. The
social costs from the resulting loss of individual liberty,
entrepreneurial initiative, and industry efficiencies obviously
would be unacceptable. Our banking system would become
stagnant and unresponsive.
Further, such a system would require almost constant
examination of banks because, as we have seen in Penn Square,
a bank can change radically in a very short time. The
maintenance of such a system would be extremely expensive.
The public interest warrants reasonable supervisory safeguards
to assure a safe, sound, and efficient banking system. This
requires a high degree of banK monitoring, supervision and, in
some cases, even coercion to prevent excessive bank failures.
However, the public interest would not be well served by a
regulatory system that is so restrictive or so protective as to
eliminate tne risk of failure altogether.
The failure of the Penn Square Bank if understood in light of
its peculiar circumstances--and the conduct of its management
and directors—does not demonstrate a need for more federal
regulation of banks.


Summary of OCC Supervisory Policies and Procedures

To aid the Committee in understanding OCC's supervisory actions
regarding Penn Square, OCC's relevant policies and procedures will
be briefly descrioed.

Uniform Financial Institutions Rating System

All the federal bank supervisory agencies, including OCC, use the
Uniform Financial Institutions Rating System. That system assigns
to each bank a numerical rating, from one to five in ascending
order of supervisory concern, reflecting the bank's financial
condition, compliance with laws and regulations, and overall
operating soundness. The system was developed in accordance with
suggestions from the General Accounting Office.
Institutions rated composite "1" or "2" pose no serious
supervisory concern. Those rated composite "4" or "5" are
generally cnaracterized by unsafe, unsound, or other seriously
unsatisfactory conditions and carry a relatively high possibility
of failure or insolvency. A composite "3" rating indicates an
institution with a combination of weaknesses ranging from
moderately severe to unsatisfactory. This rating may be assigned
to banks exhibiting significant non-compliance with laws or
regulations or those whose financial condition is weak and
vulnerable to deterioration if business conditions become
adverse. Generally, such institutions require more than normal
supervision, but their overall financial condition makes failure
only a remote possibility.

As of October 31, 1982, the number of national banks in each
composite rating were as follows:


(47.6%) were rated "1"
(44.3%) were rated "2"
(6.7%) were rated "3"
(1.1%) were rated "4"
(0.3%) were rated "5".

QCC On-Site Examinations

Tne primary supervisory tool used by the OCC to monitor the
condition of national banks is the on-site examination
process. The three types of commercial on-site examinations are:
"general," "specialized" and "special supervisory." A general
commercial examination covers all areas of the bank's operations.
However, frequent use of the exhaustive general examination
procedures is neither necessary nor desirable for most banks.
Accordingly, other more targeted examination procedures are also
used. A "specialized" examination complements the general
examination, but its scope is limited to the areas of significant
importance or significant change. Finally, a "special
supervisory" examination is usually limited to the review of
previously criticized loans, internally identified loan problems,
asset-liability management, and compliance with any administrative
actions or other enforcement documents between the bank and OCC.
The type and frequency of on-site examinations of a particular
bank depend, in part, upon its composite rating. Under the policy
in effect between January, 1979 and March, 1982, banks with a
composite "3" rating, regardless of size, were examined twice
every 12 months with at least one such examination scheduled as a

specialized exam. Those rated "4" or "5", regardless of size,
were examined twice every twelve months with at least one to be a
general examination. Under the current policy, all banks rated
"4" or "5" and those rated "3" with over $100 million in assets
are examined twice every 8 months with one examination scheduled
as a special supervisory. Banks rated "3" with under $100 million
in assets are examined twice every 12 months with one examination
scheduled as a special supervisory.

OCC Remote Monitoring Devices

OCC also supervises the national banking system through the use of
remote monitoring techniques. The computerized National Bank
Surveillance System ("NBSS") is OCC's key remote monitoring
device. The NBSS is primarily designed for the early detection of
proolem DanKS and as a supervisory and administrative system for
the OCC. As part of the NBSS, Uniform Bank Performance Reports
("UBPR") are produced by the FflEC from a data base obtained
from official Reports of Condition and Income and other reports
submitted by banks. The UBPR is designed for use oy Dank
management, bank examiners, and NBSS specialists in the evaluation
of banks.
As part of its surveillance program, the NBSS each quarter
examines all national banks with a composite rating of "1" or "2"
by means of an early warning system called the Anomaly Severity
Ranking System ("ASRS") to determine which will receive special
review. Banks already receiving special supervisory attention and
with a composite rating of "3," "4," or "5" are not subject to
ASRS selection and review since these banks are already receiving
continuous attention in the special projects program. The ASRS

is a computerized scoring system which allocates the highest
numerical score to those banks having the most abnormal positions,
changes, and trends in performance or composition. Those banks
receiving the highest scores under the ASRS are selected for
review. Such a review utilizes the skills and special training
of designated national bank examiners. It consists of an
analysis of the Uniform Bank Performance Report and other
available informaton. The 14BS3 specialist's conclusions and
recommendations are presented in writing to each Regional
Administrator. Identification of serious conditions of present
or potential concern results in an examination, investigation, or
discussion with bank management. If no serious conditions are
found, the bank may be passed with no further action required.
Finally, the dB3S has an Action Control System. This element is a
separate computerized system that records: (a) banks selected for
priority review; (b) any conditions of concern observed by the
NBS5 specialists; (c) the projected date correction is anticipated
for each condition; (d) the desired level for each condition;
and (e) each condition's current status. Status, progress,
and summary reports are rendered at intervals to Regional
Administrators and other senior OCC officials. Conditions of
concern whicn have been recorded in this monitoring system cannot
be removed until correction has been achieved or until the bank is
placed under special supervisory attention with a "3" rating or

OCC Administrative Actions

The use of formal and informal administrative actions by OCC to
direct banks in improving their regulatory compliance and

financial condition depends partially upon the composite rating
of the subject institution. This policy was also developed in
accordance with suggestions from the General Accounting Office.
For banks rated "4" and "5," it is OCC policy to take formal
administrative action. Typically, such action will involve
Agreements or Cease and Desist Orders executed pursuant to our
enforcement authority (12 U.S.C. 1818). For banks rated "3," it is
OCC policy to consider similar formal administrative action.
However, if formal action is determined to be inappropriate, then
informal remedial action is taken through the use of a Memorandum
of Understanding between the Regional Administrator and the bank.
Of course, formal administrative actions, if appropriate, may be
taken with respect to "1" and "2" rated banks.
OCC has found these policies generally successful in supervising
banks requiring special attention, particularly 3-rated banks.
Sixty-six percent of banks assigned a composite rating of "3" in
August, 1980 were rated "1" or "2," as of October 31, 1982, 23%
were stabilized at "3," and 7% were rated "4" or "5,". An
additional 3% had been acquired in non-supervisory mergers, and 1%
had failed.
II. History of QCC Supervision of Penn Square
The investigation and review of this matter by OCC is still
continuing. Nevertheless, based upon what we presently know, it
is clear that the OCC supervisory personnel followed OCC policies
and procedures in tneir supervision of Penn Square. A chronology
of events affecting Penn Square follows.


1960 - 1979

Penn Square received a national bank charter in 1960. In 1976, it
became 100% owned (less directors' qualifying shares) by the First
Penn Corporation. From the time it was chartered until 1977, the
bank experienced strong but manageable growth and was not subject
to any unusual supervisory action. However, from May of 1977
until its closing, the bank experienced a period of extraordinary

The Events of 1980
February 1980 Examination

The bank first became a matter of supervisory concern following an
examination dated February 29, 1980, which concluded on April 14,
1980. This examination revealed a bank which was basically sound
and had shown exceptional growth in the area of oil and gas
lending. Those loans resulted in a concentration of credit and
tne sale of participations to other banks. The loan loss reserve
was adequate. The internal controls were acceptable. The overall
quality of the loan portfolio nad deteriorated, but not to an
unacceptable degree, and the bank's earnings exceeded those of its
peers. Nevertheless, Penn Square had some problems, including
insufficient liquidity, inadequate capital, an increase in
classified assets, and violation of banking laws. Accordingly,
out of an abundance of caution, the bank was designated to receive
special supervisory attention and was rated a composite "3"
pursuant to the Uniform Financial Institutions Rating System.

OCC Begins Special Supervision and Enters into Formal Agreement
On June 9, 1980, tne Deputy Regional Administrator forwarded the
report of examination to the board of directors with a transmittal
letter detailing many of his concerns. Tne letter directed the
board of directors to convene a special meeting within five days
to review the report and taKe remedial action. The letter also
indicated that a full board meeting would be held in the Dallas
Regional Office of the OCC to discuss administrative action. On
the same date, tne Deputy Regional Administrator also recommended
to Washington that the OCC take enforcement action.
On June 19, 1980, the Regional Administrator and his staff advised
tne bank's chairman and the executive vice president of the
examination findings. He also told them that the Dank would be
subject to formal administrative action by this Office pursuant to
the cease and desist process. By letter dated July 15, 1980, the
Chairman of Penn Square's board of directors informed OCC that a
special meeting of the ooard of directors had been held to review
the most recent report of examination and to formulate a capital
plan. The bank's president, in a separate letter, described
specific actions the bank would take to correct some of the
problems OCC had noted in its report.
On August 27, 1980, the Regional Administrator convened a meeting
with the bank's full board of directors at its Dallas Regional
Office. During that meeting the board was clearly informed of the
problems in the bank and of the need for corrective action. They
were also presented with a formal agreement. On September 9,
1980, all the members of the bank's board of directors
individually signed the formal agreement pursuant to the cease and

13-540 0 - 8 3 - 3

desist statute. Among other things, the agreement required Penn
Square to correct all violations of law, achieve and maintain an
adequate level of capital, establish and implement a program to
reduce the level of criticized loans which included the
development of internal procedures and guidelines, conduct a
management study, take steps to improve its liquidity, and report
monthly to the OCC.
The agreement did not expressly restrict the growth of the bank
because growth that would have occurred in compliance with the
agreement would not have substantially increased the risk to the
bank. In other words, througn the capital maintenance
requirements and new operating procedures mandated by the
agreement, OCC believed that it had largely controlled and
prevented any future imprudent growth.
Notification of Other Regulators
A copy of tne feoruary 29, 1980 examination report of Penn Square
was furnished to the Federal Reserve District Bank, which had
supervisory responsibility for Penn Square's holding company, and
to the FDIC Regional Office. Additionally, when Penn Square was
placed under special surveillance in July of 1980, the Special
Projects Division, in accordance with OCC policy, provided to the
Washington offices of the Federal Reserve Board and the FDIC
copies of an OCC memorandum outlining the bank's problems and the
remedial measures to be taken. Both the FRB and the FDIC were
also notified in July, 1980 of the prospective formal action
against Penn Square by OCC.

September 1980 Examination
From September 9 tnrough September 11, 1980, OCC conducted a
special supervisory examination of the bank to review previously
critized loans, past-due loans, new loans, the bank's capital
plans, and its liquidity. The examination disclosed rapid growth
with funding neavily dependent upon rate-sensitive deposit
sources. Liquidity was strained, and the existing
staff was overtaxed oy business volume. However, a significant
improvement in the quality of the loan portfolio was found.
Additionally, the;bank was soon to receive an injection of
$3.3 ALA in equity capital from its holding company.
OCC Special Supervision Continues
On October 8, 1980, the Regional Administrator sent a letter to
the bank's board of directors which transmitted the examination
report and which analyzed existing problems and the level of
compliance with the agreement. This letter also directed further
action. Specifically, it required the board to implement
procedures within the next quarter which would improve the level
of capital and to provide additional monthly reports so OCC could
better monitor the bank's liquidity.

The Events of 1981
December 1980 Examination

Because of the findings of the September 1980 special examination,
a general examination, utilizing financial data as of December 31,
1980, was conducted by a select team of examiners from January 5,

1981 through February 27, 1981. It disclosed deterioration in
the bank's overall condition. The major concerns continued to
be inadequate capital, poor asset quality, ineffective loan
administration, inadequate staffing and policy development, weak
internal controls, deficient liquidity, and imprudent asset and
liability management practices. During 1980, the bank had more
than doubled in size. Most of this growth continued to be
concentrated in energy-related loans. Additionally, violations of
banking laws and the formal agreement were cited in the report.
The bank, however, continued to show some strengths and positive
development. The management expressed a willingness to comply
witn the agreement and to correct the deficiencies noted in the
examination report; to that end, the bank established a management
task force. Some violations of law had been corrected and more
were corrected during the examination. The bank had partially
satisfied the requirement in the agreement by adopting policies
and procedures in several areas of its operations. Earnings
continued to be high when compared to those of similar banks.
A plan to increase the bank's capital had been adopted.
July 1981 Meeting
Nevertheless, OCC remained concerned with the continued problems
at the bank and its non-compliance with the agreement. A lengthy
discussion ensued in the Washington and Regional Offices of the
OCC on whether a cease and desist order should be imposed on the
bank. Ultimately, it was determined that OCC would inform the
board of directors that, unless the bank provided convincing
assurances that it was going to correct the deficiencies, OCC
would impose a cease and desist order.

Accordingly, on June 2, 1981, the examination report was sent to
the ooard of directors and in a comprehensive letter dated
July 1, 1931, the Regional Administrator informed the board
tnat management had failed to supervise prudently the bank's
activities. The letter pointed out, among other things, that
tnis lack of supervision had manifested itself in the following:
-Numerous violations of banking laws;
-Inordinate asset/liability management risk;
-Uncontrolled growth of bank resources; and
-Noncompliance with the formal agreement with OCC.
The letter requested that the board of directors arrange a
meeting in our Dallas Regional Office to discuss the report and to
determine further action to be taken by the board and management.
On July 29, 1981, a meeting was held in the OCC Dallas Regional
Office between representatives of OCC from tne Regional and
Washington Offices and the full board of directors of Penn Square
and several newly hired oank officers. Most of these new
officers, including the new President, Mr. Seller, had impressive
prior experience in banking and were known by OCC officials in the
Regional Office. At this meeting, OCC discussed the report and
detailed its supervisory concerns. During the meeting and
afterwards, Mr. Seller, Mr. Jennings (the Chairman of the Board)
and most of the other directors indicated their agreement with
OCC's concerns and their resolve to improve the condition and
compliance of the bank. During this meeting, Mr. Seller told
OCC's Regional Director for Special Surviellance that he would not
have accepted a position with the bank unless he was to have full

control and that he did, in fact, have full control. His role as
spokesman for the Dank during the meeting tended to verify this
September 1981 Examination
In accordance with the OCC procedures requiring the examination of
"3"-rated banks, a special supervisory examination utilizing data
as of September 30, 1981, was conducted during the period October
8 through October 30, 1981. The OCC Regional Director for Special
Surveillance was the examiner in charge. rie was familiar with
Penn Square as a problem bank from nis position in the Regional
Office and was an able and experienced examiner. Although the
bank's overall condition remained of concern, this examination
revealed improvements.
The report noted tnat the bank had
significantly improved its lending staff, its loan policy and its
internal controls.
Of particular significance to OCC was the creation of a
satisfactory internal loan approval policy, loan processing
department, and an internal loan review procedure. The
examiner-in-charge ("EIC") received express assurances from
President Beller and other officers that under the new approval
policy no new loans in excess of $50,000 were to be made without
the review and approval of the president or a loan approval
committee. Further, all loans were to be scrutinized by a loan
review committee.
The SIC specifically expressed concern to Mr. Beller about the
bank's ability to control the lending activities of Mr. Patterson,
the Senior Executive Vice President in charge of the

energy department. However, Mr. Seller assured the EIC that he
had initiated efforts to bring Mr. Patterson under control and
that he would succeed. On several occasions during the
examination, Mr. Beller told the EIC that he had total control
over the Dank and that Mr. Jennings never disputed anything that
Beller wanted to do. Accordingly, the EIC left the bank assured
that there were adequate controls over Mr. Patterson. OCC had
no reason to believe that Mr. Seller's assurances of control
over Mr. Patterson were untrue. In a letter to OCC dated
December 9, 1981, the bank detailed its new management structure
and therein showed Mr. Patterson reporting directly to Mr.
Improvements were also observed during the September, 1981
examination in asset-liability management and control. The
violations of law noted in the December 1980 report had been
corrected and the bank appeared to have made considerable
progress toward full compliance with the agreement. The
periodic reports submitted by Penn Square pursuant to the
agreement similarly reflected progress and a desire by the new
management to improve the condition of the bank and to comply
with the terms of the agreement.
The implementation of satisfactory internal loan review
procedures, the quality and commitment of new management and the
now adequate capitalization tended to mitigate our concern for
the energy-related loan concentration. Given the importance of
energy to the local economy, it was neither surprising nor
improper that a Dank in that area should have a large number of
loans to energy-related concerns. Moreover, at that time, the
future for the energy industry in Oklahoma appeared quite

favorable. Spot prices on crude oil had reached a high of
$42/bol. in late 1980 after increasing tenfold in less than a
decade. Drilling companies achieved record returns in 1981.
Most analysts failed to predict the sharp decline in the oil and
gas industry which was to occur within a very short time.

The Events of 1982

In light of the problems still remaining in the ban*,
representatives of the OCC attended the board of directors'
meeting of the bank of January 12, 1982 to discuss the results
of the examination. The bank's board was informed that a more
detailed examination would be conducted near the end of the
first quarter of 1982. As late as January 1982, OCC believed,
on the basis of the information available, that the outlook for
Penn Square was favorable and that all substantial areas for
concern were being addressed and corrected.
April 1982 Examination
On April 19, 1982, OCC began the general examination that
ultimately led to tne closing of the bank. OCC entered the bank
expecting to find its condition substantially improved.
However, by the second or third week of the examination, there
were indications that the bank's condition had declined and that
it had significant problems. Among the problems discovered was
that the bank's loan files were in disarray and lacked essential
documentation. This tended to slow considerably the review of
the bank's loan portfolio. It should be noted, however, that at
this time there were no indications that the bank faced a
serious risk of imminent failure.

Much of the change in the bank's condition was directly and
indirectly due to the severe, rapid and unforeseen decline in
the oil and gas industry during the fourth quarter of 1981 and
tne first quarter of 1982, i. e. , after the September, 1981
examination. By Marcn, 1982, the price of crude oil had dropped
to below $30/bbl. By July, 1982, the number of active drilling
rigs in the United States nad decreased by 40% from December,
1981. The major oil companies experienced a record decline in
earnings; tne first quarter 1982 earnings of 72 U.S. oil
companies had fallen 3D% from the same period in 1981. Losses
and severe cash strain were also experienced by the smaller and
more highly leveraged oil and gas production companies.
The impact of this decline upon many of Penn Square's most
important borrowers was devastating. The Dank had concentrated
in loans to firms in the oil and gas industry. As tnose firms
began to experience financial difficulties the banK, instead of
prudently reducing its exposure, made large additional loans in
an effort to assist those customers. Many of those loans were
made in violation of the lending policies and procedures OCC had
insisted oe installed. More importantly, many violated the
essential tenets of prudent banking and - if viewed
realistically - had little likelihood of being repaid.
The examination disclosed that between September 30, 1981 and
March 30, 1982 the bank had originated an astonishing $800
million in new loans. A large portion of those loans were to
energy firms. Of the $49.1 in assets eventually classified as
loss, almost $28.5 million were booked after September 30,
1981. The bank's imprudent lending eventually produced total
classified assets equal to 352% of gross capital funds and
delinquency in almost 13% of the loan portfolio.

A properly managed institution with a similar concentration in
well structured energy credits could nave survived trie decline
in tne oil and gas industry. However, the combination of poor
credits, poor management, and an adverse economy proved fatal to
Penn Square. The problem assets led to deficient capitalization
and, due to an excessive dependence upon purchased funds,
severely strained liquidity.
The Insolvency
In i«lay and early June, the news media began to give increasing
attention to the bank and there were indications that the bank
might lose some of its major sources of funding. On June 25,
media attention and rumors in the industry had reached a point
to cause OCC to be concerned about the possibility of a
liquidity emergency. OCC Knew that if such an emergency
occurred, it would effectively deny the OCC an opportunity to
complete its examination in an orderly manner and deny the board
any opportunity to save the institution by recapitalizing it or
arranging a sale or merger.
Throughout the examination, OCC kept the bank's management
fully informed of the facts as they were discovered. Based on
the preliminary findings of the examination, the OCC issued a
Notice of Charges and a Temporary Order to Cease and Desist on
June 30, 19b2, to require immediate action by the directors to
rehabilitate the bank, including: the injection of $30 million
in additional capital by July, 9, 1982, correction of collateral
and documentation deficiencies, curtailment of new lending
activities, and the engagement of independent auditors to
reconcile the asset accounts of the bank. On July 1, 1982, OCC

attended a special meeting of the Board of Directors to advise
the directors of the preliminary examination findings and the
administrative action taken by OCC.
Subsequently, when the OCC determined that tne additional
capital was needed immediately to restore confidence in the bank
and slow a deposit runoff, the Temporary Order to Cease and
Desist was amended to require the bank to obtain $30 million in
new equity capital Dy the close of business on July 2, 1982. No
additional capital was injected. Subsequently, the OCC further
amended tne Temporary Order to limit transactions with
affiliates to prevent the bank from repurchasing participations
from its holding company.
In late June 1982, OCC contacted several of the banks holding
large amounts of participations in Penn Square loans. These
contacts had two ODJectives: first, to seek assistance of the
banks in averting the possible failure of Penn Square through
creation of a consortium to purchase the bank or through some
other means; and second, to ascertain the effects of the
possible failure of Penn Square on the soundness of those
OCC informed the other federal financial regulators of the new
developments at Penn Square as they were discovered. On May 21,
1982, while the examination was still in progress, the Regional
Administrator notified the Regional Director of the FDIC that
the examination was uncovering significant problems. On June
23, 1982, the Regional Administrator further informed the FDIC's
Regional Director of the conditions disclosed by the ongoing
examination. Subsequently, on June 30, 1982, the OCC met with

the Chairman of the FDIC in Washington and informed him that the
proolems had grown significantly worse. Responding to the
growing public and industry concern over the bank's condition
and mindful that the concern could create a severe liquidity
strain on the bank, the OCC invited the FDIC to join its ongoing
examination for contingency purposes. The FDIC did join the
examination on July 1, 1982. The OCC, in a letter dated July 2,
1982, formally requested that the FDIC begin preparations for a
potential purcnase and assumption transaction or payout of
insured deposits.
As of Friday, July 2, the loan losses were not sufficient to
render the bank insolvent on a book basis. However, the bank
nad lost sufficient support from the marketplace to render it
dependent upon the Federal Reserve Bank for funding. The
borrowings from the Fed allowed it to operate on a solvent basis
for July 2 and the next half day (July 3) .
Due to concerns about tne depth of tne oank's loan problems
and the possible impact upon other institutions, OCC's examiners
worked througn the weekend to try to determine the true
condition of the bank's loan portfolio. Based upon the review
done by the examiners, we determined, as of July 5, 1982, that
the losses then identified exceeded the capital funds of the
bank. Also, oy the end of the weeKend, the regulators and bank
management had concluded that withdrawals on the next day of
business (Tuesday, July 6) were likely to be enormous. On July
5, 1982, the Federal Reserve Bank of Kansas City, in response to
a question from this Office, indicated that it was no longer
willing to fund the bank's operations at the discount window.
The bank, already dependent upon the Fed for its
funding survival, would therefore not be able to meet the
demands already placed upon it in the ordinary course of
business. Because no other source of funding was available, it
was insolvent on a liquidity basis. We became satisfied on July
5, 1982, of the insolvency of the bank. Accordingly, on that
date, acting pursuant to our statutory duties, at 7:05 p.m.
(CDST) we declared the bank insolvent and appointed the FDIC as

The CHAIRMAN. Thank you very much.
Mr. Isaac.

Mr. ISAAC. Thank you, Mr. Chairman.
The events surrounding the Penn Square failure have been
widely publicized and are well known to the committee; I will not
dwell on them in my prepared remarks. I would like to focus on
the lessons to be learned from Penn Square and update the committee on FDIC's post-closing activities.

Our feeling is that the failure does not teach us much new.
Rather, it confirms a lesson of the past, namely that laws, regulations, and supervision are not always effective in preventing or
curing problems where a bank—and its board of directors—are
dominated by a strong personality who is set on a course of mismanagement. We feel strongly that uninsured depositors and other
investors need to pay more attention to how their banks are run
and must be provided better information upon which to base their
judgments. To the extent that Penn Square has heightened awareness of this, it has been beneficial.
Well before Penn Square, we were in the process of revising and
expanding the call reports we obtain from banks. We believe Penn
Square underscores the desirability of collecting more and better
information and of making more information available to the
public. Quarterly reports on nonperforming loans, for example, will
be required commencing January 1, and this information will be
made public commencing with the reports of June 30, 1983. While
some bankers have expressed concern about making this information public, I should point out that similar information has been
reported for years to the SEC by publicly held institutions without
resulting in any undue harm. If institutions with higher than
normal ratios of nonperforming loans have more difficultly attracting funds, we believe that is a healthy and appropriate result of
disclosure. Given timely and factual information about banks, we
hope and believe the investing public will reward the better-managed institutions with lower-cost funds.
In addition to seeking additional information about banks and requiring its public disclosure, we are proceeding with the deposit insurance study mandated by title VII of the Garn-St Germain Act.
In an environment where funds may be transferred almost instantaneously by electronic transmissions anywhere in the world,
where money managers must operate profitably on narrowing
spreads, and where deposits are more likely to be viewed as investments than ever before, it is appropriate to reexamine the basic
tenets of our insurance programs and regulatory structure. We are
particularly concerned that as federally mandated restrictions on
competition are diminished there be some effective substitution of
market discipline. Our study is directed toward finding answers
about how to maintain the integrity of our financial system in this

challenging new competitive environment. We look forward to appearing before you next year to discuss these matters.
When the FDIC was appointed receiver for the Penn Square
Bank on July 5, we found ourselves faced with one of the most difficult situations we have ever encountered. I cannot speak too
highly of the performance of the scores of FDIC employees who
have been working 16- and 17-hour days, 7 days a week since that
holiday weekend. The early days were chaotic, and some of the
banks participating in the Penn Square loans were understandably
concerned about their inability to get all of the information they
wanted. Our first priority had to be to make funds available to insured depositors and issue receiver's certificates to the uninsured
general creditors. During August and September, we detailed 41
extra people to the receivership to expedite the handling of loans,
and we now believe we are on top of these administrative problems.
The creation of the Deposit Insurance National Bank proved to
be an effective way of avoiding panic, minimizing inconvenience to
depositors, and limiting disruption in the community. Last week we
obtained court approval to sell the former banking house and remaining deposits to an investor group that is seeking a national
bank charter. We expect the charter to be granted soon, and when
that is done we will transfer the remaining insured deposits to the
new bank and terminate this aspect of our operations.
Attached to my statement is a report on the status of the Deposit
Insurance National Bank and the receivership. As noted there, we
acquired assets of Penn Square Bank amounting to $511.3 million.
As of October 31, 1982, we had collected $221.4 million in principal
and interest on loans—including $101.6 million on loans sold by
Penn Square to the other banks. Expenses charged to the receivership as of October 31 totaled approximately $3 million, or 1.36 percent of collections. As we work off the better assets and concentrate on the tougher problems, this ratio of expenses to collections
can be expected to rise significantly. As noted in the attachment,
interest income of the receivership through October 31, 1982, totaled $12.8 million.
Excess funds collected are invested in Treasury obligations and
earn market rates of interest pending distribution to holders of receiver's certificates. It is our hope an initial distribution can be
made to holders of the receiver's certificates in an amount of 10 to
15 percent of their face value during the first quarter of 1983.

An important part of our work in the receivership is the ongoing
investigation of possible criminal violations which may have contributed to the bank's failure. Since our last report to the committee detailing activities through September 30, 1982, we have referred 13 additional cases to the Attorney General, for a total of 43
referrals of possible criminal activity. Active and successful prosecution of these cases by the Attorney General would do more to
deter future bank problems than anything I can think of.
I would be pleased to answer any questions. Thank you.
[Attachments follow:]

December 3, 1982

Penn Square was closed July 5, 1982, by the Comptroller of the Currency,
who named the FDIC receiver.
Status of the Penn Square Receivership
Upon appointment as receiver, the FDIC acquired for l i q u i d a t i o n a l l the assets
of Penn Square t o t a l i n g $511.3 m i l l i o n . In a d d i t i o n , the FDIC acquired $8.2
m i l l i o n in assets which had been charged off by the bank prior to i t s
closing. The liquidation p o r t f o l i o included the following categories of
assets at book value:
Cash and Due From Banks
Installment Loans
Commercial Loans
Mortgage Loans
Owned Real Estate
Other Assets

$ 27,695,235

In addition, Penn Square had outstanding loan participations sold to other
banks equal to $2.1 b i l l i o n as of the date of the closing.
As of October 3 1 , 1982, the FDIC had collected $221.4 m i l l i o n in principal
and interest on loans, s e c u r i t i e s , and other assets. Out of the t o t a l
c o l l e c t e d , $101.6 m i l l i o n was paid to the holders of loan participations
sold by Penn Square, $7.5 m i l l i o n was used to repay secured advances from
the Federal Reserve to Penn Square, and $13.5 m i l l i o n was paid to owners
of pledged deposits.
Receivership Income and Expenses
Expenses of the l i q u i d a t i o n from inception of the receivership to
October 3 1 , 1982, t o t a l l e d approximately $3.0 m i l l i o n , or 1.36 percent of
c o l l e c t i o n s . The ratio of expenses to collections is expected to increase
s i g n i f i c a n t l y as the liquidation progresses and the q u a l i t y of the remaining
assets declines. Expenses of the receivership were as follows:
Employee Benefits
Outside Services
Building and Lease



Supplies, Computer & Court Costs
Interest Expense
Owned Asset Operating Expense


Interest income of the liquidation from inception of the receivership to
October 3 1 , 1982, t o t a l l e d approximately $12.8 m i l l i o n , as follows:



Collected receivership funds are invested in U.S. Treasury securities and
earn market rates of i n t e r e s t .
The FDIC operates in two separate capacities in the l i q u i d a t i o n of Penn
Square: in i t s corporate capacity, as insurer of deposits, and in i t s capacity
as receiver. Payments to a l l insured depositors, as well as a l l costs incurred
in connection with the payment of insured deposits, are borne by the FDIC's
insurance fund. In i t s capacity as receiver of Penn Square, the FDIC operates
as a fiduciary on behalf of a l l creditors of the bank, which includes the
FDIC to the extent of the insured deposits paid. The FDIC's claim against the
receivership excludes i t s administrative expenses incurred in paying deposit
claims. The FDIC does not have a preference for i t s claim but shares pro rata
with a l l other creditors with proved claims in the d i s t r i b u t i o n of the f a i l e d
bank's assets.
The FDIC bears a substantial p a r t . o f the costs incurred in the l i q u i d a t i o n of
assets. For example, lodging, meal, and travel costs (except those travel
costs incurred in connection with specific receivership functions) for FDIC
liquidators and examiners assigned to the closed bank are paid as an insurance
expense and are not recovered from the receivership estate of the bank. The
same is true for the salaries of Washington Office supervisory and support
personnel who work on Penn Square matters. However, a l l other FDIC expenses
incurred in the liquidation of assets are charged to the receivership estate
of Penn Square and are recovered f i r s t as administrative expenses from the
receiver's c o l l e c t i o n s .
The receivership s t a f f includes l i q u i d a t o r s , in-house attorneys, loan work-out
s p e c i a l i s t s , and bookkeeping and c l e r i c a l employees. In addition, o i l and gas
experts have been retained. The receivership s t a f f totals 283, including 77
permanent FDIC employees and 206 former Penn Square and other l o c a l l y - h i r e d
employees. An additional 2 FDIC employees and 14 former Penn Square and other
l o c a l l y - h i r e d employees are employed by the DINB. Prior to the closing, Penn
Square had 383 employees.
L i t i g a t i o n By and Against the Receivership Estate
The FDIC, in i t s capacity as receiver of Penn Square, i s involved i n extensive
l i t i g a t i o n , a s i g n i f i c a n t amount of which had been f i l e d prior to the bank's
closing. At the present time there are pending approximately 250 d i f f e r e n t
legal actions in which the FDIC is a party. Roughly 20 percent of these actions
are bankruptcy proceedings in which FDIC is involved as a c r e d i t o r . Many of the
actions are suits to c o l l e c t on loans and other assets of Penn Square.
Several major claims have been made in actions brought against the FDIC as
receiver of Penn Square and other parties arising out of the bank's energyrelated lending a c t i v i t i e s . These suits raise legal issues regarding l e t t e r s
of c r e d i t , the rights of loan p a r t i c i p a n t s , and general bank receivership

p r i n c i p l e s . Some l i t i g a n t s have raised allegations of fraud on the part of
certain oil d r i l l i n g companies and Penn Square o f f i c e r s .
Bond Claims and Directors L i a b i l i t y Matters
FDIC personnel have been conducting a thorough examination of Penn Square's
records since July 5, 1982, with a view toward developing and presenting
substantial claims under Penn Square's bankers blanket bond. The FDIC is
also investigating potential claims against former officers and directors of
the bank and the bank's accounting f i r m .


The FDIC is conducting, in conjunction with the FBI, a thorough investigation
of the events and a c t i v i t i e s which led to Penn Square's f a i l u r e . At the
present time, the FDIC has discovered 43 matters-which may constitute criminal
offenses under federal law. Evidence in th°*p ^tters has been referred to
the Justice Department for further invest .-jat-vn and possible prosecution.
Receiver's C e r t i f i c a t e s
Depositors with amounts on deposit in Penn Square in excess of the insurance
l i m i t of $100,000 had t h e i r deposits up to the insurance l i m i t transferred to
the DINB, while the excess became a claim against the Penn Square receivership. Each such depositor is being issued a "Receiver's C e r t i f i c a t e " in an
amount equal to the uninsured portion of the deposit. The excess depositors'
claims have general creditor status, which means they w i l l share in l i q u i dating dividends with the FDIC and other general creditors from the recoveries
realized from the receiver's liquidation of the bank's assets. The FDIC is
hopeful t h a t a f i r s t dividend can be paid to creditors with proved claims
during the f i r s t quarter of 1983.
The receivership has issued 1,792 receiver's c e r t i f i c a t e s in the total amount
of $157.8 m i l l i o n as of November 30, 1982.
I t is too early to make any r e l i a b l e estimate of the total recoveries l i k e l y
on Penn Square's assets. F i r s t estimates of possible recoveries w i l l probably
be completed in early 1983 and, once made, w i l l undoubtedly be subject to
s i g n i f i c a n t change as the liquidation progresses.
Status of the DINB's Operations
The DINB was established by the FDIC in order to make the insured deposits
immediately a v a i l a b l e .
On July 5, 1982, the DINB assumed 24,538 insured deposit accounts t o t a l i n g
$207.5 m i l l i o n . As of November 30, 1982, the DINB had 1,525 insured deposit
accounts t o t a l i n g $4.9 m i l l i o n which consisted of $4.4 m i l l i o n in demand
deposits and $500,000 in time deposits. The FDI Act authorizes the operation of a DINB for up to two years. Before the end of that period, the
FDIC may transfer the bank's business to another insured bank in the same
community or i t may conclude the bank's business and cease i t s operations.


0 - 8 3 - 4


The CHAIRMAN. Thank you very much, Mr. Isaac.
Mr. Partee.
Mr. PARTEE. Thank you, Mr. Chairman.
I am happy to appear before this committee today to discuss the
Federal Reserve's involvement with the Penn Square Bank. Let me
state at the outset that the Federal Reserve's involvement was limited to its role as a lender of last resort, regulator of Penn Square
Bank's parent bank holding company and to a general concern
over the impact of bank failures on the orderly operation of the
Nation's financial system.

As a lender of last resort, the Federal Reserve provides essential
credit to depository institutions for the purpose of providing temporary liquidity in times of need. The lending function of the Federal
Reserve is conducted through the District Federal Reserve Banks,
which operate under broad guidelines established by the Board in
Washington. In the case of Penn Square Bank, the Federal Reserve
Bank of Kansas City was the lending bank. The president of the
Kansas City Reserve Bank has appeared before a congressional
committee to explain the Reserve Bank's loans to Penn Square
Bank in detail, and his testimony is a matter of public record.
Briefly, the relevant facts are as follows.
On June 30, Penn Square Bank requested, and was granted, a
$20 million loan from the Federal Reserve Bank of Kansas City.
This loan was supported by a pledge of $26.3 million of Penn
Square Bank's customer notes. The loan was repaid the next day.
Friday, July 2, the bank again borrowed, this time in the amount
of $5.7 million, which was collateralized by $39.4 million of Penn
Square Bank's customer notes.
Over the July 4 weekend, the Federal Reserve Bank was notified
by the Comptroller of the Currency that the Penn Square Bank's
current loan losses and potential loan losses arising from irregularities in loan documentation and other business practices would extinguish the bank's capital funds. The Comptroller also informed
the Federal Reserve that the Penn Square Bank would be unable
to meet the demands of its depositors and creditors from private
funding sources. In response to the Comptroller's evaluation of the
bank's asset portfolio, its capital position, and the dissipation of its
private funding sources, the Federal Reserve Bank notified the
Comptroller of the Currency of its intention not to extend credit to
the bank under these circumstances. Subsequently, the Comptroller declared the bank insolvent, and it was closed on July 6. The
Federal Deposit Insurance Corporation, as receiver, paid the $5.7
million loans owing to the Federal Reserve Bank of Kansas City,
which released the collateral to the receiver.
The Federal Reserve also functioned as the regulator of the
bank's parent company, First Penn Corp. The condition of First
Penn Corp. was essentially reflective of the condition of the bank,
since the parent company was a "shell" principally serving as a ve-

hide to hold the stock of the bank. As is the case when the holding
company owns a national bank, the Reserve Bank relied on the
findings of the Comptroller with respect to the bank's condition.
The Federal Reserve Bank of Kansas City inspected the First Penn
Corp. on two occasions between the beginning of 1981 and the time
the bank failed in July 1982. There was no evidence that any of the
activities of the holding company contributed to or were in any
way responsible for the Penn Square Bank's difficulties. Indeed,
virtually all of the parent company's assets were represented by deposits with, investments in, or loans purchased from the Penn
Square Bank.
In the context of the Board's concern over the effect of the failure of Penn Square Bank in the markets generally, the Federal Reserve explored possible alternatives to liquidation of the bank.
Given the circumstance and the short period of time available to
arrange an alternative solution, however, it became clear on
Monday, July 5, that the bank was destined for liquidation.

Prior to the closing, the Federal Reserve was notified that the
Penn Square Bank had a substantial amount of uninsured deposits
from financial institutions. Under the receivership, the uninsured
depositors were to be given "receiver's certificates" amounts equal
to the uninsured portion of their respective deposits. In response to
the potential liquidity needs of these financial institutions, the Federal Reserve announced that the "receiver's certificates" would be
acceptable as collateral for advances at the Federal Reserve discount window. Since the failure of the Penn Square Bank, the Federal Reserve has received only a limited number of discount
window borrowing requests from these institutions. As of today,
there are no loans outstanding secured by "receiver's certificates."
The Federal Reserve has also reviewed the Penn Square episode
to determine the capacity of existing bank laws and regulations to
handle a similar situation should it occur in the future. It is our
judgment that current banking statutes and regulations, and the
supervisory tools available to Federal bank regulators are adequate
at present to oversee the safety and soundness of our Nation's
banking system. We would point out, once again, that the failure of
Penn Square resulted from an extreme emphasis on growth at the
expense of sound lending and funding practices, and in the absence
of proper management oversight and controls. The extremely unsound banking practices that caused the failure of the Penn Square
Bank represent an isolated instance, not characteristic or typical of
commercial banks or depository institutions generally. Indeed, the
evidence we have continues strongly to indicate the overwhelming
majority of banks being operated in a sound and prudent manner.
The CHAIRMAN. Thank you, Governor Partee.

Mr. SEBASTIAN. Thank you, Mr. Chairman. As you know, Chairman Callahan's brother was taken very seriously ill yesterday and
he left to be with his family. I appreciate your indulgence in allow-

ing me to testify in his behalf. We have submitted a rather lengthy
formal document for the record and Fd like to simply make a few
remarks to summarize the Penn Square failure and its effect on
credit unions.
[Complete statement follows:]


Mr. Chairman, members of the Committee, I am pleased to be here today to give
you an updated report on the impact of the Penn Square Bank failure on credit unions. It
is my sincere hope that this report will fully address any concerns which this Committee
or others might have regarding current credit union operations. I certainly welcome this
opportunity as I believe we might now have a better perspective on this matter looking at
it 5 months later.
The closure of the Penn Square Bank resulted in certain operating losses for 139
federally insured credit unions whose uninsured deposits totalled $111.5 million. All of
these insured credit unions continue to operate and serve their members. In the vast
majority of cases, the credit unions were able to absorb these operating losses through
their operating income and, of course, no credit union member has lost any money. In
those requiring assistance, traditional methods such as waiver of reserve transfers or
charges to reserves have been adequate in most cases. In a few instances, however, a
very limited amount of temporary direct assistance has been given in the form of
guarantees or deposits.
As for the amount of loans against the Receiver Certificates, $35 million has been
requested and granted thus far by the Central Liquidity Facility. For your further
information, we anticipate $10 million of this to be paid back within the next week.
At this point in time, I am quite hopeful that no credit union will have to be closed
as a result of Penn Square. I believe that valuable lessons have been learned not only by
this agency, but more importantly by credit union decision-makers. Although, in all
fairness, I must say that hindsight is certainly an advantage. At the time, a decisionmaker had to weigh two factors as I see it. One, the available information on

the financial condition of the bank which, as I understand it, included a satisfactory 1981
year-end audit from Peat, Marwick, Mitchell k Co. as well as other traditional financial
information. Against this would have to be weighed a concern for concentrating funds in
order to receive a relatively high yield. Any such concern would, of course, be somewhat
ameliorated by the fact that, prior to Penn Square, the last significant credit union losses
in a failed bank were in the Sharpstown Bank in 1971.
Nevertheless, credit union managers are re-thinking their investment strategies. In
our examinations we will be looking more closely at credit union investment policies to
make sure that they have been developed as carefully as possible. Of course, Mr.
Chairman, credit union investments are fixed by statute and in general are limited to
government guaranteed obligations or to deposits in insured institutions. Further, NCUA
regulations require that if money brokers are doing business with a credit union, the
credit union itself must transfer directly any funds involved. As far as the money
brokers are concerned, there is little doubt as to their contribution to the concentration
of credit unions in Penn Square. However, I am not aware of any impropriety or
illegality on their part. We have sought comments on our investment regulations and we
will continue to study this area before we adopt any changes. Copies of the investments
authorized by statute, the investment regulations, and the request for comments are
attached as Enclosures (1M3).
I realize that when something like this occurs, there is a very legitimate question
that should be asked of a regulator - what are you going to do to help prevent this or
similar situations from occuring in the future? Well there is no perfect answer, but we
have been taking steps. The most important is our examination. We are in the midst of

reviewing the role of the examiner towards giving him or her greater flexibility and the
opportunity to exercise judgment in the actual conduct of the exam. We want them to
not just follow the form, but to take some further initiative and ask questions and
hopefully find the early signs of the next "Perm Square" type situation.
Next, we are increasing the frequency of our exams with an eventual goal of
reaching each and every credit union yearly. Further, we are reviewing the make-up of
the exam itself in an effort to identify ways to make it more effective.
Also, I have tried to vastly increase the lines of communication between the agency
and the credit unions. Our regional offices are much more autonomous and decisions can
be made much more rapidly. If we can alert credit union managers and boards of
directors to potentially adverse situations at the earliest possible time, we can try to
minimize future problems in these areas. As a matter of fact, a letter to all credit
unions cautioning against concentration of deposits in a single institution due to yield was
sent by this Agency in June of 1981 (Encl. (4)).
Before I proceed Mr. Chairman, I do want to try and set this particular credit union
loss in perspective.
Losses are a normal part of doing business and they are planned for. In the credit
union business, the vast majority of these losses occur as a result of loans and a much
smaller percentage results from investment losses. This is due to two factors: (1) credit
unions do much more lending than investing as their primary function is to make loans to
their members; and (2) the Federal Credit Union Act limits credit union investments
primarily to those issued, insured, or guaranteed by the government.

But investment losses can occur in the safest of investments as credit unions found
out in 1979 in their experience with Ginnie Maes. Substantial credit union investment
losses occurred as the result of Ginnie Mae investments made that year and these losses
continue to be realized. But they were small compared to loan losses and they were
For example, in 1981, Federal credit unions experienced loan losses of
approximately $183 million. This was 25 times greater than their losses due to
investments of $7.3 million. Loan losses were slightly less than 1% of total loans made
while investment losses were only l/10th of 1% of all investments. Even if the Perm
Square losses had occurred last year, the percentage of investment losses would still have
been only about 4/10 of 1%. My point is that loans will continue to be the main risk area
for credit unions.
As you know, Mr. Chairman, the present financial atmosphere has raised the
question of further disclosure by financial institutions and your bill ( P.L. 97-320) has
mandated a study which includes disclosure. I agree that this could be a productive area,
but I want the Committee to see first-hand the current credit union disclosure
requirements. I have inserted at this point a sample disclosure form that is updated
monthly and posted in the lobby of all Federal credit unions.


Figure 3-1: Statement of Financial Condition
(FCU 109A)
VicembeA 31

I Internet U H Only 1
| Repon Type _ _ j










lMn.nm.mb.,. .


(Orio maturity over 12 year.l .


by <na>e.

. . T o . . . loan. , o r r * m b . , . » n c . u d e , t e r n , a.b.c. and dl

I L . . . 1 Allow.™ce tor loan loue.


N . I Loan. Out.tandino. (Sum ol 1 . plu.




A 1 vr. or . . " . r " " '



22 FTomi.»ory


23. Reverie Repurchat* Tranuc.
24 Other note.







R.m..„ln, Maturity





. '~ .





26. Account, payab


85,389 00






° "' «



28. All other llabillt


29 Total Llabilitie. (Sum of 22 through 281



Obligations . .
7. Federal i9«ncy


9. Sh3r«i.d»po»ia.



5 0 0 , 0 0 0 [00


b. Share draft K






d Other membe







1. Total «*ving»/»rur.i/d.po>rl. ISum of 3







13 Another
S h M . l n C . r n al Liquidity Facility (Direct or Indirect!





h 201





751 |

35. Undivided Earnl


36- Net Income ILo








ISum of 29. 30* and






38 U S Governmnt


39 Federal agency


40.a Another





009 |




34.Oth.rrm.rv*. .



32. Inveatment Valuation r . t t r v . ISCU'a only!



Allother » <



00 ^o7|

19. Monetary control reurve

21 T O T A L ASSETS ISum 0 ) 4 . 5 . 1 6 & 17 in



17. Land and building (n.t ol depreciation!

FCU 109A


c. Member ISCU*. Only!


& a n i l 'in
other CUi . .
I I Sar»,d.po»io.
licanll intanki

A 20


C. Total





30 a Sher.

8. Common



25. Intere.t payable









2. All other lam account, (excluding ami.



70165 A


*2n!?Jf , .'.Vrtucn.S!'" n n ' • ' • ' ' ° n ° ' " ' °


»•"•"••"»•• ' • « • ' » ' • • • • " - « > ' - n . n l . . y K h r t u . . .


Figure 3-2: Statement of Income (FCU 109B)

Intarnal U H Only'l

.FOR PERIOD ENDED ' 2 / 3 > / X ?

|Mon,h Vic^mi


.3.,345 lOO

525,3t3 bO

QUA. FzdztoU


I 42 ( L t t i l I n l . r . u ralundad .

\2.12s bo

43 Incomjlroi

134. 5ST lOO I

Sit. 201 bO


23.052 BO
I? Employ** bantfils

^ . Q / I * h<i


IS. Travel !• conl*r*oc* •>


I SO Ollict occupancy anpanta .
I S2.'Educi

* l Si outiida atrvkes .


I S7.0paratin( tatf (aaam.. Si tuptrl .

34.1^9 bQ
9.749 bO

I 59. Annual mealing axpam* .


O M I Non-Op*ratingGaini and U m i


I 67Total Nat Income f L o u i B * l o r . O i v e i l n i / D * p J _
I 68 InterenondepoiiulSCUsoniyl
I 70 N.l Income (Loul Altai D.» Si Im/CXp .
71.(Leu) Raq. tram 10 1*9. or ilat reierva. .

13.455 (

53.120 It
30,371 k
7S.2S9 loo I


As you can see it is very detailed and thorough. It includes such items as allowance for
loan losses, total loans, investment losses, and detailed information on delinquent loans.
Many people were not aware that credit unions have been making this type of disclosure
for a number of years. I would also like to point out that many of the credit unions
involved in Penn Square provided to their members a full explanation of the situation in
their newsletters.
A final point, Mr. Chairman, and I will be glad to answer any of your questions.
This concerns the matter of cooperation among the regulators. I was personally informed
of the pending action on Penn Square before it was taken and our staffs have exchanged
information on a routine basis as we went along. Even if one regulator had more
advanced information about the other's problem institutions there is only so much you
can do with this information. For example, one of the credit unions experiencing a
difficult recovery from Penn Square is having this trouble not only from the Penn Square
losses but from rumors about another bank in which it had deposits. Because of the
atmosphere set by the Penn Square fallout and newspaper stories of possible problems in
the other bank, this credit union went ahead and took its deposits out of the other bank.
The early withdrawal penalties were almost as damaging as the uninsured deposit losses
and the combination made it much more severe.
Again, I want to thank you for the opportunity to present this report, Mr.
Chairman. I hope that it has helped to place the credit union involvement in Penn Square
in perspective. In my opinion, while Penn Square was certainly a serious problem, the
credit union system seems to be handling it.
This concludes my statement.


(7) To invest its funds (A) in loans exclusively to members; (B)
in obligations of the United States of America, or securities fully
guaranteed as to principal and interest thereby; (C) in accordance
with rules and regulations prescribed by the Board, in loans to other
credit unions in the total amount not exceeding 25 per centum of its
paid-in and unimpaired capital and surplus; (D) in shares or accounts
of savings and loan associations or mutual savings banks, the accounts
of which are insured by the Federal Savings and Loan Insurance
Corporation or the Federal Deposit Insurance Corporation; (E) in
obligations issued by banks for cooperatives, Federal land banks,
Federal intermediate credit banks, Federal home loan banks, the
Federal Home Loan Bank Board, or any corporation designated in section
846 of Title 31 as a wholly owned Government corporation; or in
obligations, participations, or other instruments of or issued by, or
fully guaranteed as to principal and interest by, the Federal National
Mortgage Association or the Government National Mortgage Association;
or in mortgages, obligations, or other securities which are or ever
have been sold by the Federal Home Loan Mortgage Corporation pursuant
to Section 305 or Section 306 of the Federal Home Loan Mortgage
Corporation Act; or in obligations or other instruments or securities
of the Student Loan Marketing Association; or in obligations,
participations, securities, or other instruments of, or issued by,
or fully guaranteed as to principal and interest by any other
agency of the United States and a Federal credit union may issue
and sell securities which are guaranteed pursuant to section 306 (g)
of the National Housing Act; (F) in participation certificates
evidencing beneficial interests in obligations, or in the right to


receive interest and principal collections therefrom, which obligations
have been subjected by one or more Government agencies to a trust or
trusts for which any executive department, agency, or instrumentality
of the United States (or the head thereof) has been
named to act as trustee; (G) in shares or deposits of any central
credit union in which such investments are specifically authorized by
the board of directors of the Federal credit union making the
investment; (H) in shares, share certificates, or share deposits of
federally insured credit unions; (I) in the shares, stocks, or
obligations of any other organization, providing services which are
associated with the routine operations of credit unions, up to 1 per
centum of the total paid in and unimpaired capital and surplus of the
credit union with the approval of the Board: Provided, however, That
such authority does not include the power to acquire control directly
or indirectly, of another financial institution, nor invest in shares,
stocks or obligations of an insurance company, trade association,
liquidity facility or any other similar organization, corporation, or
association, except as otherwise expressly provided by this Act; and
(J) in the capital stock of the National Credit Union Central
Liquidity Facility; (L) investments in obligations of, or issued by,
any State or political subdivision thereof (including any agency,
corporation, or instrumentality of a State or political subdivision),
except that no credit union may invest mora than 10 per centum of its
unimpaired capital and surplus in the obligations cf any one issuer
(exclusive of general obligations of the issuer); and

(8) to make deposits in national banks and in State banks, trust
companies, and mutual savings banks operating in accordance with the
laws of the State in which the Federal credit union does business, or in
banks or institutions the accounts of which are insured by the Federal
Deposit Insurance Corporation or the Federal Savings and Loan


Insurance Corporation, and for Federal credit unions or credit unions
authorized by the Department of Defense operating suboffices on
American military installations in foreign countries or trust
territories of the United States to maintain demand deposit accounts in
banks located in those countries or trust territories, subject to such
regulations as may be issued by the Board and provided such banks are
correspondents of banks described in this paragraph;

Changes made by the Garn-St Germain Act (P.L. 97-320)




Certificates of D e p o s i t .

(a) A Federal credit union may invest in or
make a deposit evidenced by a time certificate
of deposit issued by any of those institutions
enumerated in section 107(7)(D) and 107(8) of the
Federal Credit Union Act: Provided,
(1) That such Federal credit union itself
makes the investment or deposit for which the
certificate is issued; and
(2) That no consideration is received from a
third party in connection with the making of the
investment or deposit.
(b) A Federal credit union may contract with
the issuing institution for payment of the whole
or a portion of a certificate of deposit before
(c) Certificates of deposit issued by those
state chartered financial institutions
enumerated in §107(8) of the Federal Credit
Union Act may be obtained by a Federal credit
union provided such institutions are operating
in accordance with the laws of a state in which
the Federal credit union maintains a facility.
For the purposes of the paragraph, the word
"facility" means the home office of a Federal
credit union or any suboffice thereof, including
but not necessarily limited to a wire service,
telephonic station or mechanical teller station.
(d) Negotiable certificates of deposit purchased under this authority may be sold by a
Federal credit union to a third party before
maturity subject to the appropriate regulations
governing the issuing institution involved.
(e) The purchase of a certificate of deposit
that does not meet the above provisions is not
authorized for Federal credit unions.

§703.2 I n v e s t m e n t i n l o a n s t o
n o n m e m b e r credit u n i o n s .
(a) A Federal credit union may invest in loans
to other nonmember credit unions including
loans extended under a line of credit agreement,
(1) The aggregate amount of all loans and
credit limits established to nonmember credit
unions does not exceed 25 per centum of the investing Federal credit union's paid-in and unimpaired capital and surplus;

Part 703
Investments and Deposits

(2) The maximum amount of a line of credit
shall be stated in the line of credit agreement
between the investing and borrowing credit
(3) The terms and maturities of outstanding
loans and the schedule of payments of principal
balances outstanding under a line of credit do
not exceed one year; and
(4) The investment is approved by the board
of directors, or its authorized executive or investment committee.
(b) Prior to making a loan or extending a line
of credit, and annually in the case of an
established line of credit, the investing Federal
credit union shall obtain and retain on file the
following documents from the borrowing credit
(1) A current financial and statistical
(2) A certified copy of the resolution of the
board of directors or executive committee
authorizing such borrowing; and
(3) A written statement from the secretary
of the borrowing credit union that the persons
negotiating the loan or line of credit and executing the note or agreement are officers of the
credit union and are authorized to act on its
behalf and that the amount of loan or line of
credit does not exceed the maximum borrowing
authority of the borrowing credit union.


Investment Activities.

(a) Definitions.

(1) "Security"means any investment or
deposit authorized for a Federal credit union
pursuant to sections 107(7) and 107(8) of the Act.
For the purpose of this section, the definition of

JULY 1980

PART 703



PART 703


a security shall not mean loans to members or
loans authorized under sections 701.21-6 and
701.21-8 of the rules and regulations.
(2) "Standby commitment" means an agreement to purchase or sell a security at a future
date, whereby the buyer is required to accept
delivery of the security at the option of the
(3) "Cash forward agreement" means an
agreement to purchase or sell a security, at a
future date, that requires mandatory delivery
and acceptance. The contract for the purchase
or sale of a security for which delivery of the
security is made in excess of thirty (30) days but
not exceeding one hundred and twenty (120)
days from the trade date shall be considered to
be a cash forward agreement.
(4) "Repurchase transaction" means a
transaction in which a Federal credit union
agrees to purchase a security from a vendor and
to resell a security to that vendor at a later date.
A repurchase transaction may be of two types:
(i) "Investment-type repurchase transaction" means a repurchase transaction where:
(A) The Federal credit union purchasing
the security takes physical possession of the
security, or receives written confirmation of the
purchase and a custodial or safekeeping receipt
from a third party bank or other financial institution under a written bailment for hire contract identifying a specific security in its
possession as owned by the Federal credit
(B) There is no restriction on the
transfer of the security purchased by the
Federal credit union; and
(C) The Federal credit union is not required to deliver the identical security to the
vendor upon resale.
(ii) "Loan-type repurchase transaction"
means any repurchase transaction that does not
qualify as an investment-type repurchase transaction. A loan-type repurchase transaction
represents a lending transaction and is subject
to the limitations of section 107(5) of the Act.
(5) "Reverse repurchase transaction"
means a transaction whereby a Federal credit
union agrees to sell a security to a purchaser
and to repurchase the same security from that
purchaser at a future date, irrespective of the
amount of consideration paid by the Federal
credit union or the purchaser. A reverse repurchase transaction represents a borrowing transaction and is subject to the limitations of section
107(9) of the Act.


(6) "Futures contract" means a standardized contract for the future delivery of commodities, including certain government
securities, sold on designated commodities exchanges.
(7) "Trade date" means the date a Federal
credit union originally agreed, whether verbally
or in writing, to enter into the purchase or sale
of a security with a vendor.
(8) "Settlement date" means the date
originally agreed to by a Federal credit union
and a vendor for settlement of the purchase or
sale of a security, without any modification or
extension of that date.
(9) "Maturity date" means the date on
which a security matures, and shall not mean
the call date or the average life of the security.
(10) "Adjusted trading" means any method
or transaction used to defer a loss whereby a
Federal credit union sells a security to a vendor
at a price above its current market price and
simultaneously purchases or commits to purchase from that vendor another security above
its current market price.
(11) "Bailment for hire contract" means a
contract whereby a third party bank or other
financial institution for a fee agrees to exercise
ordinary care in protecting the securities held in
safekeeping for its customers.
(12) "Short sale" means the sale of a security not owned by the seller.
(13) "Market price" means the last
established price at which a security is sold.
(b) Limitations.
(1) A Federal credit union may contract for
the purchase or sale of a security authorized by
section 107(7) of the Act, provided that the
delivery of the security is to be made within
thirty (30) days from the trade date.
(2) A Federal credit union may not enter into a standby commitment to purchase or sell a
(3) A Federal credit union may enter into a
cash forward agreement to purchase a security
provided that the period from the trade date to
the settlement date does not exceed one hundred
and twenty (120) days and the credit union has
written cash flow projections evidencing its
ability to purchase the underlying security. A
Federal credit union may not enter into a cash
forward agreement to sell a security unless it
presently owns the security. All cash forward
agreements must be settled on a cash basis at
the settlement date.
JULY 1980



(4) A Federal credit union may not enter into an investment-type repurchase transaction
unless all the conditions cited in subsection
703.3(a)(4)(i) are met. Any repurchase transaction that does not meet such requirements constitutes a loan-type repurchase transaction subject to the limitations of section 703.3(b)(5). The
purchase price of a security obtained under an
investment-type repurchase transaction must
be at the market price.
(5) A Federal credit union may enter into a
loan-type repurchase transaction only with its
own members, other credit unions, or approved
credit union organizations that are defined in
section 701.27-2 of the rules and regulations.
(6) A Federal credit union may enter into a
reverse repurchase transaction, provided that
the funds obtained are not invested under section 107(7)(I) of the Act. Furthermore, either any
investment or deposit made under sections
107(7)(B), (D), (E), (F), (G), (H) or 107(8) of the Act

JULY 1980

13-540 0 - 8 3

PART 703

or any security collateralizing the reverse repurchase transaction must have a maturity date not
later than the settlement date for the reverse
repurchase transaction. The maximum amount
of funds that may be borrowed under a reverse
repurchase transaction for investment or
deposit is 10 percent of paid-in and unimpaired
capital and surplus.
(7) A Federal credit union may not buy or
sell a futures contract unless the purchase or
sale is specifically authorized by a regulation
issued by the Administration.
(8) A Federal credit union may not engage
in adjusted trading as defined in section
(9) A Federal credit union may not engage
in a short sale as defined in section 703.3(a)(12).
(10) All purchases and sales of securities by
a Federal credit union by means of a cash transaction under section 703.3(b)(1) or a cash forward agreement under section 703.3(b)(3) must
be at the market price.




July 16, 1982

12 C.F.R. Part 703


National Credit Union Administration


Advance Notice of Proposed Rulemaking

SUMMARY: During the summer of 1981, the National Credit Union Administration
reviewed and substantially eliminated mandatory regulatory provisions governing
the granting of loans by Federal credit unions. In late 1981, the National
Credit Union Administration began a review of its regulations that govern the
liability side of the Federal credit union balance sheet. Now, the National
Credit Union Administration is soliciting comments on whether, and to what
extent, it should modify its rules governing investments and deposits by Federal
credit unions.

Comments must be received on or before August 20, 1982.

ADDRESS: Send comments to Robert Monheit, Regulatory Development Coordinator,
National Credit Union Administration, 1776 G Street, N.W., Washington, D.C.
Telephone: (202) 357-1030.

Robert M. Fenner, Deputy General Counsel,


A comment that surfaced quite frequently during this Agency's recently
culminated proposal to deregulate Federal credit union share accounts was that
NCUA should give serious consideration to relieving regulatory restrictions on
the asset side of the Federal credit union balance sheet as well. At the
outset, it should be specifically noted that Part 703 of NCUA'8 regulations
governs only the manner in which a Federal credit union may invest and deposit
its funds. The Federal Credit Union Act itself sets out in detail the types of
investments that Federal credit unions may make and the places in which they may
maintain deposit accounts.
The Current Regulation
In Its present format, Part 703 is subdivided into three essentially
separate sections. The first, Part 703.1, implements the statutory authority
provided in sections 107(7)(D) and 107(8) of the Federal Credit Union Act (12
U.S.C. §§1757(7)(D) and 1757(8)). These sections provide, respectively, the
authority to invest in shares or accounts of federally insured mutual savings
banks and savings and loan associations and the authority to make deposits in
national banks, wherever located, and in state banks, trust companies and mutual
savings banks that operate in accordance with the laws of the state in which the
Federal credit union does business. Part 703.1 adds some restrictions to the
breadth of these statutory authorizations and refines the geographic limitations
that the statute contains.
The second of the regulation's three parts, 703.2, implements the authority
presently codified at §107(7)(C) of the Federal Credit Union Act (12 U.S.C.
§1757(7)(C)) which authorizes Federal credit unions to invest their funds in
loans to other credit unions. It has been the NCUA's position that this
statutory provision allows Federal credit unions to make advances to other,
nonmember credit unions, and thus that it is not a reference to their authority
to make loans or to extend lines of credit to member credit unions.
Accordingly, Part 703.2 first recites the statutorily imposed limitation that
the aggregate of all loans and lines of credit extended to other (nonmember)
credit unions may not exceed 25% of the lending credit union's paid-in and
unimpaired capital and surplus. It imposes a one year maximum maturity limit
for all loans and credit lines. Several other procedural requirements, all
designed to reflect sound business policy, also are imposed.
The third subdivision of the rule, Part 703.3, was added in mid-1979. It
restricts or prohibits Federal credit unions from engaging in certain investment
activities. The rule reflects NCUA's determination that the specified
activities are either beyond the authority of credit unions or represent unsafe
or unsound practices. The rule prohibits the use of standby commitments,
adjusted trading and short sales, and sets forth limitations regarding cash
forward agreements, repurchase and reverse repurchase transactions, and futures
contracts. Specific limitations on the purchase and sale of securities are also
set forth. The rule was prepared by NCUA in reaction to very specific, concrete

examples of losses that credit unions were sustaining as a result of certain
speculative activities in the government securities market. The authority for
the promulgation of this rule is NCUA's general statutory rulemaking authority.
Request for Comments
The NCUA Board requests public comment concerning the course it should
follow with respect to Part 703. That is, public comment is specifically
requested on whether the Board should remove or modify any or all of the
procedural restrictions presently in place governing the manner in which a
Federal credit union may deposit or invest its funds. The Board requests that
commenters identify specific provisions of Part 703 that either are unduly
burdensome or otherwise unwarranted, or that continue to be justified, and the
reasons therefore in either case. Again, it should be noted that provisions
that govern exactly what types of investments and what types of deposits may be
made, both of which are imposed by statute, will necessarily remain unchanged.
In an effort to provide some initial guidance to this process, staff at
NCUA have identified several key issues concerning the regulation. The first
subdivision of the regulation contains restrictions on the use of third party
brokerage services in connection with the making of deposits. The restriction
reflects NCUA's past experience with losses sustained by credit unions in
dealing with institutions that utilize a broker to attract deposit money.
Comment is sought on whether conditions still warrant this type of restriction
and on what voluntary alternatives to the regulation should be employed by
credit unions to prevent investment in weak financial institutions through third
This same broad question is raised by the second subdivision of the
regulation. In view of the NCUA Board's action in 1981 substantially
deregulating the area of lending in general, the question presented is whether
the area of loans to other credit unions represents a risk that warrants a
detailed and restrictive regulation. An additional question concerns the
interplay of the aggregate 25% of paid in and unimpaired capital and surplus
lending limitations contained in the present regulation and based on §107(7)(C)
of the Federal Credit Union Act with the 10% of unimpaired capital and surplus
limitation on loans to members, based on §105 of the Act. Presently, this
interplay is dealt with by Part 703.2's specific application to loans to
nonmember credit unions only.
Quite clearly, the chief substance of Part 703 is contained in its third
subdivision, which addresses investment activities. It has been the experience
of the NCUA that problems involving investments have arisen not out of a
particular type or class of investment, but rather with respect to the method or
technique by which the investment is made. Moreover, it has been our experience
that some credit union management personnel have been overwhelmed in dealing
with sophisticated brokers and complex investment schemes. The third
subdivision of the regulation reflects this experience. The existence of the
regulation also provides a basis upon which administrative action against

dishonest or unscrupulous brokers may be brought. Each of the substantive
prohibitions and restrictions set forth in Part 703.3 except (b)(5), which is
permissive in nature, represents the Agency's view that the various specified
transactions are either unsafe or unsound or should be otherwise prohibited.
The activities which have been prohibited are standby commitments, loan-type
repurchase transactions to parties not authorized by Section 107(5) of the Act
and futures contracts except as may be incidental to a credit union's
operations. All other transactions are considered to be unsafe and unsound
beyond the limits imposed in the regulation. Standby commitments fall into this
category also. The Board specifically solicits views and comments on whether
any of these restrictions should be modified, strengthened, or eliminated and on
what voluntary alternatives credit unions should employ to prevent unsafe and
unsound investment activities. Whether additional practices should be addressed
is also a concern to the Board. Commentors are advised to support their views
with specific documentation and reasoning. Inasmuch as the regulation itself
addresses specified, concrete examples of abuses and losses that were in fact
occurring, unfocused, generalized comments will be accorded relatively less
The NCUA prepared an Interpretive Ruling, IRPS No. 79-4, to accompany
Part 703* Deregulation of Part 703 may result in a corresponding repeal of the
Interpretive Ruling. It should be noted, however, that the substance of the
Ruling will remain available, in the form of guidances set forth in NCUA's
Accounting Manual for Federal Credit Unions.
By the National Credit Union Administration Board, yuJ!^'

Secretary of the Board

*7 » 19J&2,




DATE: June 24,1981


The current interest rate environment places a great deal of pressure on
the management of credit unions to seek the highest possible yield on investment
portfolios to accommodate the dividend rates necessary to remain competitive in
the marketplace for members' funds. The National Credit Union Administration
urges that credit unions fully evaluate the risk factors associated with the
higher yields.
The dangers of failing to do so are underlined by the recent failure of a
large thrift institution. Investors, including a number of credit unions, that
had funds invested or deposited in excess of the insured limit ($100,000) stand
to lose substantial amounts. A financial analysis of that institution, coupled
with diversification of the investor's portfolio, could have resulted in
limiting the potential loss as well as reducing the overall risk exposure
inherent in the investment portfolio.
A credit union should have written investment policies; a "management plan"
to effectively meet its responsibility in managing the investment portfolios of
the credit union. There are certain key factors which must be considered when
integrating investment policy into overall goals and objectives. These factors
are safety, liquidity, and yield. As a result of the liquidity pressures placed
on financial institutions in recent years, credit unions should move to more
efficient funds management techniques to match asset and liability maturities to
effectively manage their liquidity position. Safety and yield, the other two
key elements that must be addressed in the written investment policies, should
be evaluated jointly. Very often investments with higher risk factors and
greater price volatility command the greater yields.
One important method utilized to lower the investment risk factor is
diversification in the investment portfolio. This practice effectively reduces
the credit risk (the risk one takes in recovering the principal at maturity plus
a reliable income stream over the life of the investment) by reducing the
possibility of incurring a catastrophic loss from the failure of a single or a
few institutions or the default of a single or a few obligations.


The National Credit Union Administration realizes that it is customary in
the credit union industry to maintain a significant portion of the investment
portfolio in one or a small number of financial institutions. If the officials
of a credit union choose to concentrate investments in one institution, this
should be addressed in the written investment policies under the diversification
issue. Procedures should be established to review at least on a quarterly
basis, the financial condition of the institution in which the credit union
concentrates its investments. In fact, where large concentrations of
investments are concerned, monthly evaluations are encouraged. The credit union
should also inquire about the investment policies of such a financial
institution to satisfy itself that the institution has appropriately diversified
its portfolio.
The issue of investment risk is being raised because the National Credit
Union Administration wishes to make credit unions aware of potential problem
areas arising from the increasingly competitive nature in the financial
marketplace resulting from recent legislation as wel^-as the current economic



The CHAIRMAN. Thank you, sir.
Mr. Vartanian.
Mr. VARTANIAN. Mr. Chairman, members of the committee, I appreciate the opportunity to provide the views of the Federal Home
Loan Bank Board concerning the Board's involvement in the Penn
Square matter. Unfortunately, Chairman Pratt and Board Member
Jackson were unable to be here today, but I greatly appreciate the
committee's willingness, and the other witnesses, to allow me to
appear here this morning.
I have submitted a lengthy statement for the record and just
prefer to make a brief statement at this point.
The CHAIRMAN. Your statement and all of your statements will
be included in the record in full.
Mr. VARTANIAN. Thank you, Mr. Chairman.
The interdependence of financial institutions and the relatively
large size of Penn Square indicate that there are systemic implications and valuable lessons to be learned from the Penn Square
matter. As a supervisor of FSLIC-insured institutions, having dealt
with numerous failures and near failures over the last 20 months,
we share the concern of the Federal regulators to minimize the effects of failures.
Between January 1, 1981, and October 1982, we have approved
673 mergers involving roughly $94 billion of assets in the savings
and loan industry. That has involved the disappearance of 759 institutions. Of those mergers, 256 were supervisory mergers sometimes under very difficult circumstances, and 62 of those mergers
have been assisted by the FSLIC. There have been two liquidations,
numerous receiverships, and conservatorships.

In a deregulated environment such as we are experiencing and
in a volatile interest rate environment, failures have and will continue to occur, but the critical and fundamental point it seems to

us as regulators is that the regulatory system has acted effectively
and swiftly and the structure remains safe and sound. Perhaps it is
similar looking at a glass that is only half empty or half full. We
can focus on the failure and try to devise a system that will prevent all failures, something that probably cannot be done; or we
can focus on Federal regulatory structure and a Federal insurance
safety net that will insure effectiveness of the system and will
assure that the problems will be handled without disruption in the
marketplace when failures do occur.
Based upon our experience in this matter and in other problems
over the last 20 months, we believe no remedial legislation or regulations are needed directly in response to the Penn Square matter
and we would advise against over reaction in terms of promulgating laws or rules that might handcuff the productive and creative
abilities of the fine managers who exercise their discretion
throughout the industry.
All indications are to us that deregulation is working and that
the safety and soundness features built into the system are also
working. Indeed, there are positive signs in the marketplace that
notwithstanding the severe economic strains the thrift industry has
been under over the last 20 months, that things are changing. For
instance, since the signing of the Garn-St Germain bill on October
15, 1982, and since the moderation of rates, the Federal Home Loan
Bank Board has closed seven conversions from mutual form to
stock form, bringing $75 million of new capital into this industry.
Over the past 7 years, that represents 5 percent of all the conversions and 11 percent of all the new capital brought into the industry.

The immediate effects of the Penn Square problem on the Federal Home Loan Bank Board were as follows: 14 institutions
had uninsured deposits in Penn Square with a maximum potential
loss of $15.6 million; 7 of those, totaling $13.2 million in potential
maximum loss, had uninsured deposits that exceeded 10 percent of
their net worth. Of those 14, we have classified them as follows: 7
have a minimal potential loss; 5 have a moderate potential loss
with some substantial reduction of net worth; and 2 have severe potential losses in that the total loss could have wiped out their
entire net worth. One of those institutions is already a candidate
for supervisory merger in the immediate future.
However, from our perspective, we strongly believe all problems
were resolvable and are resolvable either with assistance or supervisory mergers. Even if in all 14 cases those institutions were severely impaired, we believe we could have handled them under our
normal procedures and in fact they would have been a very small
part of our current workload.
Relatively speaking then, the effects of the Penn Square matter
on the thrift industry were fairly minimal. However, we have used
this occasion to reassess our practices and the practices and potential exposure of savings and loan associations throughout the country.

The conclusion of the Board is as follows: the Board's and the
FSLICs procedures and policies are adequate to prevent widespread problems in the industry. Those procedures and policies
center upon regulations that limit interdepository deposits, an
exam process that checks for violations of those regulations, and
the intention to issue a supervisory bulletin and to begin a task
force to determine what information ought to be provided the Federal regulators regarding such problems.
What lessons has Penn Square taught the Federal Home Loan
Bank Board? Well, from Penn Square and the other problems we
have handled over the last 20 months, we believe that the current
safeguards, regulations, and enforcement authorities of the banking agencies are adequate to insure safety and soundness throughout the system. However, no matter how stringent a regulatory
process is devised, ultimately, it depends upon the abilities, the
good faith, and the cooperation of executives and managers
throughout the industry, and absent evidence of widespread abuse,
we think it would be an error to artificially restrict the abilities of
all managers to prevent the abuses by a few.
Therefore, it is our conclusion that it would be a mistake because
of Penn Square to halt or slow deregulation and that the negatives
of one bank failure are far outweighed by the positive effects and
the public benefits of deregulation. We think it would be far better
for the regulatory agencies to spend their resources in four areas in
the future.
First, the agencies should improve the supervisory and exam procedures and data collection to obtain better information and more
timely information.
Second, the agencies should insure better general disclosure in
the industry over time.
Third, the agencies should completely reevaluate the accounting
system for financial institutions as the Federal Home Loan Bank
Board is currently doing.
Fourth, the agencies should study ways to reform deposit insurance systems so that they are focused on risk sensitivity and the
cost of that risk is internalized so as to encourage therefore marketplace discipline.
I appreciate the opportunity to present this testimony on behalf
of the Board and will be glad to answer any questions the committee may have.
[Complete statement of Mr. Vartanian follows:]

Mr. Chairman, Members of the Committee, I appreciate the opportunity to provide my views on behalf of the Federal Home Loan Bank Board concerning the circumstances surrounding the failure of the Penn Square Bank on July 5, 1982. Unfortunately, Chairman Pratt and Board Member Jackson were unable to appear
today, but I appreciate the Committee's willingness to let me appear on their behalves.
Because of the increasing interdependence of financial intermediaries and the relatively large size of the bank, the Penn Square failure had significant systemic implications for the whole federally insured financial structure. As supervisor for depositories insured by the Federal Savings and Loan Insurance Corporation, which
has handled a large number of failing institutions in the last 20 months, the Bank
Board shares the concern of the banking regulatory agencies that all possible steps

be taken to minimize the likelihood of financial failures. However, the Board believes it is also important to recognize that in this deregulated and volatile economic environment where failures have and will continue to occur, the federal insurance regulators have responded swiftly and efficiently and the structure remains in
a stable and sound condition today. The lending practices which contributed to the
Penn Square failure provide an important lesson to financial institutions and reinforce the need for prudent operating practices. The Board does not believe any further federal regulation is necessary or appropriate to safeguard against future similar occurrences.

At the time of its failure in July, 1982, Penn Square had total deposits of approximately $465 million, and it was the fourth largest commercial bank failure in the
history of the United States. As a direct result of their dealings with Penn Square, a
large number of commercial banks are expected to post substantial losses resulting
from uninsured deposits. Additionally, a large number of credit unions and savings
and loans had uninsured deposits in the bank. The full extent of these losses will
not be known for some time, until the Federal Deposit Insurance Corporation, as
receiver, completes its task of collecting and liquidating the assets of the bank.
As a result of the Penn Square failure, fourteen FSLIC-insured institutions have
potential losses in uninsured deposits totalling roughly $15.6 million at a maximum.
Seven of these 14 institutions, with uninsured deposits totalling approximately $13.2
million, have uninsured deposit balances exceeding 10 percent of net worth. Of the
fourteen institutions affected, seven have potential maximum losses which would be
classified as minimal, five have potential maximum losses which could be classified
as moderately severe or moderate, and two have potential maximum losses which
could be severe.
At the time the bank failed, in two cases, the potential total loss of the uninsured
deposits of the associations affected could have resulted in a loss of their net worth.
In four other cases a potential total loss of the uninsured deposits could have resulted in a substantial reduction of net worth. These potential immediate problems
were, however, significantly ameliorated by the FDIC's issuance to uninsured depositors of "receivers certificates" in the amount of their uninsured deposits, as evidence of their claims as "general creditors" in the distribution of the bank's assets
by the receiver. The certificates issued are eligible collateral for borrowing from the
Federal Reserve Bank, but do not qualify as liquidity under the Bank Board's regulations, since they do not represent an obligation of an insured commercial bank.
While it is not possible at this time to estimate the ultimate value of the receivers' certificates, the Bank Board has instructed each institution with uninsured
losses to establish an allowance for loss equal to a minimum of 20 percent of the
uninsured portion of its deposit. This loss reserve is based on the FDIC's historical
experience with the average rate of recovery on uninsured deposits in past bank liquidations. Additional losses or recoveries of this amount will be recorded as soon as
they are identifiable.
It is extremely important to note that, even though the maximum potential losses
of two associations with uninsured deposits in Penn Square could be quite severe,
the Board's current procedures for dealing with troubled institutions are quite adequate to resolve any significant weakening resulting from the Penn Square failure.
One of the institutions which could be most severely impacted by the failure is currently a candidate for a supervisory merger. Any problems occurring in the other
institution severely affected could also be resolved through appropriate FSLIC programs for assistance and supervisory consolidation. And even in a worst case scenario, if all fourteen associations had been severely impacted, I believe the Bank Board
could have resolved any problems through our normal procedures. Indeed, the potential "worst case" supervisory caseload which could have resulted from the Penn
Square failure would be minimal in relation to the workload the Bank Board has
experienced in the last year and a half. Between January 1981 and October 1982,
the Board acted on a total of 673 merger applications, including 256 which were supervisory or FSLIC assisted, in which there were 759 disappearing associations with
roughly $93.59 billion in assets.

A number of savings and loans will ultimately experience some degree of loss due
to the Penn Square failure. However, the Board believes that the current regulatory
and statutory protections for insured savings and loan associations provide strong
and effective safeguards on savings and loan investment. These safeguards should

insure adequate protection in the future against S&L failures due to the types of
problems experienced by Penn Square itself, and against unacceptably high loss of
uninsured deposits invested by S&Ls in commercial banks which may fail.
With regard to the potential loss of uninsured deposits of savings and loans invested in a failed bank, the Bank Board has in place regulations which are designed
to prevent overconcentration of investment in time and savings deposits of commercial banks and thrift institutions. Under the Home Owners' Loan Act, federally
chartered savings and loans are currently authorized to invest, without limitation
as to percentage of assets, in accounts of any bank whose deposits are insured by
the Federal Deposit Insurance Corporation and the accounts of any institution
whose deposits are insured by the FSLIC. Section 563.9-6 of the Insurance Regulations imposes a restriction applicable to all FSLIC-insured institutions limiting investments in the savings accounts of a commercial bank or thrift to the greater of
(1) one-hundred thousand dollars; or (2) the lesser of (i) one-half of 1 percent of the
deposits of the institution from which the investment is obtained or (ii) the greater
of the FSLIC-insured institution's net worth or one percent of the investing institution's assets. The purpose of this restriction is to preclude excessive investment in a
single source, and is analagous to the regulatory restriction on loans to one borrower (12 C.F.R. § 563.9-3).
Three of the fourteen associations which are expected to incur losses as a result of
the Penn Square failure had exceeded the limit set out in this resolution. Nevertheless, we believe that the regulatory and examination process is generally effective to
prevent losses which would result in the substantial destabilizing of an institution.
In the past, the Bank Board examination process has uncovered few significant violations of this regulatory limit. For example, between January 1, 1980, and July 21,
1982, there were only eight occasions on which the Bank Board issued warnings,
through supervisory letters, to associations that had certificates of deposits in other
financial institutions in excess of limitations imposed by state or federal regulation,
or that had deposits or investments generally considered to be excessive or risky.
In this regard, it should also be noted that the current provisions of section 563.96 reflect an amendment, effective November 3, resulting from the Board's decision
to reevaluate the potential risks in this investment area and make appropriate
changes after seeking public comment on proposed revisions. Furthermore, in response to the kinds of problems resulting from the Penn Square failure, the Board is
now planning to issue a supervisory bulletin reminding examiners to closely scrutinize association investments in the deposits of other banks and thrifts.
Regarding the more general problem involved in the Penn Square failure—massive deficiencies in the loan portfolio chiefly due to rapid expansion and poor quality
energy loans—the Bank Board believes there is very little likelihood of widespread
S&L failures from problems of this type. As of October 31, 1982, roughly 79 percent
of all FSLIC-insured savings and loan assets were invested in mortgage loans and
mortgage-backed securities. The asset quality of these loans is extremely high in relation to other loans, due both to the unique nature of the collateral and to pervasive statutory and regulatory restrictions designed to insure their high credit quality at origination. These types of loans also tend to be small individually, and provide good diversification of risk.
Although there is a great deal of evidence that S&Ls will continue to be primarily
housing lenders, the failure of Penn Square naturally raises some concern that savings and loans may use the liberalized statutory mortgage investment authority,
and the new commercial lending power, unwisely. However, the Board believes that
S&Ls will proceed cautiously in exercising their new powers, and that the Bank
Board's regulatory safeguards and planned examinations process for commercial
lending will minimize any risk in this area.

The Bank Board is confident that the current statutes and regulations governing
the investment authority of savings and loans, as well as our power to enforce the
laws where serious violations occur, provide adequate and effective safeguards for
the stability of savings and loans insured by FSLIC.
However, as the Penn Square failure demonstrates, the efficiency of our system of
financial regulation is necessarily limited by our role as supervisors. No matter how
stringent a system of statutory safeguards Congress may erect, ultimately, we have
learned that the process must depend on the abilities, good faith and cooperation of
the executives and officers of the financial institutions we regulate for its

There has been no evidence of widespread abuse of the trust which the Congress
and federal supervisors have historically placed in the financial institutions which
would warrant a significant change in the current supervisory structure. Given the
very competitive environment in whch regulated depositories are now conducting
business, it would be a grave error to artificially restrict the abilities of all financial
managers to control the very few who may abuse their positions or mismanage their
institutions. Thus, the Board does not believe that across the board statutory controls over management conduct are a desirable means of addressing the types of
problems leading to the Penn Square failure.
Moreover, given the unique conditions and circumstances resulting in the Penn
Square failure, the Board believes it would be a serious mistake to halt or slow deregulation of financial institutions in an effort to create a more "failsafe" regulated
financial system. Even with deposit insurance, credit relationships may be affected
by bank failures, resulting hardship to the business community.
The potential negative consequences of a bank failure, however, are far
outweighed by the public benefits of deregulation and the problems which might
arise from attempting to create a failure-proof system. The deregulation of the financial industry will be enormously beneficial to all segments of the public, from
consumers to business entities of all kinds. Deregulation will allow market forces to
winnow the weakest competitors from the marketplace, and will result in more efficient competition, thus giving the public a wider range of choice and better quality
in services and products, higher yields on deposit investments, and lower costs of
Given these considerations, the Board believes that deregulation should proceed
without expansion of the traditional role of federal supervision of insured depositories. However, this continued commitment to deregulation should be carefully balanced by a thorough and ongoing review of the efficiency of current supervisory procedures, by continuously strengthening these procedures in response to the types of
problems seen in the Penn Square failure, we can achieve the goal of minimizing
disruptive liquidations without sacrificing the marketplace efficiencies and consumer benefits which have been so important in sustaining a strong, stable financial
structure in the last five decades.
Thus, rather than imposing new statutory controls on the financial industry, the
Bank Board believes our resources can best be spent in revising the regulatory process in four ways. First, we should strive to improve the supervisory and examinations procedures to obtain better and more timely information. Second, we should
encourage better general disclosure of the financial condition of regulated depositories. Third, we should reevaluate the accounting system applicable to insured institutions. The Board is currently reviewing the accounting system used by FSLICinsured institutions and has appointed a task force to study throroughly the issues
involved. The Board welcomes any assistance and comments in this area from the
accounting profession and other interested parties. Fourth, we should study possible
ways to reform the current deposit insurance system. The Bank Board also believes
that the current deposit insurance system may be strengthened by a partial or pure
variable-rate schedule for insurance reserve premiums. The Board has recently proposed to implement a variable-rate rebate program, and is studying the desirability
of a pure variable rate premium assessment scheme pursuant to section 712 of the
Garn-St Germain Act. A risk-variable insurance premium would internalize risktaking by institutions and encourage marketplace discipline to replace in part the
less efficient, more cumbersome structure represented by federal supervision.

The CHAIRMAN. Mr. Conover and Mr. Isaac, I would like you both
to comment on this first question.
We often have the tendency in this country to credit the large
money center banks with a great deal of sophisticated financial understanding, good management, expertise and so on. Yet we find
that some of our country's best known banks in this situation, institutions that have very large, well-trained staff, highly paid in
many cases, find themselves holding $2 billion of Penn Square

Now with this background that we all expect of these sophisticated, well-managed banks, how did they get themselves in that kind


of situation? It's one thing for a small suburban bank that grows
very rapidly to make bad loans, but why in the world would our
big money center banks be picking up $2 billion of them?
Mr. CONOVER. If I may, I think it's a situation in which those
large banks saw the opportunity to participate in what they regarded as an energy boom without expending a significant amount
of effort on their part.
Clearly, their control systems broke down and they found themselves saddled with a large volume of relatively worthless loans. I
think they have paid significantly for their mistakes in this regard.
Their stocks have been battered. Some of them have had difficulty
funding themselves in the financial markets. Officers of several of
those banks have been dismissed or resigned and their reputations
have been tarnished.
The CHAIRMAN. Mr. Isaac.
Mr. ISAAC. I don't know what I could add to that except I think
in several instances you probably had an excessive concentration
on growth and earnings. There was probably too much incentive
for officers to make loans and not enough regard to the soundness
of those loans. The banks have paid a dear price and have learned
some lessons, and I would assume in the future we will see more
caution exercised in placing loans on the books whether done directly or through participations.
The CHAIRMAN. I'm amazed that they so blindly accepted some of
these loans and in such large amounts, in contrast to the way they
in "Scrooge-like" fashion, look over a small consumer loan and run
all the credit checks on an individual that wants to borrow $1,500
and then turn him down because it might be a bad loan. I don't
really know that you have any answer to my questions, but I don't
understand how they can accept these huge loans in such an apparently frivolous manner and be so tight on some of the small consumer loans that would be very small change for them even if they
did turn out to be bad.
Mr. CONOVER. YOU know, it's a well known common banking
practice that one ought to exercise the same diligence and judgment in obtaining a loan participation as one would in making a
loan directly. Obviously, they did not follow that principle.
The CHAIRMAN. I suppose I really won't open this can of worms,
but it would also include—some day we are going to talk in this
committee about some of these large loans to foreign countries that
many of our fine banks seem to have made without the same concern for whether they be repaid or not. But again, I won't start
that today. That's a big subject for another day, but we will be
looking into it.
Mr. Conover, it's my understanding the president of the Penn
Square Bank had little, if any, control over the lending activities of
the oil and gas division. The oil and gas division represented some
80 percent of Penn Square's lending activity.
Isn't it one of the functions of a bank examiner to evaluate the
management of an institution? Isn't this something that possibly
was overlooked, that the president of the bank had so little effect
or authority over such a large portion of his bank's lending activities?


Mr. CONOVER. It is the responsibility of a bank supervisor to
evaluate the management. When the new president, Mr. Beller,
was brought in, it was our understanding that he was to have control over the entire operations of the bank. We got that impression
from him directly in a meeting in Dallas in our regional office. Yet
there were conflicting pieces of evidence. Although the heads of the
oil and gas division were shown to report to Mr. Beller on the
bank's organization chart, in fact, it turns out that his position description, which we did have, indicated otherwise. That he did not
have authority over the oil and gas division. It is true that we did
not nail down that inconsistency.
The CHAIRMAN. The Penn Square Bank had been operating
under a formal written agreement with your office for the period
from September 9, 1980, until June 30, 1982. The Comptroller's
Office issued a cease and desist order shortly before the bank's failure.

It's my understanding that the disclosure of a cease and desist
order is mandatory for any SEC registered bank that goes to the
market to raise capital.
Do you believe that such information should be disclosed even if
a bank is not SEC registered?
Mr. CONOVER. I think the basic principle ought to be that banks
that are SEC registered and other banks ought to have approximately the same disclosure requirements. We are considering what
aspects of our enforcement actions ought to be disclosed.
The CHAIRMAN. What's your position on the disclosure of formal
written agreements, as an example, the September 9 agreement?
Mr. CONOVER. I think that it does not really matter whether it is
a formal agreement or whether it is a cease and desist order. I
think that the existence of such an agreement probably is a diselosable incident under SEC regulations, although generally what we
do in that regard is leave it up to the bank and the bank's securities attorneys to advise them on whether or not those matters
ought to be disclosed.
Generally speaking, however, I think that we could do with the
discipline that we would obtain by having greater disclosure for
both formal agreements and cease and desist orders. As I indicated,
we are trying to figure out precisely what aspect of that ought to
be disclosed because there may be some things that could be damaging to the bank and would cause it harm rather than aid in its
rehabilitation if disclosed. It is not a simple black and white question.
The CHAIRMAN. Well, do you think that potential investors would
be deterred with disclosure of this type of investing in the bank?
Mr. CONOVER. I think potential investors may be deterred. I
think depositors may very well be deterred and other banks that
might be buying participations from them might be deterred. That
would be a very healthy turn of events.
The CHAIRMAN. Gentlemen, if any of you have any comments on
any of these questions—Mr. Conover is going to get the brunt of

them because his agency is primarily responsible—but if you have
anything you wish to add on any of them, please feel free to do so.

Mr. Conover, at hearings held on the Penn Square matter by the
House Banking Committee there seems to be some disagreement
between the FDIC and the Comptroller regarding your authority to
remove officers for activities which may be willful violations of law
which fall short of demonstrating personal dishonesty.
Have you and Mr. Isaac resolved your differences over those interpretations, if there were any?
Mr. CONOVER. I think there was a misunderstanding on our part
as to the specific terms under which we have the authority to
remove officers. We have resolved our differences both with Mr.
Isaac and with Chairman St Germain on that issue.
I think that the basic question is: Why did we not take action to
remove officers in the Penn Square Bank prior to its failure? As
has been indicated before, we felt and management led us to believe that they were in compliance or working to get into compliance with the formal agreement that they had entered into with
us. For that reason and because of the bank's overall performance,
we saw no reason to initiate removal proceedings.
Had the bank not failed by the middle of April 1982 examination, we might very well have had grounds for removal of officers
as a result of some of the findings of that exam, but we did not feel
that we had such justification prior to that time.
The CHAIRMAN. Mr. Isaac, it's my understanding that the FDIC
was only given about 5 days warning of the collapse of Penn
Square. If that's true, would a longer notice of these problems have
given you an opportunity to have maybe found a merger partner to
help save the situation rather than having to pay it out of the
FDIC fund?
Mr. ISAAC. It's true that we were given about 5 days notice of the
seriousness of the problems and the fact that FDIC involvement
would be required. If we had been given more notice, it's possible
that we could have worked out another way to handle the transaction. It would have been very difficult because of the potential for
large contingent claims that might be asserted in connection with a
The CHAIRMAN. Senator Riegle.

Senator RIEGLE. Thank you, Mr. Chairman.
I would be interested in asking first what is this failure costing
the Government in dollars? Gentleman, you indicated in your presentations that many people have been working a long time trying
to sort this thing out, so obviously we have to pay for that effort.
But beyond that, in terms of any other costs that have been involved, what would be the best and the most accurate and full estimate of what this failure has ended up costing the Federal Government?
Mr. ISAAC. The people costs are shown in our report, and to some
degree those costs are being borne by the receivership and, thus,

the uninsured creditors of the bank. The primary cost is going to
be the losses the FDIC takes in the receivership. We paid off the
insured deposits.
Senator RIEGLE. Why don't you give me the numbers, either the
specific figure or your closest estimate?
Mr. ISAAC. I believe the insured deposits were in the vicinity of
$200 million. The exact number is in our report.
Senator RIEGLE. SO your estimate on that item is $200 million?
Mr. ISAAC. That's not the loss. That's what we paid out to the
insured depositors. Then we will make collections on the loans and
we will share those collections pro rata with the uninsured creditors. It's too early to say what our losses will be. We do intend
sometime in the next few months to give our preliminary estimates
of what we expect the recoveries might be and thus what the losses
might be.
I might add that the FDIC is entirely self-funded and so none of
the money, to the extent we experience losses, is coming from the
taxpayers. We are funded by the banking system through premiums and by interest on our investment portfolio.
Senator RIEGLE. In other words, it's not a complete washout.
When you have a failure and lose $100 million or $50 million or
whatever the final figure may be, you make it sound as if nobody
incurs a loss. Let's be realistic—who finally does incur the loss
Mr. ISAAC. The losses will be shared. The uninsured creditors are
going to share in losses and that is
Senator RIEGLE. That obviously affects your insurance premiums.
Mr. ISAAC. That's exactly right.
Senator RIEGLE. And that affects the other banks in the system
who have not failed and they have to reflect that in their cost of
service to borrowers. So eventually, this will increase the interest
rates and service fees that consumers must pay.
Mr. ISAAC. TO the extent the FDIC bears losses, two things
happen. One, our insurance fund doesn't grow as rapidly as it otherwise would; and, second, our insurance premiums go up a bit.
And all banks bear that cost and presumably they pass at least a
portion of it on to customers of banks.
Senator RIEGLE. I know you're going to make formal estimates
later after sorting this out—it's a tangled situation—but is it likely
that the losses are going to exceed $50 million?
Mr. ISAAC. It wouldn't surprise me that the losses will exceed $50
million. I would not want to be very precise about it at this time
because I don't want to get ahead of our folks who are trying to
make the estimates. I would say that we thought going into Penn
Sguare in July that it was a bad situation and that the losses
would be significant. Everything we have learned of the bank since
then indicates that it's far worse than we expected.

Senator RIEGLE. Over the last few years how many other failures
have occurred that would fall into this category of failed banks?
Mr. ISAAC. HOW many bank failures?
Senator RIEGLE. Yes, in the last 2 years?

Mr. ISAAC. This year so far we have had 40 bank failures and last
year we had 10.
Senator RIEGLE. From year to year that sounds like a big jump.
Mr. ISAAC. The failure rate has been running about 10 to 12 a
year for the past 10 to 20 years. This year it is at 40 to date. The
previous high since 1940 was 16 banks in 1976. So the failure rate
this year is significantly higher than normal. It is likely to continue at a high rate through next year. How much longer it will
remain at this level, we don't know. I believe the failure rate is a
function of two factors. First, the economy. We have had 4 years of
virtually no growth and very high and very volatile interest rates
that are having an effect on bank customers and thus banks.
Second, we are coming into an intensely competitive, deregulated
environment and that certainly has to have some effects. We don't
believe we are going to get back to the days any time soon where
we have seven or eight bank failures a year. I think we should
expect a higher than normal number of bank failures, if normal is
what we have experienced over the past 10 to 20 years.
Senator RIEGLE. Recognizing again that we are just discussing
preliminary numbers here, if the ultimate cost of the Penn Square
failure is in excess of $50 million and if you take all 40 banks that
have failed and try to make some kind of estimate as to the aggregate loss, what's that figure going to be? Are we talking about $300
million, $500 million?
Mr. ISAAC. I wish we were. It's much higher than that. Over the
past 14 months—this is going a little bit beyond the 40 banks this
year and into the tail end of last year—we have handled the failure of 11 large mutual savings banks with assets totaling $15 billion. Our estimated cost in handling those 11 transactions was $1.7
billion. In most of those mergers, we entered into the transactions
which involved income maintenance payments to cover the negative interest rate spread on the assets acquired from those institutions. We made calculations of what those income maintenance
payments might be over the life of the agreements—which tended
to be in the 5- to 10- year range—on the assumption that interest
rates would continue at the same levels they were at when we entered the transactions. Rates were very high, as you recall, toward
the end of last year and the earlier part of this year. So it was a
very conservative investment. We now are revising our estimates
and the numbers will come down. We probably will reduce the estimate by $350 million.
Senator RIEGLE. IS that just for the 11 large ones or all of them?
Mr. ISAAC. That's for the 11 savings banks that we handled,
roughly $1.3 billion.
Senator RIEGLE. If we consider the 40 or so that failed over the
last 2-year period, what would be the estimate?
Mr. ISAAC. We will have those estimates shortly too. We are
working up those numbers for our yearend statements. They
shouldn't be of much consequence, apart from the Penn Square.
Senator RIEGLE. Are we talking about losses in the range of $2
billion or thereabouts?
Mr. ISAAC. It depends on our Penn Square estimate. I don't think
we could possibly approach $2 billion. That's way too high I would


0 - 8 3 - 6


Senator RIEGLE. SO it's probably between $1.5 billion or $2 billion.
Mr. ISAAC. I would say less than $1.5 billion.
The CHAIRMAN. Would the Senator yield just a moment?

I'd just like to say at this point that the FDIC has an unusual
situation. The major problems have been with those institutions
that have had long-term loans, primarily housing and primarily
due to interest rate ceilings, that borrow short and lend long. That
problem has fallen on the FSLIC, and poor Chairman Pratt came
in at a time when most of his work was trying to create mergers
and save dozens and dozens of thrift institutions. The FDIC gets
into the situation of having mutual savings banks that are essentially a thrift in many characteristics, but not under the FSLIC,
which have developed many of these same problems. I'd just like to
comment that Chairman Isaac was just incredibly good at keeping
me informed at all steps of the way of these various institutions
primarily last year and early this year when interest rates were
still high and the pressure had not been relieved somewhat. I
would just like to say both for the FSLIC, the Fed and the FDIC,
with some unusual problems over the last 2 or 3 years, with staffs
that really had never had to face so many problems all at the same
time, under the circumstances the potential losses that were there
were much, much higher than the range you and Chairman Isaac
are talking about had they not been able to arrange some of these
mergers. I've taken a lot of criticism, a lot of mail, on why in the
world are they wasting their money, and I think the type of losses,
whatever they amount to in the end, at this particular time are
far, far less than they could have been. I'm not one who's often
complimentary of regulatory agencies, but I have followed this very
carefully and the potential losses were so much more than what
they have all collectively, with their various responsibilities, been
able to put together in mergers rather than simply having to bail
out the depositors through the insurance funds. So I just wanted to
interject that and I appreciate the Senator yielding because it's an
extremely difficult and scary period and, fortunately, the lower interest rates have relieved a great deal of that pressure. I think all
of you are deserving of a great deal of credit despite a lot of the
criticism for handling an extremely difficult situation, and minimizing those losses rather remarkably.
Senator RIEGLE. Well, let me just say that I think the chairman
makes some good points there. My concern at this point is that I'm
not convinced we are yet out of the woods.
The CHAIRMAN. NO, I'm not either. I'm just saying the pressure
has been relieved. It's better than it was considerably, but we're
not out of the woods.
Senator RIEGLE. The concern I have, and you will recognize this
during my next line of questioning, is that we are seeing some lowering of interest rates. We all want that and it's going to help in
some respects and we hope it will start to revive the economy at
some point, but things look pretty bad out there right now. There's
not much sign of an economic recovery that anybody in the admin-

istration or that any outside economists can put their finger on.
And there is great apprehension because the problem is worldwide
in scope.
The concern I have at this point is that the leveling off of interest rates seems to be a response to the fact that the economy has
been shutting down and those two often tend to be connected. We
want to get the economy revived and hopefully we can keep interest rates from taking off at the same time, but there's no sign of an
economic recovery at the moment. So I think the financial stress
and pressure is going for continue for many institutions despite the
fact that interest rates are down.
We have a large number of nonperforming loans, many of them
domestic loans and very large foreign loans that the chairman has
spoken about, and I agree with him that we get into that issue, not
today because that's not our purpose, but at an early date, because
I think this is a serious problem.

My real concern is how many other Penn Squares are there out
there right now that may be waiting to happen and are we in a
better position today to identify these banks than we were in the
case of Penn Square? I think we were late in responding to Penn
Square and we must try to reconstruct why that was. It seems to
me that the regulatory agencies were not on top of this problem
and while a good job may have been done in picking up the pieces
and sorting through the wreckage here, the real test of our system
is to try to prevent these things from happening. That's why we
regulate. We failed in this particular instance and we have in the
case of others.
Now we're not going to prevent all bank failures, but when we
jump from an annual average of a dozen banks failures to suddenly
40 this last year, I think it suggests that we take another look at
whether or not our monitoring mechanisms are sufficient and
whether our early warning mechanisms are adaquate so that we
can move in on a problem situation before the roof caves in because the fact that we bail it out with insurance I am not comforted by, nor do I believe we somehow deserve a lot of credit for the
fact that the insurance system is there and it sort of absorbs the
loss. I think it is an economic loss. I think the country is poorer for
the fact that it happens and I think it's damaging to public confidence in our system. Every time a bank failure occurs it makes it
tougher to get an economic recovery going.
In fact, my own view is that part of the increase in the savings
rate is that people are saving because they're not sure what the
future looks like. Even though we all want and have wanted for
some years to see higher savings rate, that's not the kind of motivation that we ought to have.
So I think the question is, how many more Penn Squares are
there out there right now and how many banks do you have on the
problem list right now and can you tell us how the problem list
sorts out? In other words, how do you differentiate between banks
that are in grave danger and those that are on the radar screen as
problem situations but are not in severe trouble?

Mr. ISAAC. Before I respond to that, if I might just clarify one
point with respect to our earlier dialog. We were, I believe, talking
about two different numbers, and I want to make sure we're clear
on it.
In discussing the 11 savings bank failures, I jumped back into
last year. You were focusing on the 40 banks this year when you
were asking the cost numbers, and we agreed that the losses would
be less than $1.5 billion. If you're only talking about this year, and
you don't include the three savings banks handled last year, you're
talking about the losses being more in the billion dollar range.
That's still a lot of money and more than we care to spend in a
given year, but I want to note that the insurance fund, despite extraordinary losses over the past 2 years, has been growing and remains strong. The fund began 1981 at $11 billion in size and today
it exceeds $13 billion, despite absorbing the full impact of all of
these failures. Our annual income is currently running at $2.5 billion a year. So whatever comes up, we feel we are in a good position to deal with it effectively.
As far as whether there are any more Penn Squares on the horizon, I can't be positive there aren't. I don't know of any. But, on
the other hand, we didn't know of Penn Square much before it occured. It's always possible that we will be surprised by a situation,
but that doesn't happen very often.
Senator RIEGLE. HOW many banks are on the problem list?

Mr. ISAAC. Currently we have 345 banks. That is up from 220
banks at the beginning of this year. We expect the list to keep on
rising. It remains below the levels it reached in 1976 where it
peaked out at 385 banks.
The problem bank list is a lagging indicator and it continues to
rise after the economy begins to improve.
Senator RIEGLE. My time is up here and I want to yield and then
wait for my next turn, but let me just pose a question that I'd like
to get into later so you can be thinking about it. That is, I want to
take a closer qualitative look at the situation with the 345 problem
banks we have now versus the picture we saw in 1976 which was
the last time we had a large number of banks in these circumstances, and I'd like to know if the anatomy of the problem is
pretty much the same as it was then or are we looking at a situation that is different?
The way that we grade banks and we grade problem situations,
has that system changed so that we have to know more before
making comparisons between the two time periods, and also just
qualitatively is the nature of the problem that is now upon us in
this time frame somehow different than it was then. If so, how
could you help us understand the difference? Do we now have a
larger number of the broader kinds of nonperforming loans, is
there international versus national activity, and what can you tell
us about the anatomy and the profile of that problem in the aggregate? That's what I would next like to discuss. My time is up but I
wanted you to have a chance to think about my concerns.

The CHAIRMAN. Governor Partee, let me just follow up for a
moment Senator Riegle's line of questioning and apply it to bank
holding companies which the Fed regulates. You don't regulate
banks. You regulate the bank holding companies.
Can you just give us a brief overview of the problems along this
line you see in the holding company area?
Mr. PARTEE. Well, I think it mirrors the kind of impression that
Chairman Isaac gave. That is, we have a rising number of problem
holding companies. The figures wouldn't be much different than he
has except that the numbers would be smaller because there are
fewer holding companies than there are banks. But the movement
would be just exactly the same. I'm sorry to say I don't have the
exact number nor do I for the group of banks that we do directly
regulate, but I think we are all experiencing very much the same
kind of indication of growing difficulty and, of course, in Washington and in the field the banking regulators are doing everything
they can to coordinate and to compare notes and to try to ride herd
on these developing problems as they become apparent to us.
The CHAIRMAN. Well, don't apologize for not having the figures.
You were all called to testify on the specifics of Penn Square and
obviously we can't isolate that problem from the overall economy
so we are expanding beyond that to get a picture of what the general problem is and if there are things that you as regulators
should be doing to avoid other Penn Squares. So don't feel badly
about not having all the figures on subjects you were not invited to
testify on.
Mr. Conover, I certainly agree with you that we cannot afford or
even design a system in which a bank cannot fail, but I think you
would agree that we need to insist on a system where a bank failure will continue to be viewed as an isolated aberration and not a
general thing by any means.
On reviewing the procedure for classification of Penn Square as
a 3, your supervision of all banks classified as 3 in 1980, you have
shown that 66—percent of them have improved, 23 percent are still
rated 3, 7 percent have deteriorated to 4 or 5, 3 percent have been
merged out of existence, and 1 percent are insolvent and placed in
That presents a pretty good picture. Most of them are improving.
Only 1 percent insolvency. But in the course of that kind of a
review, have you ever performed an aging of classifications similar
to an aging of accounts receivable done by companies so you can
determine how quickly those banks in the 66-percent category improved? In other words, what I'm getting at, to give you a closer
view rather than these general categories and suddenly they drop
from one to another, do you have a better handle or is it possible
for you to have a better handle on those shifts?
Mr. CONOVER. Yes, it is possible. We could track by looking at
the banks and when they became 3's and how long they stayed 3's
or changed to either a lower or higher rating. I don't know that
information off the top of my head, but we would be pleased to
submit it for the record if you would like.
[The following was received for the record:]


Comptroller of the Currency
Administrator of National Banks
Washington, D.C. 20219

February 18, 1983
Dear Mr. Chairman:
During the Senate hearings of December 10, 1982, you requested an
aging of banks that were "3" rated as of August 12, 1980 (the date
of the first Priority Bank Summary which included Penn Square Bank,
N. A . ) . In response to your request, two charts have been prepared
tracking banks that were rated "3" as of December, 1979. Using
this date permitted us to expand our test group of "3" rated banks
and permits comparisons at successive year ends.
As of December, 1979, there were 220 "3" rated banks. Of this
segment or test group, the large majority became "3" rated after
December 31, 1976. Chart A details changes in their ratings as
of each year end, over a three year period. As shown in the chart,
42% of the group improved to a "1" or "2" rating by year end 1980,
and 61% had done so by year end 1981.
Of the population of 220 banks, 51 became "3" rated during 1979.
Chart B focuses solely on this sample of banks and tracks their
disposition over the same three year period. The purpose of this
chart is to provide a general idea of the time period a sample of
banks remain in a "3" rated status before the condition improves
or deteriorates. As illustrated in the chart, the majority of
these banks shifted into an improved category over a two year period
of time, with 65% improving to a "1" or " 2 " rated status while 23%
maintained a "3" rating. By year end 1982, the improved group
increased to 68% and the group of "3" rated banks declined to 14%.

C. T. Conover
The Honorable
Jake Garn, Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D. C. 20510

AGING OF 220 BANKS RATED " 3 " AS OF 12/79

































220 100%



220 100%


51 "3" RATED
















































The CHAIRMAN. We would appreciate that.
Also, what methods might you use, if any, that you could pursue
the seriousness of a management's agreement to follow their signed
agreement or prudent banking practices after they are in a category 3? In other words, you testified Penn Square signed an agreement. You thought things were coming along. Six months later,
pow; they didn't follow the agreement. They didn't do what you
had outlined for them to do and went completely in another direction.
Mr. CONOVER. I think monitoring compliance with agreements or
cease-and-desist orders or memoranda of understanding for that
matter is something that is getting increased attention in our office
as a result of the Penn Square situation. I don't think there is any
question about that.
The CHAIRMAN. YOU indicated that special exams are usually
limited to previously criticized loans or loan problems. Doesn't this
type of examination make it more difficult to really evaluate management's sincerity and their dedication and willingness to correct
any underlying problems? Aren't some managers, in other words,
likely to correct only those items that you have reviewed?

Mr. CONOVER. That's precisely right. There is that danger in
doing an examination that only follows up on deficiencies uncovered in the previous examination. For that reason we have spent
considerable time reviewing both the scope and the frequency of
our examinations. And, as I indicated earlier, we are upping the
frequency of full-scope examinations on troubled banks to avoid
precisely that kind of problem.
The CHAIRMAN. In order to improve the results and efficiencies
of the exams that you do, shouldn't financial examiners insist on
good internal controls and then penalties—stiff penalties for failure to achieve those internal controls?
Mr. CONOVER. One of the things we focus on
The CHAIRMAN. In other words, you simply can't be there following a bank day after day with 15,000 banks in this country and so
on. You've got to insist they have some internal controls, and if
they don't, some penalties for not instituting them.
Mr. CONOVER. That is precisely right. The method of examination
has to some degree shifted in recent years from being what might
be described a bottom-up approach, in which you get into each individual transaction, to a top-down one in which the examiners satisfy themselves that sufficient systems and control mechanisms are
in place. Then they do a limited amount of testing to insure that
the system itself works.
So the examination approach that we are following now is very
much oriented toward identifying good control mechanisms and
systems, making sure that they are effective and that they are updated to meet changing conditions.
The CHAIRMAN. What about the complaint that I often hear from
banks that have been in existence for a long, long time, not new
ones like Penn Square, not rapidly increasing in size—good old,
long-time banks that have been around forever, so to speak, who


feel they are being harassed by you and yet for 6 months you didn't
know what was going on with Penn Square. Wouldn't your resources be better used to follow the problem banks on a shorter
time frame rather than harass—and I use that term in quotes—
harass those who have never given you any problem, never been in
trouble, good old stable management. You know the type of situation I'm describing because you undoubtedly have heard it far
more than I have.
Mr. CONOVER. Exactly. We think that it is important to focus our
resources on banks that represent the greatest potential risk to the
system. That means by definition larger banks and troubled banks,
and so as we look at our exam priorities in terms of how frequently
we examine different categories of banks. We intend to shift them
and we are shifting them away from small, well-managed banks
toward larger ones and toward problem banks so that we can focus
on the areas that need the greatest attention.
The CHAIRMAN. Did the Comptroller's Office ever conduct any
surprise examinations at Penn Square?
Mr. CONOVER. Not in the sense of a surprise audit, no, we did
The CHAIRMAN. DO you think that those type of examinations
ought to be increased in frequency for a bank like Penn Square
that isn't performing as rapidly in previous examinations as
they're supposed to?
Mr. CONOVER. It might offer the potential of finding a condition
that you might not otherwise find. The alternative I suppose to the
surprise exam is a more regular involvement with the bank itself
on a continuing basis. I suspect that both techniques are appropriate and we will give consideration to the concept of surprise examinations in the future.

The CHAIRMAN. YOU have also indicated that more public disclosure of financial condition of banks will exert a marketplace discipline and I have received several complaints from small banks that
say, well, that may be fine for the big banks in a big metropolitan
area but in a small town you start publicizing about one of the citizens of the town that everybody knows, that type of thing, and are
you exerting marketplace discipline or are you causing problems?
Again looking at the small banks there are unique situations
compared to something that can be swallowed up in New York if
you start publishing the names of people who are delinquent on
their loans. There nobody cares except those who are involved, but
it's different in the small market area. I assume you have received
some of those inquiries.
Mr. CONOVER. Yes, we have. I think it's a natural tendency for
bankers not to want to disclose their financial results. Of course,
the plan is not to disclose the transactions of any individual borrowers. It will not be possible to discern
The CHAIRMAN. YOU need to make that very clear.
Mr. CONOVER. IS there some misunderstanding about that?
The CHAIRMAN. Yes, there is some misunderstanding about that.


Mr. CONOVER. OK. The idea is that the increased disclosure will
be in aggregate dollar terms by the individual banks. For example,
as far as the pass through loan categories are concerned, there will
be different ages of pass through loans and loans will be broken
down according to whether they are real estate, commercial, consumer, and the like, but no individual borrower will be named. Because of the way the data is aggregated it will be virtually impossible for even the most clever analyst to discern the identity of an
individual borrower from the data that is going to be prepared.
The CHAIRMAN. Even those who are not confused, whether they
be individuals or what, claim that in the small towns that that's
impossible for you to do. They simply know each other so well that
there's no way you can disguise it. I'm serious. I have had those
kind of complaints and I suppose if my mother were still alive,
talking about her little town of 600, she would agree because she
knew everybody in town and it was amazing her intelligence
system about that little town.
Mr. CONOVER. I just do not see that the data that is going to be
produced in the new disclosures could provide anybody with sufficient information to identify the affairs of any individual borrower.
If there is that misunderstanding, we certainly want to correct it. I
just do not think that is the case.
The CHAIRMAN. My time is up, but let me just follow up on the
other side of the coin. It may exert some market discipline, but
what about the other side of the coin; if the disclosure creates
panic, that suddenly you get a run on the bank because people
don't like what they're seeing and you precipitate having to close
down a situation where you might not have to. There are two sides
to that coin.
Mr. CONOVER. Yes, and I think it is the other side of the coin, or
the potential for the other side of the coin, that provides some of
the needed discipline. Most banks in this country are well managed. Their financial conditions are in pretty good shape and they
have nothing to fear I think from increased disclosure. Those
whose affairs are perhaps in not such good shape today have some
time to try to do something about it and to figure out how they will
explain their financial condition when those disclosures are made.
Mr. ISAAC. Mr. Chairman, I would like to say a couple of things
on the issue of the small towns and knowing what's going on with
respect to borrowers. I don't see how that comes from the call
report data, but being from a small town myself that's only somewhat bigger than your mother's home town, I suspect that in many
cases people in the town know who is paying their bills and who
The CHAIRMAN. YOU think the disclosure has already been made?
Mr. ISAAC. That's correct. It has little to do with the report that
may be filed and maybe there is some market discipline in that.
As far as whether there would be more instability caused by the
disclosures, I think in given situations it could bring a matter to a
head more quickly than otherwise would be the case, but if I look
at the alternative of what would happen in a deregulated climate
where banks are permitted to pay whatever they wish for deposits
and engage in a broader range of activities, I believe we would
have a very unstable system in the absence of disclosure. You can't

move into a deregulated environment and not couple it with some
market discipline and you can't achieve market discipline without
adequate disclosure. So I think disclosure, viewed in the context of
a deregulated environment, will bring us a much more stable
system than we will have in the absence of disclosure.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
I want to go back to our earlier discussion. We talked about the
present number of problem banks and we were about to compare
them to the experience in 1976. What would be the asset value of
the banks that are in trouble today or on the troubled list?
Mr. ISAAC. The total assets of the banks on the problem list today
versus 1976? I don't have that number on the top of my head, but
I'm certain it's lower today.
Senator RIEGLE. Would that be because the size of the average
bank that is now in difficulty is smaller than the average troubled
bank back in 1976?
Mr. ISAAC. Well, for one thing, there are fewer banks on the list
at this point than there were in 1976 and, second, in 1976 we had
at least a couple of fairly large institutions on the list and we don't
Senator RIEGLE. HOW about the profile of the problems that are
facing the banks? Are they roughly comparable? Are we looking at
1976 all over again or are we looking at a different mixture of
Mr. ISAAC. I think the situation is different. I don't know how to
compare it in terms of severity because it is different. In 1976 we
had problems that were more focused in specific sectors such as
real estate. We had a boom in real estate which came to an end in
a hurry. We had other specific industries such as the shipping industry which got hit pretty hard in 1976. In the 1976, 1975, 1974
period, we had a very sharp recession that was of comparatively
short duration compared to what we are experiencing now where
we have had 4 years of stagnation and high and volatile interest
rates, coupled with deregulation. So the situations are different.
I can't say that today is any worse a problem for us than 1976.
The number of banks that have actually failed is higher, but that
doesn't mean the problems are any worse. The number of banks on
the problem list remains lower, although we could yet exceed the
earlier period.

You asked earlier about monitoring systems and whether the
current problem bank list is comparable to 1976. If anything, I
would hope that our monitoring systems are better today than they
were in 1976. I'd like to think we get better at it as time goes
along. I know the Penn Square Bank has caused some improvements in our monitoring systems. So, if anything, I would hope
that the problem bank list today is a more accurate reflection of
problems than it was in 1976.
Senator RIEGLE. I think it would be good to have you submit for
the record what specific changes have been implemented in our
monitoring procedures since Penn Square.

Mr. ISAAC. Sure. I would be happy to.
[Information subsequently supplied for the record can be found
on p. 100.]
Senator RIEGLE. NOW I think your points about the nature of the
problem situation at this time is a very interesting analysis because we have experienced four years of virtually no growth in the
economy combined with the other problems that you speak about,
such as a more intensive competitive environment.
My question is, again, to reframe it, where are we, where are we
going and what are we likely to be facing? Are we prepared sufficiently to deal with problems either from the point of view of monitoring arrangements or the capacity to absorb a higher rate of failure should that come about, and let's hope that it doesn't?
According to your little summary, if the economy does not snap
back most of the problems bearing in on the industry are likely to
remain. I mean, the competitive pressures of deregulation are
likely to become even more intense. It's going to be more intense
even between each other with the ceiling rates off and so forth.
So I'm wondering, in the absence of economic recovery how
many banks are there that are in trouble and that are essentially
going to be ground down to failure. Let's say the economy stabilizes; we just continue to bump along in sort of a protracted recession or with an absence of real strong growth. Can these banks
that are on the problem list just tread water over that period of
time or are we likely to find that their problems will worsen and
other banks may join the list?
Mr. ISAAC. If the economy remains flat for the next couple years
and we don't see a significant improvement and we couple it with
the pressures brought about by deregulation, it seems likely that
the problem bank list will continue to grow in size and that the
failure rate will be higher than the 10 to 12 we've been accustomed
to over the past 10 to 20 years. At the FDIC, we have to plan for
various types of contingencies. There is no contingency that concerns me in terms of our ability to cope with it. We are certainly in
a position to deal with anything that we believe might happen.
You can't place too much emphasis on the problem bank list because the typical bank on the list gets off within a year or as its
condition improves. New management is brought in or new capital
is placed in the bank or policies in the lending area are corrected.
There's a great deal of turnover on the list and there will continue
to be.
Senator RIEGLE. There have been lots of warning signals recently
and rather urgent steps taken by our government and other governments to try to cope with what appears to be a deteriorating or
more difficult problem of our world financial system. The chairman
mentioned some of the countries involved, but more and more stories are being written about it. I'm being visited by members of the
administration that have a great sense of urgency about beefing up
our commitment to the International Monetary Fund. So there are
all the signs that those problems are getting more severe and
there's great stress out there and efforts should be made to try to
do something about it.
At what point do those pressures start to, in a new way, bear in
on our domestic problem? If the problem of nonperforming foreign

loans continues to increase and more and more countries need additional credit, are we approaching a point here where that problem could begin to have an impact on what you're dealing with
that we should at least start thinking about it, or are you feeling
that the international problem is sufficiently detached from the
Penn Square type failure that now is not the time to discuss it?
Mr. ISAAC. Well, I'm not sure I could tie that problem very directly to Penn Square, but I think
Senator RIEGLE. We're now talking about the future Penn

Mr. ISAAC. Certainly the FDIC has to give thought to what could
occur in this area. I hear and read a lot of doomsday scenarios on
this and that and one flaw I find in all of them is they forget that
we have a number of institutions in place to deal with precisely
these kinds of matters, and they all presume that the managers of
commercial banks and the people who run institutions like the
FDIC, the Federal Reserve, the Comptroller of the Currency, the
IMF, the Congress and others are not going to react rationally;
indeed, aren't going to react at all it seems from some of the
doomsday scenarios.
If we look at what's been taking place over the past several
months, I think we're seeing people behaving in a rational fashion
and dealing with the problems as they come up. I'm sorry that
Chairman Garn has stepped out because after that nice compliment he paid me I wanted to return it in his presence. As an example of what I'm referring to is the Garn-St Germain bill, which I
know you were quite helpful on, Senator Riegle. That bill was a reaction by the Congress to the request of the regulators to enhance
our authority to deal with large banks that might get into difficulty. We talked with Chairman Garn, yourself and others and said,
we believe we ought to have this kind of standby authority, and
you agreed and we received the legislation.
Arrangements are being made to deal with the problems in
Mexico. The IMF, commercial banks, the central bank and others
have been involved in that process. Secretary Regan has been over
in Europe this week. There are steps being taken to deal with problems as they come up. We have safety nets in place and they will
be used rationally and intelligently.
Senator RIEGLE. Let me give you one. We are in the midst of terrible economic problems in this country. It comes as no news to
you. I mean, it's in every day's news on the front of every newspaper's business section and it's on the very front pages of many of
the newspapers in the country.
But to bring it home, I happen to come from Michigan which is
one of the largest states. The unemployment rate as of last Friday
in Michigan was 17.2 percent. That's an understated rate because
we don't count people when they stop seeking unemployment. So
our unemployment rate in Michigan is about 20 percent. When you
think about what that means either in sheer numbers or personal
economic impact, it's a depression level really. We have a population which is larger than the populations of 12 of the 50 States. In

the trade area, Michigan and the rest of the Nation is being absolutely demolished. I'm talking about the flow of goods in and out of
the United States, it's a major problem and continues to get worse.
As these other countries who feel they need to borrow more
money both from the United States and other nations do that, they
are being asked to make certain other tough disciplinary steps
within their own domestic economies which press back on those
economies in terms of consumption levels, taxation and higher unemployment and so forth. It gets very, very difficult for those countries to succeed. It's very difficult for us to do the same.
I frankly don't have as much confidence as I'd like to have in
foreign governments. Are they going to be able to secure additional
credit? If they can't, one of the ways they are going to have to
change is they are going to have to export more, which means
more foreign goods in this country and more American workers
displaced. We have got a disastrous problem in this area now and
it all gets to the same bottom line, and that is that the world economy is now interconnected and we are part of it. It's gotten to the
point where one country pulls itself up at the expense of another
and before long it creates almost impossible consequences, and I
think we are very close to that point in this country right now.
As a matter of fact, I'll give you another interesting illustration.
We are going to put in the new highway jobs bill, both in the
House and Senate, a Buy American provision on steel used in construction projects on the highway system. We've got a major issue
cooking on domestic content, which is the issue in another form. So
I think we may very well find that we are getting right out near
the end of the string here in terms of our ability to lever our way
out of this problem unless we get some real growth going again and
I think all this relates to the bank problems here.

Let me ask you this. What percentage of nonperforming loans
are you seeing today versus 1976? In other words, is there an equivalence in terms of the fact that we are just looking at x percent of
nonperforming loans versus the 1976 experience.
Mr. ISAAC. I can't give you the exact number in terms of nonperforming loans today versus 1976. I can certainly get that for you. I
can tell you that the loan charge-offs are lower today. It's my recollection that the loan charge-offs in 1976 were in the vicinity of 0.56
percent of loans. Today they are running about 0.35 percent of
loans which is roughly the same as they were last year and the
year before. So I can only presume that the number of troubled or
nonperforming loans is likewise lower than in 1976. But the
number of problem loans is on the increase, and I'm sure that it
will continue to increase for a while.
Senator RIEGLE. Has any sectoral analysis been done of the nonperforming loans to compare the number of nonperforming loans
coming out of the manufacturing sector versus, for comparison,
those coming out of the agriculture sector. Because more and more
Members of Congress who come from predominantly agricultural
States are in a state of almost total apprehension about the future
because so many farm areas of the country and farm loans at the

moment are nonperforming. We have an enormous buildup of sectoral problems in that particular area unlike what we would have
seen I think in 1976.
In other words, what I'm getting at—and I could cite other sectoral areas—it seems to me that nonperforming loans are building
up in different areas of the economy that I think are in very serious trouble and that are likely to cause more jeopardy if we don't
get a recovery soon. And I cite all this not $o just raise everybody's
concern level but for the reason that I'm not sure we are sufficiently aware of the dangers that may be confronting us now and
whether or not our safety nets, as you speak of them, are really
sufficient for the kind of problem that we may face not today but
out over the next 12 months or 24 months if we continue to limp
along in terms of both the national economy and the world economy.
I think the overhanging problems as I see them are so severe and
of enough disparity that unless we start making measurable real
growth progress we may find that the nature of our banking problems could start to change on us faster than we could deal with
them. And I just tell you frankly that I'm very concerned about
that and I am not just talking about Penn Square, but Penn
Square is important in terms of the next set of Penn Squares that
are likely to happen. That's why we're really here.
Mr. ISAAC. In the answer I gave earlier, in terms of comparing
1976 to today, one of the things I said was we had a more specific
set of problems than we are facing today. Today's problems arise
from a variety of sources and are harder to predict.
I would like, before the time is up, to respond to a point you
made earlier about whether we are doing all we should be doing to
cope with the new climate. My response to that is that we are probably thinking about all the things we need to be doing, but there
hasn't been adequate followthrough yet in a number of areas.

One, I believe that bank supervisors must improve their supervisory techniques. We began that process well before Penn Square
and it is continuing, but more needs to be done. They include refocusing our examinations away from the smaller, nonproblem banks
and paying more attention to the larger banks and to the banks
that are exhibiting difficulties, improving our offsite monitoring
and surveillance systems—the new call information will be terribly
valuable in that respect—and improving our computer capabilities.
We also need to retrain our people to get them to focus on interest
rate sensitivity and other such matters instead of focusing so much
attention on credit problems and balance sheet analysis.
Second, there are some legislative issues that must be considered.
As we remove the restrictions on competition, such as regulation Q,
and broaden the powers of financial institutions, what is going to
replace the controls?
In our opinion, we have two choices. We can either put examiners full time in every bank in the country and participate in every
decision of any import the banks make—which in our judgment
would be a very bad policy to pursue and we don't recommend it—

or we can look for ways to increase market discipline. Fuller disclosure is one way to increase market discipline. Additionally, we
should look at the deposit insurance system as we've been directed
to do under title VII of the Garn-St Germain bill. This includes
risk-related deposit insurance premiums, risk-sharing by merging
insurance funds and so forth.
There are some very important legislative issues that should be
considered in the next year or two if we're going to deal successfully with this new deregulated climate.

The CHAIRMAN. Chairman Isaac, along this line of thinking
again, there have been several comments today indicating that in a
deregulated environment this is part of the problem. Obviously
there are pluses and minuses, but, as a matter of fact, you've heard
me say many, many times that there's a revolution going on in the
financial services industry not only nationally but internationally.
I have been accused by some bankers, particularly small bankers,
and some people involved in S. 1720, the so-called Garn-St Germain
bill, of causing a revolution. I don't consider that the case at all.
In the 8 years I have been on this Banking Committee the markets have been changing dramatically and, in my opinion—regulators, supervisors, Congress, administrations—the revolution has
been there and we have all been behind the power curve. We
haven't been responding to it.
So I think what you're saying about thinking these things
through—I'm pleased that you are looking at new supervisory regulatory techniques, but S. 1720 or its successor barely scratch the
surface. There are a lot of legislative things we've got to take a
look at. We simply have to catch up.
None of us are starting anything, at least in my opinion. We are
not causing it. I didn't cause $230 billion of money market funds. I
didn't have anything to do with it. I didn't even have enough
money to invest in it, not with seven children and two houses and
all that. And it seems to me we're starting to catch up but we are
still well, well behind.
I don't want to leave the impression that deregulation is causing
the problems. In my opinion, it is an attempt to try and address
some of those changing market conditions and it must continue.
It's totally apart from the problems of the last 4 years of no
growth, of high interest rates and all that. We have to look at the
situation in its totality. For example, the changes through technology—I was just over to a conference in England on electronic funds
transfer, and the technological changes in the way we do business
are dramatic. Again totally apart from deregulation, there are
changes going on in the marketplace and we've got to address
them. We can't simply sit back and continue doing the business of
regulating and supervising the way we have for the last five or six
decades and say that's sufficient. And that's the hardest point I've
had to try to educate people on and achieve over the last couple
years and that is taking place more rapidly every day. I never
cease to be amazed at how rapidly the markets are changing and
we've got to run very fast to try to modernize and keep up with


0 - 8 3 - 7

those changes because they will occur no matter what we do because we are not causing the changes.
I assume you all agree with that.
Mr. ISAAC. I couldn't agree more. Technology and the economy
have forced deregulation. Deregulation is simply a reaction—and it
has been a delayed reaction at that. With the Garn-St Germain bill
and some of the things we are trying to do now, maybe we'll begin
to catch up a bit.
The CHAIRMAN. Well, it's only a small beginning. Too many
people talk about Garn-St Germain as some big cure-all. It's the tip
of an iceberg. It's just a very small part in what I think we need to
Mr. ISAAC. It's an important first step but it must be recognized
that it's just that—a first step.
Mr. CONOVER. If I may add to that, Mr. Chairman, I would just
like to say that we have touched on deregulation a couple times
this morning as if it were something we were causing or could stop
if we wanted to stop. I see it very much as the marketplace phenomenon that is going to take place whether we are agile enough
to get out of the way or not. If you look at some of the problems
that we face today, particularly the mutual savings banks' problem
that Chairman Isaac and Senator Riegle were talking about earlier, in a very real sense the problems of the mutual savings banks
are the result of regulation. They are the legacy that an overregulated system has left us.
So I think that there is an awful lot more to be done in a deregulatory way in the months ahead.
Now one of the things, of course, that that brings is it will put
pressure on managements because they will have to behave in a
way and make decisions on subjects that they have never had to
deal with before. One of the things I think we have to do is recognize that phenomena as we go and encourage managers and banks
and thrifts and other financial institutions around the country,
who recognize the changes that are taking place around them, to
come up with ways to cope with those changes in their own institutions.
I think, most of them will be able to do that effectively. Some
won't and we will end up with a shakeup to some degree in the
financial services area. We will end up with institutions that look
very different in the future than they look today.
The CHAIRMAN. Let me ask just another couple of specific questions of Mr. Sebastian and Mr. Vartanian.

Do either NCUA or the Federal Home Loan Bank Board have
procedures that would allow you to discover excessive concentrations of assets or imprudent loans? In other words, I'm looking at
some of your members who were involved with Penn Square or
other concentrations that might have occurred. Is there any way
you have that you could have been alerted to some of your membership being involved in that sort of thing?
Mr. SEBASTIAN. AS we examine credit unions we can look at their
investments and see if they have too much of their money in a par-

ticular institution, but we have no way of looking at the other institutions to see if they have too much credit union money.
We haven't gone over every single case, but I'm aware of one instance where, just by luck, we were in a very large credit union
about a week before Penn Square and saw that in our examiners'
opinion, they had too much money in Penn Square. They wrote
that fact in their comments as they left the credit union and the
credit union in fact took a substantial amount of money out right
before the closing, and that was without any foreknowledge. It was
just that there was too much concentration in our opinion.
We feel very strongly that getting credit union examiners into
credit unions at least every year and more often in problem credit
unions is the best way to monitor that kind of activity.
The CHAIRMAN. Mr. Vartanian.

Mr. VARTANIAN. Yes, Mr. Chairman. We are also in the same position as the credit union regulators. We have a regulation in effect
which limits interdepository deposits to the greater of $100,000 or
certain minimum percentages of the borrowing institution's deposits, or the investing institution's assets or net worth. We think that
regulation will be effective.
The question then becomes monitoring that regulation. We do
monitor that regulation through the exam process.
With respect to the three institutions who had exceeded and violated that regulation because of the size of their investments in
Penn Square, one of them had received a warning from the Federal
Home Loan Bank Board prior to the failure of Penn Square.
Our enforcement procedures essentially focus on the examination
process. There are basically four different types of composite ratings for institutions, and those result in four different frequencies
of examination. The level 1 institutions, which are the best, are examined every 16 to 20 months. For level 2, generally they are examined from between 12 to 16 months. Level 3 institutions which
begin to get into the more severe problems are examined every 9
months, and level 4 institutions are examined every 6 months.
So hopefully the existence of the regulation and that examination schedule will be effective in finding any problems. As I said
before, in the period between January 1, 1980, and July 21, 1982,
we did find only eight such concentrations which were in violation
of Federal or State regulation, or were generally considered to be
excessive or risky.
The CHAIRMAN. Thank you.

Governor Partee, what was the level of debt to First Penn from
Penn Square in relation to Penn Square's equity base?
Mr. PARTEE. The holding company was funding the bank to a
goodly extent, an increasing extent as a matter of fact. As 1981
went on and into 1982 and toward the end, they had a rather high
total debt-to-equity ratio. I can find it if you like, but I don't know
exactly what it was.
The CHAIRMAN. YOU can supply it for the record.
[Governor Partee subsequently furnished the following information for inclusion in the record of the hearing:]

[In millions of dollar]


lm m



31, 1976
31, 1977
31, 1978
31, 1979
31, 1980
31, 1981

Sho m




Total debt













Parent equity

Mr. PARTEE. The holding company sold commercial paper and
was using the proceeds almost entirely to buy deposits in Penn
Square and toward the end for loan participations, just like these
other banks.
The CHAIRMAN. DO you feel that the relationship between Penn
Square and its holding company strengthened the bank?
Mr. PARTEE. It began strengthening it because as a result of the
holding company substantial capital was developed and was put
into the bank in 1981—and there were plans for more capital in
1982 that was being handled by the holding company. But, as I say,
in evaluating our holding company inspection, our view is that the
holding company didn't create the bank's problems, but it certainly
didn't prevent them either.
The CHAIRMAN. In denying Penn Square further access to the
discount window over the July 4 weekend, the Federal Reserve
Bank of Kansas City was then not acting as the lender of last
resort. Do you believe that decision was proper, and what criteria
does the Fed use for making that kind of decision?
Mr. PARTEE. AS I stated in my testimony, Mr. Chairman, the Reserve Bank did not attempt to withdraw lending until it received
notification from the Comptroller that the institution was not
viable. That is technically the point—assuming there is some collateral to be used for the lending—at which we withdraw, when we
get the chief supervisor's warning that the institution isn't viable
any more. We got that on the 5th. We had loaned them what they
wanted on the 2d. We got the Comptroller's letter on the 5th and
would not have renewed the loan on the 6th had they opened up.
The CHAIRMAN. Thank you.
Senator Riegle.

Senator RIEGLE. There are just a couple other items I hope you
can cover briefly here. Let me ask you what do you think of the
idea of perhaps setting up a new mechanism, setting up an outside,
independent audit committee that would come into being in the
case of problem banks that are in severe trouble and that are being
told they have to make certain changes to conform to recommendations and requirements that you're putting upon them as you try
to help them work out of their difficulties. A mechanism to insure

that, for the most troubled situations, compliance is taking place
and that has an ongoing monitoring capability? What about setting
up in those instances an independent audit committee with the expertise to monitor requirements and agreements and to make absolutely sure that they were taking place so that the regulatory
people would not have to camp on the doorstep of the institutions
each day to see in fact whether the corrective steps or the modifications were taking place. And if there were a failure, to so report so
that we could make sure that we were on track with the recovery
How would you feel about that?
Mr. CONOVER. Senator, we have within the Comptroller's Office a
special projects group which is a nice name for the problem bank
group, a group of people who focus on monitoring and tracking the
affairs of problem banks. So we have concentrated within our office
a group of people who specialize in that.
Senator RIEGLE. Let me just stop you a minute. I want to make
sure you understand what I'm saying. I'm saying if you've got a
problem out in any part of the country that you would set up an
independent audit group in that community, people in that area,
who don't have any tie-ins to you as such and who are not your
internal people, but an absolutely detached outside independent
Mr. CONOVER. I understand the question. The point is, when we
do enter a formal agreement with a bank that's in some difficulty
specifying corrective action to be taken, we generally require that a
compliance committee of the board of directors be established and
that it be at least headed by and a majority of the members of that
committee be outside directors, not part of the day-to-day management of the bank. It is their responsibility to monitor compliance
throughout the agreement and to report to us on the progress that
they are making in their compliance efforts.
It seems to me that since the agreement is between, in this case,
the Comptroller's Office or the supervisor and the board of directors of the bank, that that is appropriately a responsibility of those
directors and I think that is the way it ought to be done. I think we
accomplish the same end as you suggest by this mechanism rather
than by having some outside party being involved in it.
Senator RIEGLE. Did we have that in Penn Square?
Mr. CONOVER. Yes, we did. We had a committee and they did
report to us on a monthly basis, as a matter of fact, at least
through the September 1981 exam. You recall that we indicated
that we thought they were making progress in achieving compliance with the agreement through that date.
Mr. ISAAC. Senator, if you can't count on the board of directors,
you ought to run them out of the bank and bring new directors on
to the board. There are a couple of disadvantages in working
through outsiders. One, the directors are more competent to do this
job than outsiders and, second, if the directors don't do their job
they are going to have legal responsibility. It's hard for me to envision how you would place the outside group in the same position
with respect to potential legal liability.
The FDIC has been pretty aggressive in recent years in terms of
pursuing officers and directors, accounting firms and others after a

bank fails. I believe that has had a therapeutic effect, and I assure
you we are pursuing those investigations vigorously in Penn
Senator RIEGLE. I would like you to submit for the record whether such an audit committee was established in each case of the
banks that have failed over the last 2 years. These presumably
were insider monitoring groups headed by or composed of so-called
independent directors or directors who were not in the day-to-day
management of the particular bank in question. I would like to
know in each case how well that worked. I'm not sure that is a sufficient monitoring device for the kinds of problems we're seeing
I mean if we used that device in Penn Square and we come along
after the fact and run people down in court on possible misconduct,
that is sort of an after-the-fact remedy, and we should bring
charges if there's that kind of problem, but what I'm looking for
here is a way to try to find these situations before they become so
advanced and so aggrieved that we have to go through the wringer.
Mr. ISAAC. That's the problem, though. If you find a problem situation, you can deal with it without a committee. If its a situation
you don't find, you would never have occasion to set up the committee.
Senator RIEGLE. I have great regard for you, but I share the reservation that I believe the chairman expressed earlier and I don't
want to put words in his mouth, but I think regulatory agencies
from time to time shuffle their feet as well. Even with the best of
intentions, you want to be able to work something out if you can.
However, I've seen regulators who are aggressive and tough to too
great an extreme, too confrontational and too combative, and I've
seen others from time to time who will let problem situations continue until finally they are beyond the point where maybe something constructive could be or should be done.
I think the public has some right to be certain that there is a
monitoring device that can insure that if agreements have been
made that they are kept and that things don't slide and the clock
continues to run and the problems do not become more severe until
finally we wake up having to shut down the bank literally overnight. Everybody says, well, we really didn't anticipate this; 5 days
ago we didn't see this coming and now, bang, it's here. We ought to
see it more than 5 days ahead of time.
If our monitoring and auditing devices are not sufficient to give
us more than 5 days leadtime, we ought to be drafting one that
does a little better job. I think one way to do it, and a fair and
square way is to have competent professionals monitoring severe
problem situations where certain corrective actions have to be
taken to make sure they are being done so the whistle gets blown if
it needs to be blown. Maybe it needs to be blown on the regulators.
You certainly don't bat 1.000. We don't and nobody does. The gravity of the situation is such that I think it's important that the
public be able to know that we are doing everything we possibly
can to find these problems before they blow up in our face. I don't
think anybody is covered with glory by what happened in the Penn
Square case.

I think our obligation is to spot problems early enough in the
game, intervene and be able to do something about it before we are
left with full-blown bank failures. I think bank failures do damage.
I think they damage the system. I think they damage people's confidence and to the extent we can head some of them off I think
that would be useful.
So Fm interested in seeing how that monitoring device you speak
of has worked in each of the cases of the bank failures we have
seen over the past few years.
[The following letter was received for the record:]





January 27, 1983
Honorable Donald Riegle
Committee on Banking, Housing,
and Urban Affairs
United States Senate
505 Dirksen Senate Office Building
Washington, D. C. 20510
Dear Senator Riegle:
We are pleased to supply supplemental information you requested for the
record of the Senate Banking Committee's hearing into the failure of
the Penn Square Bank N.A. of Oklahoma City.
Question No. 1 :
Please submit for the record, what changes in monitoring procedures have
been implemented since the Penn Square failure.

Answer to Question No. 1:
Since the failure of Penn Square Bank, we have taken the following steps
to improve our monitoring procedures:
(a) FDIC policy relative to the priority, frequency, and scope of
examinations has been modified to provide more effective supervision and
surveillance of banks rated 3, 4 and 5. Previously, banks rated 4 and 5
were required to be examined at least once each 12 months and banks rated 3
at least once every 18 months. Additional examinations and/or visitations
were encouraged and generally performed; however, this was discretionary on
the part of our Regional Directors. Recent revisions require that an examination or a visitation be performed quarterly on banks rated 4 and 5 and
that off-premise reviews of banks rated 3 be performed in any six-month
period when an examination is not conducted. To free up resources for this
purpose the examination interval for smaller 1 and 2 rated banks was
increased from 18 months to three years with visitations or off-site reviews
to be conducted in intervening years when no examination is performed.
(b) The FDIC has, for many years, operated a memo system relative to
problem banks (currently defined as banks rated 4 and 5 ) . This memo system
provides a financial summary, a definitive description of the nature of a
bank's problems, and a discussion of the corrective program being pursued
along with other information. This memo system is the focal point for our
oversight and Internal communications relative to problem banks. Since the
Penn Square failure, we have extended this system to include all banks with
assets of $250 million or more which are rated 3.

Honorable Donald Riegle


January 27, 1983

(c) New procedures have been adopted jointly with the Comptroller
of the Currency to improve interagency identification and communication
relative to national banks likely to involve FDIC in a financial assistance
transaction. I t is hoped that similar procedures can be worked out with
the Federal Reserve.
(d) Several changes have been and are being made in our computerized
surveillance system in conjunction with the availability of new data. The
Federal Financial Institutions Examination Council implemented i t s Uniform
Bank Performance Report (UBPR) in 1982 and, earlier this year, agreement was
reached among the regulatory agencies to substantially improve the Call
Reports submitted by banks. Beginning with the December 3 1 , 1982 reports,
a l l banks w i l l submit data regarding their nonperforming assets.
On March 31, 1983, accrual accounting will be extended to banks with assets
between $10 and $25 million, and on June 30, 1983, a l l banks w i l l provide
information regarding the volume of their rate sensitive assets and l i a b i l i t i e s . Our surveillance system has already been modified to provide compatab i l j t y with the UBPR and new test ratios are currently being developed to
u t i l i z e the new information which w i l l soon be available. The UBPR, which
is generated on a quarterly basis, has enabled us to formalize the "off-site"
analysis program mentioned earlier which allows us to evaluate the condition
of banks more frequently between, examinations. Our early warning system,
which identifies banks failing critical financial tests, is being revised to
take advantage of the new Call Report data. In addition, a separate specialized
surveillance system for larger banks is also being developed which will improve
our ability to monitor these banks 1n recognition of the potentially greater
insurance risk they pose to the Corporation.
(e) In addition to the above, a review of all 4 and 5 rated banks which
are not subject to formal enforcement actions has been performed to determine
i f such actions are appropriate, and FDICs Board of Directors has delegated
some of its authority with respect to enforcement actions to improve our
efficiency in the use of these powers. Also, we have started advising banks
in the report of examination of composite ratings (1 through 5) assigned under
the Uniform Financial Institutions Rating System together with the narrative
definition of what the rating means. This l a t t e r step will provide improved
communication to banks as to their precise supervisory status with FDIC and
serve to formalize our oral discussions with banks rated 3, 4 and 5 as to
the seriousness of their problems.
You may wish to note in the response that we have interpreted your request
l i t e r a l l y and that not all these actions were directly related to the Penn
Square f a i l u r e . Specifically, Items 1(a) and 1(d) were in process prior
to the failure of Penn Square. Also, the points in Item 1(e) dealing with *
delegations of authority on Section 8 actions and notification to banks of
their ratings were either in process or under discussion prior to Penn Square.
Question No. 2:
Request that we review our files on banks that have failed over the last two
years and advise i f an audit committee was established (apparently with the
express purpose of monitoring the bank's efforts at resolving i t s problems)
and, in each case, how i t worked.

Honorable Donald Riegle


January 27, 1983

Answer to Question No. 2:
A review has been conducted of the files of banks closed during the last two
years to determine the use of audit or oversight committees to monitor the
banks' efforts to correct their problems. This review disclosed only one
such instance which involved the use of an independent consultant to aid in
the resolution of the bank's problems. There may have been other instances
where committees of outside directors or outside consultants were used;
however, these were not readily apparent from a review of the f i l e s .
The r T\C has not heretofore required or even encouraged the use of committees
or consultants as a means of achieving correction of a bank's problems. We
are aware that bank boards frequently appoint such committees; however, we
have not generally sought to work through or communicate with them directly.
While a conscious posture in opposition to the use of such committees has not
been adopted, our approach to this matter has been largely influenced by two
factors. F i r s t , the FDIC has sought to establish responsibility and accounta b i l i t y with the full board of directors and has structured i t s communications
and enforcement activities accordingly. Secondly, our experience with problem banks has taught us to be wery skeptical of information reported by a bank
indicating corrective actions which are taking place without independent
confirmation by examiners. Frequent progress reports from banks are always
required and are helpful to our efforts; however, these are not used in lieu
of but rather in conjunction with on-site v i s i t s or follow-up examinations.
While steadfast in our belief that full board accountability and frequent
examiner contact are necessary to effective supervision of problem banks,
we do not reject the idea that productive use can also be made of oversight
committees. We are presently taking a serious look at this idea to see i f
i t can be productively employed in problem bank rehabilitation.
Question No. 3:
What percentage of nonperforming loans are you seeing today versus 1976?
Has any sectoral analysis been done of nonperforming loans?

Answer to Question No. 3:
The attached table indicates that the two primary measures of nonperforming
loans reported by banks — past due loans and nonaccrual loans — are higher
today as a percentage of total loans than in 1976. Furthermore, the
nonperforming percentage of each separate loan category has been increasing
substantially since 1980 after a slight downward trend during the period
1976-79. The most notable increases in nonperforming loan ratios have
occurred in real estate and commercial and industrial loans.

H i am M. Isaac


* Past Due % of Loans By Type
Real Estate
Commercial & Industrial
Total Domestic **
Foreign Offices

* Non-accrual % of Loans













































! 4
















* The past due and non-accrual loan Information is for national banks only. Non-accrual loan information is only
reported by national banks of over $300 million in assets. The determination of past due status 1s as follows:
(1) Single payment notes—These shall be considered past due 15 days or more after maturity.
(2) Single payment loans, with Interest payable at stated intervals, and demand notes—These shall be considered past due when an Interest payment is due and unpaid for 15 days.
(3) Consumer, mortgage, or term business installment loans—These loans are past due in whole after one
Installment is due and unpaid for 30 days or one month. When an installment payment is past due, the
entire unpaid balance should be reported as past due.
(4) Overdrafts are considered past due when not paid in 15 days.
** Also Includes loans to other financial institutions, agricultural loans, and loans for purchasing or carrying

Averages of Individual bank ratios.


Senator RIEGEL. The final thing I'm interested in is can any of
you tell me what percentage of bank lending has now made its way
abroad? In other words, what percentage of our bank lending today
by banks in this country, through whatever number of transactions, actually ends up overseas. If you can give me a percentage in
the aggregate t h a t I might compare, say, with what t h a t figure
might have been 5 years ago, 2 years ago, 1976 or 1975, the last
time we went through a severe wringing out problem. Where do we
stand today? How much money has made its way out of the country into foreign loans of whatever sort?
Mr. CONOVER. Senator, we can supply that specific percentage for
the record. I believe the number is t h a t U.S. banks have a total foreign exposure of approximately $320 billion today and t h a t number
is up significantly I think by approximately 80 percent over the
yearend—I do not remember if it is 1977 or 1978 figures—but
there's no question t h a t in the past 4 or 5 years, U.S. bank exposure in the form of foreign loans has increased significantly.
Senator RIEGLE. What is that as a percent of lending today
versus what it would have been in previous years?
Mr. PARTEE. One clarification, it isn't necessarily money coming
from this country. A large amount of this is raised in the foreign
branches of U.S. banks and re-lent abroad.
Senator RIEGLE. HOW close can you get to an answer today? This
can't be a new subject for you. Somebody must have some idea
what the percentages look like.
Mr. CONOVER. I know the numerator but not the denominator or
the fraction, so we'll have to provide it for the record.
Senator RIEGLE. IS it your impression
Mr. PARTEE. My guess would be t h a t it's on the order of 10 percent, but I don't have a figure in mind. I didn't come with this in
Senator RIEGLE. Mr. Isaac, would you have an answer to t h a t
Mr. ISAAC. I believe it's higher t h a n 10 percent, but I'm not going
to get into guessing what the exact percentage is.
The CHAIRMAN. Rather than deal in guesses, if you can supply
the exact figures for the record.
[The following information was subsequently supplied for the
Foreig)i loans as of June SO, 1982

Extensions of credit to foreign borrowers
Net claims of U.S. banks on their foreign branches



Total credit to foreign borrowers


Deposits of foreign offices of U.S. banks


Deposits of foreign governments in domestic U.S. offices
Total foreign deposits
Foreign loans minus foreign deposits (Net)
Total assets of U.S. banks (foreign and domestic)
Net as percent of U.S. bank assets


Senator RIEGLE. I would just say in conclusion t h a t I think that's
something t h a t we need to know and I think it's something t h a t
you folks ought to know. We need to know what fundamental
changes and shifts are going on that bear on larger pressures and
My concern here is what's likely to happen in the next year and
2 years, how many more Penn Squares are there, and how different is today's climate from what we saw in 1976, the last time we
saw a significant number of bank problems? I'm not even sure
we've got t h a t fully sorted out. Not t h a t we can do it all in one
hearing, but it seems to me t h a t if we've got fundamental changes
t h a t have taken place and you have enumerated many of them,
Mr. Isaac, and I agree with you about deregulation and other
things, I think we're going to have to do a better job of adding all
this up and deciding what this means in terms of the overall pressures and stress on our financial and banking system. We must
know if we are into a period and circumstance and condition t h a t
may be new and different, and sufficiently so t h a t we may need to
understand it better and we may need to consider whether the
mechanisms t h a t we have developed out of past experiences are
really sufficient to what we may see in the next 2 years. That's
what I'm principally concerned with.
Mr. ISAAC. If I might just say a couple words. First, we know
quite well what is happening in foreign lending. The fact t h a t we
can't come up with t h a t exact ratio right now does not mean we
don't know what is happening. We know which banks have what
Senator RIEGLE. And you're going to provide t h a t for the record.
Mr. ISAAC. Second, I am troubled by the comparison of Penn
Square and what's going on in the international arena and in
banking generally. We cannot lose sight of the fact that Penn
Square is a unique situation. We had a small shopping center bank
t h a t grew from $50 million in size to $500 million in size in 5 years.
In addition, it had originated another $3 billion in loan participations, outstanding letters of credit and loan commitments. In other
words, it went from $50 million to $3.5 billion. It grew 70 times in 5
years. It concentrated its loans in high-risk lending areas and
didn't diversify. It relied on expensive, volatile money purchased in
money markets at above market rates and the bank was fraught
with abusive insider transactions and irregularities. Are we going
to have a lot more banks like Penn Square? The answer is clearly
Occasionally we will have banks like this. This one got a lot of
publicity because it was bigger t h a n most and involved other banks
t h a t bought loan participations, but there have been smaller Penn
Squares over the years.
We are talking two different things. One, what is happening in
the economy generally and how are those factors coupled with deregulation, affecting banking? The other is how do you stop abusive
situations like Penn Square. The two issues are not related.
Senator RIEGLE. Well, I think you make some useful points there
and let's consider them both.
When we talk about Penn Square, you, yourself, in describing
what took place at this bank have given me a very powerful set of

reasons as to why we should have seen the failure coming. We, the
regulators, the people in Government, can intervene much earlier
to do something about it.
Whatever the reasons for the failure in that respect, whether the
mechanisms weren't adequate, whether the people didn't do the job
or whatever, what you have just outlined, that should have been an
advance sign that somebody should have been paying very careful
consideration to the situation.
I think we were late responding to that problem and I think our
response was not sufficient.
The second point I want to make relates to the other issue. If we
only had one bank failure recently, whether a Penn Square sort or
any other sort, I don't know if it would have been necessary for us
to meet, but as a matter of fact, in the last year we have had 40
bank failures of a variety of different circumstances. I'm not here
to suggest they were all of the Penn Square sort There's a variety
of circumstances. But the fact is we have had 40 this year.
Your recollection was that we had a low number last year,
whether it was 7, 12, 15, somewhere in that range, and when you
were using a 20-year average I believe it was to talk in terms of
roughly a. dozen or so that have been occurring each year. We have
seen a sudden increase in the number of bank failures of which
Penn Square happens to be only one kind of situation.
So, yes, we are interested in both things, absolutely, and I'm just
as glad to make a differentiation as you are. We want to find the
abusive Penn Square type situations and try to head them off earlier in the game than we were able to do or succeeded in doing this
time but, second, we want to understand what's bearing in on the
whole system that's creating not one or two bank failures or not
the averages we have seen over the last several years, but 40 in the
current year. That is very worrisome and very alarming and that's
why we are looking for answers to both problems.

Mr. ISAAC. If I might make a couple points on the latter problem.
I asked our regional directors at the beginning of this year to
project the number of bank failures they expected during 1982.
They predicted that we would have between 40 and 50 bank failures this year. Right now we are at 40. So I don't believe what's
happening is unforeseen or not understood. I think we knew what
might happen, were prepared for it, and dealt with it successfully.
As far as Penn Square goes, did we get on top of it too late; yes,
in my judgment, we got on top of it too late.

But having said that, I think you've also got to take into account
that ours is a privately owned, privately operated banking system
and there has to be a limit on the Government's involvement in it.
The primary responsibility for Penn Square does not lie with the
regulators. It lies with the shareholders who purchased stock in
that institution and elected certain people to be directors of it. It
lies with the directors who didn't do their job properly. It lies with
the management the directors selected. It lies with the accounting

firm which issued an unqualified statement on that bank after an
earlier accounting firm had issued a qualified statement. It lies
with the correspondent banks, the S&L's and credit unions which
funded it, and the participants who bought loans from it. That's
where the primary responsibility lies.
The regulatory agencies reacted pretty well. In all honesty, I
would have to say we would like to have been on top of the situation at an earlier stage than we were and closed it down earlier.
But in our free enterprise system of banking we should hesitate
before we say that the regulatory agencies are the real culprits and
should take primary responsibility. That would require some fundamental changes in our system of banking in this country—
changes that I'd hate to see made.
Mr. CONOVER. I think I need to respond to at least a couple of
points that Mr. Isaac made. Remember that through September
1981 the bank was making significant progress. Remember that between September 1981 and April 1982 is the time in which they
originated some $800 million of new loans and the very major portion of the loans that were ultimately categorized as lost and led to
the insolvency of the bank were made during that very brief time
period. I don't think that any regulatory system could have prevented the binge that they went on from happening.

As to whether or not the bank could have been closed down earlier, we regard the declaration of insolvency and the closing of the
bank as a very serious step, one that is not to be taken until it is
clearly demonstrated that the losses that exist in a loan portfolio
exceed the capital of the bank and that the bank cannot fund itself
from private funding sources.
We have been asked on a number of occasions why we did not
close the bank down on Friday—it must have been the second—or
why we didn't close it down on Saturday or why we didn't close it
down on Sunday. The simple fact is that we were working on analyzing that loan portfolio and discussing loans with the management of other banks to verify that, yes, those were in fact losses.
The bank was closed at precisely the time it should have been
closed which was the time when we were confident that losses exceeded the bank's capital and it was therefore insolvent. Any time
earlier than that would have been, I think, not only unfair to the
depositors and the shareholders, but also illegal. So I think we
closed it down precisely when we ought to have closed it down.
Senator RIEGLE. Let me just say, Mr. Conover, I don't think
that's the critical question, quite frankly. It is an important question. The critical question is, what might have been done earlier to
have prevented it having to close down on that day or 2 days later
or 2 days earlier? I'm not here to challenge the issue of whether or
not you closed it at precisely the right moment. The question is,
what might we have done weeks or months earlier and more effectively.
Might a way have been found to have avoided the final outcome
in this situation or even, if it was going to happen, to have prevent-

ed some of the abuses t h a t took place once it was well known t h a t
this bank was in trouble and t h a t there were difficulties here?
I'm just simply saying t h a t to say it closed at precisely the right
moment, that's fine and dandy, but if you think that's sufficient,
then I think you miss the point of a lot of today's discussion.
Mr. CONOVER. Senator, the fact is, t h a t as we indicated earlier,
any supervisory effort in dealing with a bank has got to depend on
the compliance of the management and the board. Of course, if we
tell them to do something and they do it, that's fine. For the most
part, 99.9 percent of the banks with which we deal, we ask them to
do something, whether it's been in the course of an examination or
through a formal agreement or cease and desist order, they comply.
But there's no question t h a t if a management or a board tells you
t h a t they are working toward compliance and submits evidence
t h a t indicates t h a t they are working toward compliance when in
fact exactly the reverse is the case, then there is very little t h a t
any supervisory agency can do about it. I do not think t h a t we
ought to have a system t h a t would enable us in the near term to
detect such instances of bad faith on the part of managements or
P u t another way, our system has got to be based on a fundamental premise t h a t directors and managers are honest and want to
comply with the law. If we have a system that is based on the reverse assumption, we have an horrendous regulatory system.
Senator RIEGLE. I think you view it the wrong way, if I may say
so. It isn't just a question of somebody who's lying to you and who's
dishonest or who has criminal intent. You may also have situations
where people can't respond or the circumstances change and so
they find themselves in an impossible situation and things t h a t
ought to be done or were to be done were not. Maybe they are identified or maybe not; but the notion t h a t we are just going to wait in
the end until things sort of fall in on themselves and t h a t you don't
have any way of improving the monitoring or making sure that
things that you think are going to be done or you think ought to be
done are in fact being done and that no changes are needed along
t h a t line, I just find t h a t a very weak line of argument.
Mr. CONOVER. I am not saying there are no changes t h a t are
needed along that line. What I am saying is t h a t as we deal with
banks in our normal supervisory process, if a bank finds itself in a
situation in which it cannot comply with the request t h a t we make,
in whatever form t h a t we make it, most managements and boards
will come to us directly and say, "I'm having this kind of difficulty;
what can we do about it?" The nature of the process is not simply
t h a t we tell them to do something and disappear from the scene
and hope that they do it. There is then a constant dialog and supervisory activity that takes place.
The CHAIRMAN. Mr. Conover and gentlemen, the precise time has
come to close this hearing. I do appreciate very much your willingness to come and testify today. I would suggest that we constantly
have to review our regulatory and legislative agenda to make sure
we are doing the best job possible. I do believe there are some improvements t h a t can be made in the system to try and do a better
job and I'm sure you're working on t h a t and I m sure we can't
solve all of those problem, here today. There will be additional,

more specific detailed questions that we would like to send some or
all of you for your response for the record in writing, but we do
thank you very much for your testimony here today.
[Whereupon, at 12:05 p.m., the hearing was adjourned.]
[Additional material received for the record follows:]


0 - 8 3 - 8


January 27, 1983
Honorable Jake Gam
Committee on Banking, Housing,
and Urban Affairs
United States Senate
505 Dirksen Senate Office Building
Washington, D. C. 20510
Dear Mr. Chairman:
We are pleased to respond to your request for answers to supplemental questions
regarding the Penn Square Bank f a i l u r e . You also submitted three questions on
behalf of Senator Tower. The f i r s t two questions submitted by Senator Tower
relate exclusively to the Comptroller of the Currency. We understand he is
responding to the same questions so we w i l l defer to his o f f i c e for this and
confine our response to his t h i r d question.

Questions No. 1, No. 2, and No. 3:

Call reports for commercial banks have recently been revised to require
quarterly reporting of data on past due nonaccrual and renegotiated loans.
In addition, beginning with the June report, the Federal supervisory
agencies w i l l make these reports available to the public. I f the reporting
of such past due loans is now being added to banks' Reports of Conditions
and Income, what were the procedures prior to such changes for gathering
data on, and monitoring,' delinquent loans?


Presuming that these new reporting requirements w i l l be of valuable
assistance to the regulators in e a r l i e r detection of future "Penn Squares",
what is the need to go the extra yard and require public disclosure of
such data?


Do you share the concern that such public disclosure would be easily
misinterpreted by the public, could further damage a troubled i n s t i t u t i o n
and would erode public confidence in our financial system?

Response to Questions No. 1, No. 2, and No. 3:
The FDIC is upgrading i t s o f f s i t e computerized monitoring system and reducing
the burden placed on well-managed banks with respect to frequent onsite
examinations. Similar efforts are underway a t the Office of the Comptroller
of the Currency and other regulatory agencies. The newly-instituted report
on past due, nonaccrual, and renegotiated loans and lease financing receivables
is c r i t i c a l l y important to these efforts which should not only improve our
surveillance of banks but also lower our costs and reduce the overall supervisory burden on banks.

Honorable Jake Gam


January 27, 1983

An excessive volume of past due and nonperformlng credits is a common t r a i t
of "problem" banks and is frequently the precursor of increases in loan and
lease losses. This, in t u r n , is one of the predominant reasons for bank
f a i l u r e s . Prior to the implementation of this new report, complete current
information on a l l forms of nonperforming credits was available only from
that fraction of insured commercial banks that had recently undergone onsite
examinations. Our o f f s i t e monitoring of problem credits was largely limited
to analysis of Call Report generated information on increases in the reserve
for loan losses and actual loan losses recognized by reporting i n s t i t u t i o n s .
Current public policy in this country calls for deregulation of the banking
industry thereby markedly decreasing the government's involvement in the
banking business. Banking i s a business that relies heavily on public t r u s t .
Heretofore, the public has relied on s t r i c t government regulation to ensure
that i t s interests are not compromised by excessive risk taking by banks.
In a deregulated environment, the government w i l l no longer determine what
interest rates banks may pay and w i l l play a smaller role than at present
in determining the services banks may o f f e r . We must, in this kind of
environment, seek new ways to control excessive risk taking.
In our view, the market mechanism holds significant potential for acting as
a safeguard against mismanagement or abuses. However, the market can only
play this role i f i t has sufficient Information to judge performance. Our
decision to make public the information on nonperforming loans is intended
to f a c i l i t a t e this process and provide a foundation for the market to
substitute, at least to some degree, for the regulatory authorities in
determining how well industry participants have carried out t h e i r duties.
The market w i l l reward the good performers and encourage the marginal performers to improve.
We share, to some degree, the concern about misinterpretation of the data by
the media. This could happen on occasion, but on the basis of our extensive
dealings with the media throughout the nation, we believe the press w i l l
generally be cautious 1n i t s use of the data. Banks and bank holding companies
whose securities are registered have disclosed similar types of information for
many years with no dramatic effect on public confidence in those i n s t i t u t i o n s .
We firmly believe that sound, well-managed banks have nothing to fear - - in
f a c t , have much to gain - - as we implement these new requirements.

Questions No. 4 and No. 5:

There are legal requirements applicable to loans to Insiders and t h e i r
related interests which require that they be on nonpreferential terms,
that the bank's Board approve loans above a certain threshold and that
they be reported. (These reporting requirements are now being revised
by the agencies, as mandated in the Garn-St Germain Act.) Similar
requirements apply to loans to insiders of correspondent banks. To
what extent were loans to Insiders and t h e i r related i n t e r e s t s , both
by Penn Square and i t s correspondent banks ( I . e . , Continental and
S e a f i r s t , e t c . ) a factor: a) in the Penn Square f a i l u r e ; and b)
1n the purchase of participations which created large losses for the
purchasing banks.

Honorable Jake Gam


January 27, 1983

Do you believe there should be special lending limits applicable t o
insiders that are more stringent than the single borrower limits?

Response to Questions No. 4, and No. 5:
The FDIC has over the years paid special attention to bank insider lending
and i t s ramifications. This attention has been reflected in both the
regulatory and supervisory processes. I t has been our experience that most
bank * *ansactions with insiders and related interests involve no abusive or
preferential treatment. A bank directorate is often composed of the most
reputable and creditworthy individuals in the community. Their businesses
w i l l , in many instances, necessitate bank loans, and these w i l l ordinarily
be among a bank's better assets.
On the other hand, there have been cases where improper loans to o f f i c e r s ,
directors and their interests resulted in serious losses or embarrassment
to banks. I t i s , of course, these cases that have led to the enactment of
regulations, reporting requirements and increased supervisory focus.
Existing regulations prohibit the granting of preferential loans to insiders
and t h e i r interests (including insiders of banks which maintain correspondent
balances with the lending, bank). Under the Garn-St Germain Depository
Institutions Act of 1982, the bank supervisory agencies are responsible for
setting insider lending l i m i t a t i o n s , thresholds for approval of such loans
by a bank's board of directors and reporting and disclosure requirements.
Recognizing the inherent potential for conflict of interest in insider lending,
we nevertheless believe there is no need for regulatory lending limits a p p l i cable to insiders (other than executive o f f i c e r s , to whom we believe no credit
should be extended) that are more stringent than lending limits for comparable
transactions with regular bank customers. Rather, i t is our feeling that this
potential risk can be e f f e c t i v e l y self-regulated by appropriate requirements
for board approval and disclosure of insider loans. The banking agencies
provide adequate monitoring and supervision via the processes of o f f s i t e
review and onsite examination as well as by enforcement actions.
The FDIC has temporarily placed a $25,000 l i m i t on insider loans without prior
board approval; however, we are working with the Office of the Comptroller
of the Currency and Federal Reserve to arrive at an appropriate uniform
standard for a l l banks. The objective is to assure that bank directorates
are aware of, and w i l l strive to regulate insider loan demands. I t is our
intent also to work with the other two banking agencies to improve reporting
and disclosure requirements on insider lending as set forth in FIRICA for
better o f f s i t e monitoring by the agencies and more effective market d i s c i p l i n e ,
through disclosure, without imposing an undue reporting burden on the banks.
The combination of self-regulation by board awareness and approval, marketplace
discipline by disclosure and agency supervision by o f f s i t e analysis of reported
data, onsite examinations and enforcement actions w i l l , i n our opinion, permit
effective regulation and supervision of insider lending practices in banks.

Honorable Jake Gam


January 27, 1983

Question No. 6:

Many credit unions and t h r i f t s have experienced substantial losses as
a result of the Penn Square f a i l u r e . Did the FDIC consider the impact
of a deposit payoff on these institutions before advocating that route?

Response to Question No. 6:
The f a i l u r e of my large banking i n s t i t u t i o n can be, and usually i s , a
disruptive economic event. I t w i l l seriously impact depositors (large and
small a l i k e ) , other creditors, loan customers and often the local community
i t s e l f . With the protection of federal deposit insurance and liquidation
procedures enabling an orderly t r a n s i t i o n , the impact of a bank f a i l u r e is
substantially eased. As with any business f a i l u r e , some creditors w i l l incur
losses; however, the FDIC's function is to minimize the consequences of such
an event rather than to prevent a l l bank f a i l u r e s . While we are not insensit i v e to the impact of individual losses, we must carefully weigh the available
alternatives in choosing a course of action.
Before a final decision in the Penn Square situation was made, our Washington
headquarters s t a f f analyzed the incoming data from our onsite investigators
to consider a l l p o s s i b i l i t i e s and alternatives. These efforts l e f t us,
essentially, with three choices:
(1) Pay off insured depositors. This alternative is a simple and
straightforward means of handling a bank f a i l u r e when other less dramatic
arrangements cannot be effected. In a bank the size of Penn Square, however,
such a payoff can be time consuming and disruptive. Because we were concerned
about the adverse public reaction and effects on public confidence, a more
favorable alternative was desirable.
(2) Effect an emergency purchase and assumption transaction. This often
u t i l i z e d tool w i l l permit, with FDIC assistance, the transfer of a l l of the
l i a b i l i t i e s of the troubled i n s t i t u t i o n to another operating bank, e f f e c t i v e l y
insulating a l l depositors and creditors from loss. In such situations, the
FDIC indemnifies the purchasing i n s t i t u t i o n against a l l contingent claims.
In the case of Penn Square, these claims had the potential to become massive.
Accordingly, we concluded that a purchase and assumption transaction was not
j u s t i f i a b l e on a cost basis. Moreover, we were deeply concerned about the
long-range impact on market discipline that such a bailout might have had i f
employed in a situation as egregious as Penn Square.
(3) Creation of a Deposit Insurance National Bank. As you know, we
f i n a l l y settled upon a solution whereby a deposit insurance national bank
was created, and insured deposits were transferred. This course of action
permitted immediate access to insured funds and, importantly, allowed us to
continue to honor checks drawn upon individual accounts up to the insured
l i m i t . In order to further minimize the public impact and to f a c i l i t a t e an
orderly t r a n s i t i o n phase, we chose to continue to pay interest on time and
savings deposits for a 90-day period.

Honorable Jake Garn


January 27, 1983

Our procedures and decisions in the Penn Square Bank failure resulted in what
we believe to be the most favorable course of action possible, given the
particular set of circumstances and time frames involved. Each bank f a i l u r e
is d i f f e r e n t with i t s own unique characteristics requiring d i f f i c u l t choices;
we can assure the Committee that the FDIC always weighs carefully a l l viable
alternatives and is cognizant of the potential ramifications of these decisions.
Question No. 7:

Estimates of the amount that may be paid on receiver c e r t i f i c a t e s have
ranged from as high as 80% to as l i t t l e as 25%. Can you give us any
idea at this time of how may cents on the dollar uninsured depositors
w i l l ultimately recover?

Response to Question No. 7:
I t is too early to make any r e l i a b l e estimate of the total recoveries l i k e l y
on Penn Square's assets. Several major claims have been made in actions
brought against the FDIC as receiver of Penn Square, and the outcome of l i t i gation related to these claims may affect the recovery to common creditors.
F i r s t estimates of possible recoveries w i l l probably be completed in the
f i r s t half of 1983 and, once made, w i l l undoubtedly be subject to significant
change as the liquidation progresses.
Question No. 8:

In rethinking your decision to close Penn Square and pay o f f i t s
insured depositors, do you wish that the FDIC had the authority to
effect a solution which would produce more marketplace discipline
than arranging a merger but less costly and severe than a pay out?
Should the FDIC be given the authority to arrange an acquisition
of an i n s t i t u t i o n where only a portion of the uninsured l i a b i l i t i e s
would be transferred to the acquiring i n s t i t u t i o n ?

Response to Question No. 8:
Under our current method of effecting an emergency purchase and assumption
transaction in a f a i l i n g bank s i t u a t i o n , all depositors (both insured and
uninsured) and other creditors are effectively insulated from loss, with the
net consequence of ultimately spreading the increased costs throughout the
banking system by means of a higher net insurance premium. This, some would
argue, is inequitable as i t serves to insulate high risk takers while penalizing
prudently managed i n s t i t u t i o n s . Further, over time, such a practice erodes
normal market discipline as depositor/creditor perception of the danger of
loss from a bank f a i l u r e and deposit pay-off is reduced. Many now perceive
that no large bank w i l l be allowed to f a i l , £er se_, and therefore, there is
less need to equate risk with y i e l d when placing funds with a large insured

Honorable Jake Gam


January 27, 1983

We feel strongly that market discipline can be a desirable check upon imprudent
bank management practices, and that i t can play an increasingly important role
in a deregulated banking environment. Implementation of some consistent form
of loss sharing arrangement in emergency purchase and assumption transactions
woud help to restore t h i s discipline and, we believe, may be desirable.
As you know, these issues are broached in Section 712 of the Garn-St Germain
Depository Institutions Act of 1982 am they w i l l be more thoroughly explored
in our April 15, 1983 response to the- q jest ions posed t h e r e i n . Our s t a f f is
currently working to develop a viable means to permit an equitable loss sharing
Question No. 9:

In your analysis of risk-based insurance premiums of depository i n s t i t u t i o n s ,
doesn't the rapid decline of Penn Square from September 1981 to April 1982
indicate that improvements in the method of assessing risk of f a i l u r e are

Response to Question No. 9:
Certainly we have learned from the Penn Square Bank f a i l u r e , but we feel
obliged to say that the current system of evaluating risk i s generally
quite successful. As part of our analysis of a risk based insurance system,
we have looked closely at bank failures and assistance cases since 1970 and
found most were clearly i d e n t i f i e d as high risk operations well before they
f a i l e d . Of course, as the banking industry changes, so must our techniques
for assessing risk. I d e n t i f i c a t i o n is only part of the problem though - the key is to reduce risk to acceptable levels before i t is too l a t e .
Usually we are very successful in doing t h a t , but not always. The problem
quite simply is that risk can be increased very quickly and in many different
ways. I t is much easier to increase risk than i t is to reduce i t .
We are continuously s t r i v i n g for better ways to identify and reverse risk
trends before the problems become too severe. Whenever a bank f a i l s , we
t r y to learn from the experience; however, we are not l i k e l y to ever have
a foolproof system. There w i l l be failures and some w i l l be surprises;
the purpose of regulation and deposit insurance is not to prevent these
occurrences, only to ensure they are isolated events whose impact is
minimized to the extent possible.
Senator Tower's Question No. 3:

I t appears that in our heavily regulated banking environment that our
"early warning systems" have broken down. Tell me what you believe
to be bank regulators' role in a deregulated world?

Response to Senator Tower's Question No. 3:
In a deregulated environment, i t is clear that the risk of f a i l u r e w i l l
increase as institutions engage in newly authorized a c t i v i t i e s and compete
to a much greater extent based on price. As a result, supervision must
become more sophisticated and better focused. The frequency and scope of

Honorable Jake Gam


January 27, 1983

examinations of r e l a t i v e l y small, well-managed Institutions are being reduced.
Increased emphasis is being placed on examining larger institutions where
the magnitude of exposure i s greater, and on resolving known problem situations
where the risks have become evident. Examination techniques and approaches
are being developed to review credit quality more e f f i c i e n t l y and additional
attention is being focused on other areas of r i s k , such as asset and l i a b i l i t y
mismatches and interest rate s e n s i t i v i t y . O f f s i t e monitoring and surveillance
systems are being improved, data processing capabilities enhanced and examiner
training broadened and improved. A greater effort is also being made to more
consistently strike that delicate balance, which is perhaps the essence of
effective supervision, between allowing management every reasonable opportunity
to voluntarily correct known problems or adverse trends and proceeding t o a
formal enforcement action without undue delay to achieve the results desired.
We believe greater reliance must also be placed on public disclosure and the
marketplace to discourage unsound practices and prevent or l i m i t losses.
While the marketplace cannot e n t i r e l y supplant supervision, the marketplace
and the discipline i t imposes can be of major assistance in achieving supervisory objectives. There is a need as well for improved communication,
coordination and cooperation among federal and state regulators in achieving
supervisory and regulatory objectives.
The FDIC is moving forward in these areas along the lines indicated with the
fundamental objective of minimizing failures and losses while preserving
public confidence in the banking system and the v i t a l role i t plays in our
economy. This is the traditional role of the supervisor and i t w i l l continue
to be in a deregulated environment although, as indicated, the techniques and
approaches must change. We do not believe that we can or should s t r i v e for a
f a i l - s a f e banking system; any such attempt would be i n t r u s i v e , involve
excessive costs, and be doomed to f a i l u r e . The regulatory system, however,
can and must be made more effective and e f f i c i e n t ; we believe we are making
considerable progress in that d i r e c t i o n .
We appreciate this opportunity to expand on the issues addressed in the

WrlliarirMj Isaac


Honorable John Tower



•7^4LR^* *


January 7, 1983

The Honorable 3ake Garn
Chairman, Committee on Banking
Housing and Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Chairman Garn:
Thank you for your letter of December 10, 1982, requesting written
responses to additional questions from the Committee concerning Penn Square
and related issues. The following responses correspond to the questions
contained in your letter. I would also like to take this opportunity to thank the
Committee for the opportunity to discuss the Federal Reserve's role in the
Penn Square episode. If I can be of further assistance to the Committee, please
contact me.

Certain banks, in fulfilling the credit needs of their particular trade areas,
characteristically have loan concentrations to a particular industry. Banks
in agricultural areas* for example, often have relatively heavy
concentrations in this particular sector as they serve as financial
intermediaries in the agricultural community. I believe that limitations on
such concentrations could seriously hamper the ability of such banks to
service the needs of their communities or particular trade areas.


Prior to the recent revision of the call report, the primary source of
information regarding delinquent loans at commercial banks was the report
of examination. Examiners review the level and trend of delinquent loans
during the on-site examination and include summary data regarding the
delinquencies in their written report. In addition to reviewing and judging
the potential collectibility of delinquent loans, the examiner will make
written comment if the trend or level of such loans is adverse. Because
on-site examinations are relatively infrequent events, however, it seemed
to the supervisors highly desirable to supplement the on-site information
with more timely periodic reports.


The banking agency members of the Federal Financial Institutions
Examination Council determined to make certain information on aggregate
past due, nonaccrual, and renegotiated loans available to the public as an
aid to individual depositors, investors, and the general public in making
decisions concerning their deposits or other business relationships with a
particular bank. Public disclosure of this type of information is not
entirely a new requirement in the banking industry.
Bank holding
companies with significant numbers of public investors have been required
by the rules of the Securities and Exchange Commission for several years

Chairman Gam


to make public disclosures on the amounts of their nonperforming loans. In
making this information available to the public, the agencies believe that
the disclosure requirement will help promote an enhanced marketplace
discipline during this period of substantial deregulation.

The bank regulatory agency members of the Examination Council are
aware of the concern that the public availability of the loan data to be
released may be subject to misinterpretation and that the disclosure could
conceivably result in problems for some individual banks with particular
kinds of lending experience. Against these concerns, the right of uninsured
depositors—those with deposits in excess of $100,000—other nondepository
creditors and investors to know about any developments that may
materially affect the condition of the bank were weighed. As previously
indicated, the primary reason to provide this information to the public is to
assist in making knowledgeable decisions about deposit and other business
relationships with a particular bank.
The concerns that you mention were carefully reviewed and the
Examination Council decided to delay the release of this information to the
public until the reporting period of 3une 30, 1983, to permit time to resolve
problems that may arise in the reporting and processing of the data. The
Council also decided to maintain the confidentiality of data on the amount
of loans that are only moderately past due—that is, past due from 30 to 89
days. This will remove from public attention a large and volatile number
that potentially could be subject to misuse and misinterpretation, and at
the same time conform the public disclosure standards more closely to the
existing SEC required disclosure for bank holding companies.


The Board believes that the present statutory restrictions on loans to
executive officers, principal shareholders, and directors are adequate.
With respect to your question, the Board notes more stringent limits on
loans to insiders already exists. Section 22(h) of the Federal Reserve Act
requires all loans to executive officers and principal shareholders of
insured banks to be aggregated with loans to their related interests for
purposes of determining the bank's legal lending limits to these individuals.
The Federal Reserve has reviewed the circumstances surrounding the
failure of Penn Square Bank, N.A., and continues to believe that the
current statutes, regulations, and supervisory tools available to federal
bank regulators are sufficient to oversee the safety and soundness of the
banking system.


From its formation on January 24, 1976, through the initial inspection
report at the end of 1979, the holding company, First Penn Corporation,
was essentially a shell corporation. The holding company's assets consisted
primarily of its investment in the subsidiary bank and receivables relating
thereto, while its liabilities were limited to acquisition debt and accrued
expenses. Consequently, the holding company was placed on a three-year
inspection cycle.
During this period, the Federal Reserve Bank of
Kansas City monitored the condition of First Penn Corporation by
analyzing the holding company's annual report (F.R. Y-6) and examination
reports of Penn Square Bank performed by the Comptroller of the

Chairman Garn

- 3-

The Initial Inspection of First Penn Corporation was conducted as of
December 31, 1979, and thereafter the holding company was subject to an
annual Inspection. A total of four Inspections were conducted by the
Federal Reserve Bank of Kansas City.

All of these reports of inspection by the Federal Reserve Bank Indicated
that the holding company's condition paralleled that of the subsidiary bank.
There was no evidence that any of the activities of the holding company
contributed to the difficulties encountered by the Penn Square Bank. As
previously stated to the Committee, the inspections of First Penn
Corporation showed that* practically all of the parent company's assets
consisted of its investment in, deposits with, or loans purchased from the
Penn Square Bank.


Through receipt and review of bank examination reports, the Inspection of
the holding company, and discussions with the Comptroller's office, the
Federal Reserve had been aware of the nature of the problems at the
Penn Square Bank and the efforts of the Comptroller's office to address
them since the bank was determined to require more than normal
supervision in 1980.
In mid-June, the Regional Office of the Comptroller of the Currency
informed the Federal Reserve that the problems of the Penn Square Bank,
then under examination, had intensified and that the bank's overall
condition had rapidly deteriorated. As a result, an inspection of the
holding company was immediately commenced. 'In addition, Federal
Reserve examiners initiated a review of the bank's loan portfolio to
identify eligible collateral in anticipation of a borrowing request. During
this period, daily communications were made with the Comptroller's office.


The Federal Reserve continues to believe that the current tripartite bank
regulatory system is working reasonably well. The banking agencies have
and should continue to make good progress in coordinating their policies,
procedures and examinations. The Federal Reserve is of the opinion that
consolidating the supervision of a bank holding company and its banks under
the jurisdiction of one regulator could have perverse consequences. First,
a single regulator would be more Inclined to abrupt shifts in supervisory
policy. One of the advantages of the present tripartite system is that it
contains certain checks and balances that tend to guard against such
extreme shifts. Second, the growing incidence of significant nonbanking
activities in the holding company structure is better subjected to
supervision on a functional industry line basis, especially since such
activities are not usually restricted geographically. Finally, there has been
considerable concern expressed in recent years about regulators becoming
unduly responsive to the Industries that they regulate. While one should
not assume that a single bank regulator would necessarily be swayed by
such pressures, consolidating the supervision of a bank holding company and
its banks would tend to increase that risk.

Chairman Garn

- $-

For almost half a century, all debt and equity instruments issued by a bank
have been exempt from the registration and reporting requirements of the
Securities Act of 1933. However, since 1964, banks with 500 or more
stockholders have been subject to substantially the same rules of disclosure
as are mandated by the SEC for bank holding companies and for
corporations, in general. In addition, equity securities and nondeposit
deposit debt instruments of all banks are subject to the anti-fraud
provisions of the securities laws. In Marine Bank v. Weaver (U.S.S.C.
No. 80-1562, decided March 8, 1982), the United States Supreme Court
determined that the holder of a certificate of deposit issued by a federally
regulated bank is "abundantly protected" under comprehensive federal
banking laws and that, therefore, there is no need to subject Issuers to
anti-fraud liability under the Securities Exchange Act of 1934.
In considering any new regulation, one must weigh the costs as well
as the benefits and consider whether there are alternative means to reach
the same goal. Viewing the exemptions from securities laws for deposit
obligations that have existed over the past 50 years, I would have to
conclude that the existing system has worked reasonably well and that
elimination or limitation of the exemption at this time would not be cost
The bank regulatory agencies have recently taken significant steps to
increase public availability of information concerning the financial
condition of banks. As I previously mentioned, publicly held banks and bank
holding companies are already subject to comprehensive disclosure
requirements. In addition, since 1973, the reports of income (as well as
the balance sheets) of all banks have been publicly available. This past
year, under the auspices of the Examination Council, the FDIC has
developed and will make available (for a nominal fee) a financial profile on
any bank which compares that bank to its peer group. As previously
described, increased disclosure will be available beginning in 3une 1983
with respect to delinquent loans. And late in 1983 the banking agencies
expect to have available new reports on a bank by bank basis that will
analyze interest rate exposure and set forth selected contingent liabilities
not now included or disclosed in the balance sheet. These sources of
information will, I believe, be quite helpful to both investors and depositors
alike and will provide an effective substitute for any further extension of
direct coverage by the securities laws.

Sincerely yours,

j}fcharles Partee




December 29, 1982

Honorable Jake Gam
Committee on Banking, Housing
and Urban Affairs
U.S. Senate
Washington, D.C. 20510
Dear Mr. Chairman:
In response to your letter of December 14, I am pleased to submit the
following responses to Committee questions from the hearings on the Penn
Square Bank failure.
Question 1. Call Reports for commercial banks have recently been revised
to require quarterly reporting of data on past due nonaccrual
and renegotiated loans. In addition, beginning with the June
report, the Federal supervisory agencies will make these reports
available to the public. Does your agency have comparable
reporting requirements on past due loans for your institutions
and is the information available to the public? If not, why not,
and do you contemplate adopting similar requirements in the near

Credit unions have been making such public disclosures since 1936.
Therefore, the agency plans no changes in the near future. Due
to the fundamental difference between credit unions (member owned
and operated cooperatives) and the other financial institutions,
extensive disclosure of their financial operations have been
made publicly available since their inception. On pages 5 and 6
of the NCUA testimony are copies of a standard disclosure form
posted monthly in credit union lobbies. Among the many items
of disclosure is the information on overdue loans which is found
on page 6, item #74 a.-e. As can be noted, aggregate data is
disclosed for delinquent loans in the time periods of 0-2 months,
2-6 months, 6-12 months, and 12 months and over. Further the
agency requires that aggregate data on overdue loans be reported
to the agency on a semi-annual basis.
In reality, the new disclosure by banks would be less than
is presently required for credit unions.




- 2
Question 2.

Since credit unions are by statute generally limited to
government guaranteed obligations or to deposits in insured
institutions, do you believe that their investment in uninsured
jumbo CD's should be limited?


No. The inter-institutional activities of credit unions are quite
a different matter from member deposits and, in our opinion, such
activities should not be governed by consumer derived limits.
Loan losses remain the major operating expense for credit unions,
and ceilings on deposits in banks would not alter significantly
the credit unions' costs of doing business, but might well affect
their earnings capability.

Question 3.

It does not appear that your disclosure forms distinguish uninsured
deposits from insured deposits. Do you believe that such a
delineation would be helpful in supervising credit unions compliance
with more thorough investment policies?


No. We do not find the term "uninsured deposit" to be very
meaningful. A deposit in a good institution is a good investment
regardless of the amount of insurance. Insurance should not be
the substitute for prudent investment choices. We do, of course,
caution against any over-concentration of investments and encourage
the adoption of such investment policies.

Question 4.

In your opinion, do credit unions or other potential investors have
access to sufficient information and financial data to make an
informed investment decision?


Yes. In our opinion there exists a good supply of information.
Penn Square taught the lesson that all of this available information
must be utilized and that investment policies must be constantly
reviewed. It might be helpful if existing information could be
consolidated by investment advisors or others. As further changes
take place in financial markets, information will have to continue
to be refined, and such changes will be most useful.



Executive Director

1700 G Street, N.W.
Washington, D.C. 20552

Federal Home Loan Bank Board


Federal Home Loan Bank System
Federal Home Loan Mortgage Corporation
Federal Savings and Loan Insurance Corporation

The Garn-St Germain Act, enacted in October, increased the
single borrower limits of National banks to 15% of capital and
surplus, plus an additional 10% if the transactions are fully
secured. This same limit was also applied to the new commercial
lending powers granted to federally chartered S&Ls. While theselimits protect against concentrations to a single borrower, there
is nothing that protects against loan concentrations in a particular
industry. Do you believe there is a need for limitations on industry
loan concentrations> in addition to individual borrower limits?
Consistent with the Bank Board 's support of deregulation of
the savings and loan industry, I believe the answer to the question
is no. First, supervisory oversight cannot guarantee or replace
prudence in loan underwriting. The vast majority of lenders have
adopted prudent loan underwriting standards with respect to loans
to one borrower, collateral, industry diversification, and borrower
qualification. I believe it" unwise to selectively substitute the
judgment of regulators for the judgment of managers.
Second, while firms within a given industry face similar
conditions of price and demand, it does not follow that loan
rescheduling by one firm in an industry need imply loan rescheduling
by others. The ability to repay a loan depends in large measure on
the cumulative decisions of management of a given firm concerning
such factors as expansion, capitalization, and diversification. It
seems inappropriate to curtail profitable lending opportunities by
regulatory fiat without considering firm-specific factors.
Finally, certain lenders may find it profitable to prudently
specialize in lending to a small number of industries. This would
increase operating efficiency by allowing lending officers to spend
less time in assembling credit information. Although I do not
necessarily recommend this course of action, I note that some
lenders may find it in their interest to concentrate on a small
number of industries. Specifically, savings and loan associations
initially might concentrate their lending to the construction
industry because they know it best. A diversification requirement
that would prevent such lending could well be counterproductive.
Call Reports for commercial banks have recently been revised
to require quarterly reporting of data on past due, nonaccrual and
renegotiated loans. In addition, beginning with the June report,
the Federal supervisory agencies will make these reports available
to the public. Does your agency have comparable reporting requirements on past due loans for your institutions and is the information
available to the public? If not, why not, and do you contemplate
adopting similar requirements in the near future?

- 2 ANSWER 2
The Federal Home Loan Bank Board does not have any reporting
requirements for past due loans precisely comparable to the banking
agencies* call reports. Instead, our reporting requirements are
for "scheduled items". This is considerably more extensive than
"call report" requirements and is more closely analagous to
"classified" assets, as that term is used by bank regulators in
connection with supervisory examinations. That is, "scheduled
items" are assets that are reported, not within the simple context
of delinquency as with the banking agencies, but after the application of a series of formulas, which incorporate the degree of
delinquency and other factors having a direct bearing upon the
inherent risk characteristics of each loan and/or asset type.
The "scheduled items" report is considered confidential and
not available for public disclosure, just as the banking agencies
would not disclose supervisory examination findings with respect
to "classified" assets.
Further, as stated previously, our reporting requirements are
currently more extensive than the banking agencies ' call reports and
we do not contemplate reducing these requirements in the near future.
Do you believe that supervision and examinations of savings
and loans should include an analysis of the interrelationship such
institutions have with financial institutions with a 3, 4, or 5
I feel that an analysis of the interrelationship between an
association and other financial institutions should be conducted
on all supervisory examinations, regardless of such financial
institutions' ratings. However, sufficient information concerning
financial institutions other than savings and loan associations
has not generally been available in the past to enable performing
such an analysis. Consequently, in an effort to analyze an association's activities for risk and unsafe or unsound practices, our
examination procedures require the obtaining and review of available
information in many areas, including:

Loans-to-one-borrower limitations
Liquid and non-liquid investment limitations
Loans made to and/or loan participations with
other 'financial institutions
Depository relationships with other financial
Transactions with affiliated persons and/or other
possible conflict of interest situations.

It should be noted that Section 432 of Public Law 97-320,
October 15, 1982, amended the Right to Financial Privacy Act of
1978 (U.S.C. 3412) to permit:

- 3 "... the exchange of financial records or
other information with respect to a financial
institution among and between the five member
supervisory agencies of the Federal Financial
Institution's Examination Council ..."
It is anticipated that this new opportunity, which will be
used in conjunction with the aforementioned examination procedures,
will greatly improve the Bank Board's capability to analyze the
interrelationship between financial institutions.
Do you believe that financial institutions should be required to
disclose the amount of funds solicited or investments made through
the use of money brokers?
The Bank Board's current examination procedures require that
the association disclose data on broker originated funds in a
savings questionnaire during each examination. Examiners are
required to review this information and to determine the safety
and soundness of an institution's policy regarding the solicitation
and use of brokered funds. Any material concerns are required to
be included in the report of examination for supervisory review
and/or action.
In addition, each association files with the Bank Board semiannually a "Federal Home Loan Bank Board Management Information
System Semiannual Financial Report" which provides for disclosure
of the number and aggregate amount of brokered deposits. This
report is available to the public for a small fee (with certain
data other than brokered deposits excluded).
Beyond these disclosure requirements, we do not believe that
additional disclosure requirements are necessary.

13-540 0 - 8 3 - 9


Comptroller of the Currency
Administrator of National Banks

Washington, D.C. 20219

March 1 ,


Dear Senator Garn:
We appreciated having the opportunity to participate in your
Committee's hearings on the failure of the Penn Square Bank. We
have reviewed the list of questions the Committee has sent us and
welcome this further opportunity to provide the Committee with
our views.

Do you believe there is a need for limitations on industry
loan concentrations, in addition to individual borrower

No, we do not. A limitation on "industry loan concentrations" would be very difficult to define and to enforce.
Furthermore, such a limitation would have an undesirable
impact in areas which are predominately agricultural or in
towns which are dominated by one company or industry.
Although a policy of loan diversification is certainly a
sound one, we do not believe it is a prerequisite to sound
banking operations. If a bank has a particular expertise in
an area and, most importantly, exercises sound credit
judgment on each loan made within that area, a resulting
"concentration of credit" should not present an unwarranted
risk to the bank.
As far back as Penn Square's 1977 specialized exam, and in
each subsequent exam, a concern was expressed over the heavy
concentration of lending to oil and gas concerns and the
need for Penn Square to develop a system to prevent such
concentration. However, no formal action appears to have
been taken to require greater diversification and such a
requirement didn't appear to be included in the Formal
Agreement of September, 1980. Since these concentrations
were of concern to the OCC examiners, why wasn't more
emphasis placed on this aspect of Penn Square's operations
in the Formal Agreement?

The formal Agreement between the OCC and Penn Square
addressed the subject of concentrations of credit in
general. Thus, specific reference to concentrations of
credit in the energy area was not deemed necessary.
With respect to concentrations of credit to individual
entities, Article II, paragraph 4, of the Agreement
reiterated the restriction on the bank from lending money in
excess of the legal lending limitations. And Article VI,
paragraph 14, required the bank to review and revise its
lending policy to ensure that the policy included guidelines
on the "types of loans to be considered for participations"
and that the policy identify "the categories of loans, if
any, where concentrations of credit will be permitted and
the limits thereto." In conjunction with these provisions
(and perhaps most importantly), the Agreement stressed the
need for detailed and sound credit judgment. When the bank
chose to ignore these dictates of the Agreement between
examinations, it accumulated the large volume of poor
quality loans which led to its demise.

Call Reports for commercial banks have recently been revised
to require quarterly reporting of data on past due
nonaccrual and renegotiated loans. In addition, beginning
with the June report, the Federal supervisory agencies will
make these reports available to the public. If the
reporting of such past due loans is now being added to
banks' Reports of Conditions and Income, what were the
procedures prior to such changes for gathering data on, and
monitoring, delinquent loans?

The reporting of past due and nonaccrual loan information is
not new for the OCC or for national banks. Actually, the
OCC has been collecting similar data from all national banks
since 1975. The new requirement applies basically, with
some modification, to state member banks (FED) and state
non-member banks (FDIC). The collection of information on
renegotiated loans and the public disclosure of this data
will be new for the OCC and national banks.
The OCC has used, on a quarterly basis, past due loan
information from our call reports to monitor changes in the
volume of delinquencies of individual banks as well as the
national banking system. Generally, banks that reflected
significant variances in the amount of delinquencies were
identified for further review and possible action, including
the initiation of an examination. A form of these figures
was also made available publicly, stated as an average bank

ratio. The ratios were calculated based on the size and
regional location. This information was used in various
publications and acted as the only public source for
monitoring the trend of delinquent loans.

Presuming that these new reporting requirements will be of
valuable assistance to the regulators in earlier detection
of future "Penn Squares," what is the need to go the extra
yard and require public disclosure of such data?

We are moving steadily in the direction of a more
deregulated environment for the banking industry - an
environment in which banks will have greater freedom to make
business decisions without government interference and to
offer more services in response to public demand. This
reduction in government regulation, however, must be
replaced by the discipline of the market place. Since the
effectiveness of market discipline is dependent upon the
adequacy of information available to its participants, we
decided to make information on past due loans publicly
available and, thus, increase the information base available
to the market.

Do you share the concern that such public disclosure would
be easily misinterpreted by the public, could further damage
a troubled institution and would erode public confidence in
our financial system?

Although it's impossible to predict public reaction to past
due loan data with any degree of certainty, I have confidence
in the public's ability to deal intelligently with additional
information about banks. Moreover, consideration must also
be given to the fact that if banks know that information
regarding problem loans will become publicly available, they
may act to avoid these problems before they occur. Thus, the
discipline of the marketplace will act to replace restrictive
government regulation. In the less regulated environment
that banks are seeking, the loosening of government regulation must be replaced by some other form of discipline
because banks cannot take on increased flexibility and powers
without also accepting an increased responsibility. We
believe that increased public disclosure is an appropriate
form of discipline and safeguard for the market.

To what extent were loans to insiders and their related
interests, both by Penn Square and its correspondent banks
(i.e. Continental, Seafirst, etc.) a factor: (a) in the
Penn Square failure; and (b) in the purchase of participations which created large losses for the purchasing banks.

(a) Losses on loans to Penn Square insiders were
substantial and, consequently, a contributing factor to Penn
Square's failure. During the final examination of the bank,
national bank examiners discovered approximately $49,000,000
in total losses. Of this amount, approximately $9,100,000
(or roughly 19%) were attributable to insiders of the bank.
One should note in connection with these figures, however,
that since the closing of the bank, the FDIC has identified
more losses (this Office stopped reviewing loans once it
determined the bank was insolvent) and has identified
additional insider affiliations which were not apparent
(b) As of December 31, 1982, the four major upstream
correspondent banks reported loan losses relating to Penn
Square of $411,000,000. This figure is broken down as
Continental Illinois
Michigan National


These totals include loans to Penn Square insiders which
these upstream banks not only purchased, but, also, made
directly on their own. We are unable, however, at this time
to provide more detailed information on these credits.
Do you believe there should be special lending limits
applicable to insiders that are more stringent than the
single borrower limits?
Such limits already exist under the provisions of 12 U.S.C.
§§375a and 375b. This issue, however, is again under review
by the bank supervisory agencies as the result of the recent
amendment to 12 U.S.C. §375a in the Garn-St. Germain
Depository Institutions Act of 1982. As you know, that Act
authorizes the supervisory agencies to set appropriate
limits on general purpose loans to executive officers.
Since this matter will be the subject for public comment and
further discussion and debate within the agencies prior to a
final decision, it does not appear appropriate to comment on
it at this time.
The Board of Directors at Penn Square appear not to have
received several communications sent by the Comptroller's
Office to them through officers in the bank. Do you think

it would be worthwhile to send these communications directly
to the members of the Board rather than through an intermediary whose interests may be at stake?
The OCC is not aware that the Board did not receive several
communications sent by the Comptroller. Quite the contrary,
the OCC is of the firm opinion that the Board of Directors
of Penn Square was fully aware of the bank's problems. Not
only were there repeated written communications to the Board
detailing the bank's problems, the OCC twice brought the
full Board to the OCC's Dallas Regional Office for the
express purpose of reviewing these problems. In addition,
the Committee should note that the directors are under a
legal obligation to "diligently and honestly administer the
affairs" of the bank. (12 U.S.C. §73) As set forth in
numerous cases, directors are expected to retain and
exercise general supervision over the affairs of the bank.
They cannot discharge their duty by reposing the entire
administration to officers selected by them, without
supervision or examination. Gibbons v. Anderson, 80 F. 345
(W.D. Mich. Cir. 1897). Failure to exercise reasonable
supervision over the conduct of such officers and the
affairs of the bank will result in personal liability on the
part of the directors for losses which may occur. Bowerman
v. Hammer, 250 U.S. 504 (1918).
Consequently, regardless of the communications from the OCC,
the Board had a legal and fiduciary duty to monitor the
affairs of the bank and to be aware of any problems.
In spite of their clear responsibilities, the directors, in
their testimony before the House Banking Committee in
Oklahoma City, contended that they were unaware of the
problems in the bank. They also stated that they had not
read the OCC's Reports of Examination on the bank which
detailed those problems. Such claims are disingenuous and
self-serving. As noted above, the directors had been
personally informed of the problems in meetings with OCC
personnel. In addition, all of the directors signed
statements stating that they had "personally reviewed the
contents of the Reports of Examination dated [February 29,
1980, September 9, 1980, December 31, 1980 and September 30,
1981]." Either these signed statements to our Office or
their testimony before the House Committee was false.
In response to the specific question of whether we think it
worthwhile to send communications directly to directors of a
bank, we should point out that, on occasion, we have done
so. But such action is rare since our Reports of
Examination and other correspondence contain confidential
and sensitive material. In most instances, we can be

assured that the directors are informed through meetings
with the Board and by requiring the signed statements
referred to above indicating that the directors have
personally reviewed the Reports of Examination.

Do you think that financial regulators should establish
automatic penalties for a failure to improve basic practices
over a prescribed period?

No, we do not. Automatic penalties would significantly
hinder the regulators in analyzing situations on a case by
case basis. This type of analysis is essential to the
equitable and effective supervision of the banking system.
While penalties and other forms of administrative action are
often necessary and appropriate, one cannot determine in
advance either the nature or severity of the administrative
action which might be appropriate in any particular case.
One should keep in mind, however, that where an ongoing
problem is discovered, we already have the authority to
condition corporate and capital approvals on the correction
of the problem. In many cases, we also have the authority
to assess civil money penalties for the failure to correct
the problem. When warranted, we have not hesitated to use
these administrative remedies.

What disclosure requirements are non-registered banks (like
Penn Square) exempt from which in your opinion they should
not be?

The issue of what disclosures required of registered banks
should also be required of non-registered banks comes up
periodically. In addition, we frequently face the issue of
what new disclosures (such as in the area of administrative
actions) should be required of all banks. At this time we
are reviewing the disclosure question to determine whether
additional information should be disclosed by registered or
non-registered banks.

As interest rates are deregulated, it would seem that diversification of a loan portfolio not only among borrowers but
among industry types will become more important. Do you
agree? Do you plan to give increased weight to loan portfolio diversification in your classifications?

The OCC has always believed that diversification in a bank's
loan portfolio is good. But, as stated in response to the

Committee's first question above, the OCC has rarely sought
to impose diversification on a bank. Diversification in
many banks is possible only to a limited extent. Obtaining
total diversification might well force a bank to extend
credit beyond the limits of its trade area, a practice which
is seldom desirable.
The specific question of whether we plan to give increased
weight to loan portfolio diversification in our classifications must be answered two ways. First, the classification of any loan is more a reflection of its credit quality
than of its bearing with other loans in the bank. A single
loan to one entity should be judged on its own merits and
not upon the merits of loans to a completely different
borrower. Second, what does need to be addressed in banks
concentrating heavily on one type of lending is the foundation upon which they build their credits. If the bank
exercises sufficient credit judgment on the individual loans
and possesses sufficient expertise to justify the larger
positions, then the regulator's action should be minimal.
If, however, the bank is imprudently generating its loans
without sufficient credit analysis or review of the industry
risks, then some restrictions should be placed upon the
We are responding to Senator Tower's letter under separate cover,
but enclose a copy for your information. If we may be of further
assistance, please let us know.

C. T. Conover
Comptroller of the Currency
The Honorable Jake Garn
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D.C. 20510


Comptroller of the Currency
Administrator of National Banks
Washington, D.C. 20219




Dear Senator


I am pleased to p r o v i d e you w i t h the i n f o r m a t i o n you requested
p e r t a i n i n g to the number of a d m i n i s t r a t i v e e n f o r c e m e n t a c t i o n s
issued by the O f f i c e of the C o m p t r o l l e r of the C u r r e n c y (OCC)
d u r i n g the p e r i o d 1 9 8 0 - 1 9 8 2 , and the e x t e n t to w h i c h c o m p l i a n c e
c o m m i t t e e s w e r e u t i l i z e d to m o n i t o r c o m p l i a n c e w i t h these
The OCC issued 434 a d m i n i s t r a t i v e e n f o r c e m e n t a c t i o n s
during the p e r i o d 1 9 8 0 - 1 9 8 2 , 1/ the b r e a k d o w n of w h i c h is as

O r d e r s to C e a s e and D e s i s t :
M e m o r a n d a of U n d e r s t a n d i n g :













N i n e t y - e i g h t (98) of the e n f o r c e m e n t a c t i o n s t a k e n d u r i n g this
period required the a p p o i n t m e n t of a c o m p l i a n c e c o m m i t t e e
(twenty-nine (29) a c t i o n s in 1 9 8 0 ; thirty (30) a c t i o n s in 1 9 8 1 ;
It should a l s o be noted
and t h i r t y - n i n e (39) a c t i o n s in 1 9 8 2 ) .
that a l t h o u g h board c o m p l i a n c e c o m m i t t e e s are o r d i n a r i l y
e s t a b l i s h e d p u r s u a n t to an e n f o r c e m e n t a c t i o n , they h a v e on
o c c a s i o n been e s t a b l i s h e d on the b a n k ' s own i n i t i a t i v e or in
r e s p o n s e to s u g g e s t i o n s from this O f f i c e .
T h e " t y p i c a l " c o m p l i a n c e c o m m i t t e e c o n s i s t s of three to five
m e m b e r s of the b a n k ' s board of d i r e c t o r s , the m a j o r i t y of w h o m
are required to be i n d e p e n d e n t , n o n - o f f i c e r d i r e c t o r s .
A l t h o u g h there is no m a n d a t o r y l a n g u a g e u t i l i z e d by the O C C
require the e s t a b l i s h m e n t of a c o m p l i a n c e c o m m i t t e e , the
following e x a m p l e is a r e p r e s e n t a t i v e p r o v i s i o n :


O m i t t e d from this listing are N o t i c e s of C h a r g e s , N o t i c e s
I n t e n t i o n to R e m o v e from O f f i c e , N o t i c e s of S u s p e n s i o n from
O f f i c e , and C i v i l M o n e y P e n a l t i e s .


Within ten (10) days, a Compliance Committee of the BOARD
shall be appointed. This Committee shall consist of at
least five (5) directors, a majority of whom shall be nonofficer directors of the BANK. The chairman of this
Committee shall be a non-officer director of the BANK. The
Compliance Committee shall be responsible for monitoring
adherence to the provisions of this Agreement.
Within thirty (30) days and every thirty (30) days
thereafter, the Committee shall submit to the BOARD a
written progress report detailing:

the actions taken to comply with each Article of
this Agreement; and


the results of those actions including dates for
implementation of any recommended corrective

Upon completion of review by the BOARD, copies of the
written progress reports, and a statement of any action
taken by the BOARD based upon such reports, shall be
The BOARD shall forward to the REGIONAL ADMINISTRATOR any
reports prepared by outside consultants, or other advisors,
to assist in actions that relate to matters addressed by
this Agreement.
With respect to Penn Square Bank, N.A., Oklahoma City, Oklahoma,
the September 9, 1980 Agreement with the Bank did not require the
appointment of a compliance committee. The Agreement required
extensive involvement by the full board of directors in
correcting the Bank's deficiencies. The Penn Square Agreement
required the board to, among other things:

develop a capital growth program;


develop a program to remove the grounds of criticism
for each criticized asset;


review, revise, monitor, and enforce the lending


conduct a management study and develop a management


review the Allowance for Possible Loan Losses;


develop a written liquidity, asset, and liability
management policy; and


submit monthly reports to the Regional Administrator on
actions taken to correct criticisms in the examination
report, on actions taken by the Bank to comply with the
Agreement, and on the results of those actions.

We have found success both in requiring the use of a compliance
committee or in requiring the full board to monitor compliance.
The specific circumstances of each case dictate which method
should be followed.
In light of the duties and responsibilities of the board of
directors, we believe the ultimate duty of monitoring and
ensuring compliance with an administrative enforcement action
rests with the board. Absent a demonstrated need to require a
special investigation or audit through the use of an independent
counsel or auditor, we do not believe it is necessary or
appropriate to turn the compliance or monitoring responsibility
over to an outside person.
I appreciate your continued interest in this matter, and trust
that this information will be suitable to your needs.

C.T. Conover
Comptroller of the Currency
The Honorable
Donald W. Riegle, Jr.
Committee on Banking,
Housing, and Urban Affairs
United States Senate
Washington, D.C.


Comptroller of the Currency
Administrator of National Banks

Washington, D.C. 20219
March 1 ,


Dear Senator Tower:
Thank you for the statement and giving us the opportunity to
respond to various concerns about the Penn Square Bank and the
Abilene National Bank.
The statement suggests that the OCC spent a relatively long
time analyzing the situation at Penn Square before taking
administrative action, but only waited a few days before taking
administrative action against the Abilene National Bank. The
timing of the cases, however, was very similar. The final
examination at Penn Square started on April 19, 1982, and the
Temporary Order to Cease and Desist was issued against the bank
on June 30, 1982, approximately 10 1/2 weeks later. At the
Abilene National Bank, the final examination started on May 17,
1982, and the Temporary Order to Cease and Desist was issued
against the bank on July 23, 1982, approximately 10 weeks later.
In both cases, national bank examiners spent considerable time
and effort in reviewing the condition of the banks and in
establishing violations of law and unsafe and unsound practices.
Once the necessary evidence as to the condition and practices of
the two banks was gathered, and we were satisfied that we had a
legally supportable basis, the Office took quick and decisive
The statement asks why Mr. Poole, the Regional Administrator
of National Banks for the Eleventh National Bank Region, made the
following public statement ten days before the OCC issued the
Temporary Order to Cease and Desist:
Abilene National Bank is not in receivership and the
Office of the Comptroller of the Currency has no plans
to place it in receivership.
Mr. Poole made this statement, after consulting with and
obtaining the approval of OCC's Washington Office. The OCC had
received reports from the bank during the day that local Abilene

TV stations might report on the evening news that the bank was to
be closed. This was not true and the bank and the OCC were
concerned that such reporting would set off a run on the bank's
deposits from which the bank could not recover. The OCC released
the statement to avoid the panic that could have occurred. In
making the statement, Mr. Poole made it clear he could make no
representations as to what might happen to the bank. He
indicated, however, that based on the information we had at the
time, the OCC had "no plans to place it in receivership."
Although there was the possibility that the condition of the bank
might worsen, failure was not imminent. In fact, even though the
bank's condition subsequently worsened, the rescue package
arranged by the OCC and the FDIC averted the OCC's having to
place the bank in receivership.
In response to the comments about the consistency of bank
regulation, we would like to assure you that, during the course
of the examination of the Abilene National Bank, we strived to
give equal and fair treatment. Although there were many
dissimilar features between the situation at the Abilene National
Bank and that at Penn Square, we were sensitive to the
similarities pertaining to the banks' concentrations of credit in
the energy industry. For that reason, we detailed a special team
of examiners to assist in the Abilene examination. The team
included two senior national bank examiners, one of whom also
participated in the Penn Square examination.
With reference to the concern about the OCC's "early warning
systems," please be assured that they did not "break down." The
computer analysis of the condition of banks has proven to be
invaluable in numerous instances. The system, however, cannot,
and is not designed to, identify all the potential problems which
can arise in the national banking system. With respect to the
problems which arose at Penn Square and at the Abilene National
Bank, even the placement of examiners in the banks on a full time
basis might not have prevented their failures.
Last, our opinion is sought on the role of bank regulators in a
more "deregulated world." We believe that the ultimate role of
bank regulators in a more deregulated environment is the same as
it has always been - to assure a safe and sound banking system.
The difference is that deregulation requires regulators to use
different tools. To that end, we are seeking better and more
detailed information about bank condition, particularly
concerning past due loans, interest rate sensitivity, maturity
structures, etc. We intend to make more information about
individual banks public, so that the market can play an increased
role in disciplining those banks that are poorly managed or take
unnecessary risks. We will continue to devote significant
resources to those portions of the industry that pose the
greatest risk to the system.

As we move into a more deregulated environment, the role of bank
regulators will be particularly important in smoothing the
transition. Regulators will continue to be responsible for the
safety and soundness of the banking system as a whole.
Individual bank managements will continue to be responsible for
managing their banks. The difference will be that the management
will be held more publicly accountable for their decisions.

C. T. Conover
Comptroller of the Currency
The Honorable John Tower
United States Senate
Washington, D.C. 20510