Bank Capital Regulation by Enforcement: An Empirical Study

Indiana Law Journal, Mar 2012

Improving commercial bank capital requirements has been a top priority on the regulatory agenda since the beginning of the 2008 financial crisis. Unfortunately, some of the information necessary to make informed decisions about capital regulation has been missing. Existing regulations establish numerical capital requirements. Regulators, however, have significant discretion to set higher capital requirements for individual banks. In considering necessary reforms, regulators often focus on specific numerical requirements but sometimes ignore enforcement efforts. Without clear information about capital enforcement, it is impossible to make informed judgments about the current capital regulation system. This Article provides a more complete picture of capital enforcement. It reports an empirical study of all publicly available formal capital enforcement actions between 1993 and 2010. The data, compiled from 2350 enforcement actions, reveal four significant insights. First, the number of capital enforcement actions has dramatically increased during the current economic downturn. Second, an increasing number of banks are subject to individual capital requirements— requirements that are higher than the requirements specified in statutes and regulations. Third, the data suggest that enforcement rates are not consistent among bank regulators. In particular, the Federal Reserve is less likely than other regulators to bring serious capital enforcement actions and is less likely to increase capital requirements. Fourth, the data show a near-complete absence of capital enforcement actions issued to the largest banks. The Article examines the proper role of this discretionary enforcement. It concludes that a capital regulation system that relies heavily on individual bank capital requirements is troublesome. This type of discretionary capital enforcement can be ineffective and costly. Moreover, the focus on individual bank conditions can blind regulators to macroeconomic problems. Instead, policymakers should work to create capital rules that are sufficient without significant discretionary capital increases.

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Bank Capital Regulation by Enforcement: An Empirical Study

" Indiana Law Journal: Vol. 87: Iss. 2 Bank Capital Regulation by Enforcement: An Empirical Study Julie A. Hill Follow this and additional works at: http://www.repository.law.indiana.edu/ilj Part of the Administrative Law Commons, and the Banking and Finance Law Commons Recommended Citation - Bank Capital Regulation by Enforcement: An Empirical Study JULIE ANDERSEN HILL* Improving commercial bank capital requirements has been a top priority on the regulatory agenda since the beginning of the 2008 financial crisis. Unfortunately, some of the information necessary to make informed decisions about capital regulation has been missing. Existing regulations establish numerical capital requirements. Regulators, however, have significant discretion to set higher capital requirements for individual banks. In considering necessary reforms, regulators often focus on specific numerical requirements but sometimes ignore enforcement efforts. Without clear information about capital enforcement, it is impossible to make informed judgments about the current capital regulation system. This Article provides a more complete picture of capital enforcement. It reports an empirical study of all publicly available formal capital enforcement actions between 1993 and 2010. The data, compiled from 2350 enforcement actions, reveal four significant insights. First, the number of capital enforcement actions has dramatically increased during the current economic downturn. Second, an increasing number of banks are subject to individual capital requirements— requirements that are higher than the requirements specified in statutes and regulations. Third, the data suggest that enforcement rates are not consistent among bank regulators. In particular, the Federal Reserve is less likely than other regulators to bring serious capital enforcement actions and is less likely to increase capital requirements. Fourth, the data show a near-complete absence of capital enforcement actions issued to the largest banks. The Article examines the proper role of this discretionary enforcement. It concludes that a capital regulation system that relies heavily on individual bank capital requirements is troublesome. This type of discretionary capital enforcement can be ineffective and costly. Moreover, the focus on individual bank conditions can blind regulators to macroeconomic problems. Instead, policymakers should work to create capital rules that are sufficient without significant discretionary capital increases. * Assistant Professor of Law, University of Houston Law Center. I am grateful to Michael Hill for his editing and assistance with the study data. I am also grateful to Paul Andersen, John Buchman, Timothy Canova, Anna Gelpern, Erik Gerding, Lonny Hoffman, Joe Sanders, Spencer Simons, Jeffrey Schwartz, and David Zaring for their helpful comments on this Article. Earlier versions of the Article were presented at The George Washington University Law School’s Center for Law, Economic, and Finance Junior Faculty Workshop, the Southeastern Association of Law Schools Annual Conference, Arizona State’s Southwest/West Junior Faculty Conference, a University of Denver faculty workshop, a South Texas College of Law faculty workshop, and the University of Houston Law Center’s colloquium series. The Article benefited greatly from the many comments I received from participants at these conferences and workshops. 1. Robin Sidel, Sterling Bancshares Puts Itself on Block, WALL ST. J., Jan. 14, 2011, at C1. As used in this Article, the term “bank” refers to federally insured commercial banks and thrifts. It does not include credit unions, foreign banks, bank holding companies, financial holding companies, or investment banks. 2. See Joe Adler, How Many to Fail; Do We Hear 1,000?, AM. BANKER, Mar. 23, 2009, at 1; John R. Engen, M&A in 2010: The Year of the No-Frill Deal, BANK DIR., Jan. 1, 2010, at 38. 3. David Leonhardt, Heading Off the Next Financial Crisis, N.Y. TIMES MAG., Mar. 28, 2010, at 36. 4. See Cheyenne Hopkins, Regulatory Revamp Newest Plank in Obama’s Platform, AM. BANKER, Mar. 28, 2008, at 1 (noting President Barack Obama’s support for capital regulation reform). 5. 12 U.S.C.S. § 5371 (LexisNexis 2010). The new capital requirements cannot be lower than the existing bank capital requirements and must address “the risks that the activities of such institutions pose, not only to the institution . . . but to other public and private stakeholders in the event of adverse performance, disruption, or failure of the institution.” Id. 6. John Walsh, Acting Comptroller of the Currency, Remarks at the Exchequer Club (Jan. 19, 2011), available at http://www.occ.treas.gov/news-issuances/speeches/2011/pubspeech-2011-5.pdf (noting that “notice of proposed rulemaking to implement [new capital] standards is just getting underway and final rules lie well into the future”); Oversight of Dodd-Frank Implementation: A Progress Report by the Regulators at the Half-Year Mark: Capital is the amount by which a bank’s assets exceed its deposits and other liabilities.7 When a bank experiences a loss, the losses first reduce capital. Once capital is depleted, losses fall on depositors or the deposit insurer. Adequate bank capital protects depositors (or the deposit insurer) from losses.8 By law, banks must maintain specific ratios of capital to assets. Most simply, banks must maintain at least a 4% leverage ratio—the bank’s capital divided by its assets must equal at least 4%.9 Although the existing regulatory framework sets numerical capital requirements, it leaves regulators significant discretion to increase capital requirements for individual banks.10 For example, a regulator can require a bank to maintain more capital if the bank is operating in an unsafe or unsound manner.11 Regulators implement discretionary increases in capital requirements through capital enforcement actions. In considering capital adequacy reforms, policymakers often focus on specific numerical requirements but sometimes ignore the structure of the regulatory system and the role discretionary enforcement plays.12 Perhaps this is because little academic research has examined regulators’ discretionary capital enforcement.13 How often do bank regulators bring capital enforcement actions? How often do regulators exercise their discretion to depart from the numerical capital requirements? How much capital do regulators require? Are different bank regulators consistent in their enforcement of capital standards? Do regulators treat large banks and small banks similarly? This Article provides a better understanding of the answers to these questions through an empirical analysis of capital enforcement actions. After first offering an overview of existing bank capital statutes, regulations, and agency guidance,14 this Article reports an empirical study of all publicly reported formal bank capital enforcement actions issued between 1993 and 2010.15 By examining these 2350 formal capital enforcement actions, the study provides a clearer picture of regulatory capital enforcement. The data reveal four significant insights: • First, there has been a sharp increase in the number of formal agency capital enforcement actions during the current economic downturn. More and more banks are subject to capital enforcement actions. • Second, an increasing number of banks are subject to individual bank minimum capital requirements. Through discretionary capital increases implemented on a bank-by-bank basis, bank regulators are creating ad hoc capital requirements that are, in some cases, much higher than capital requirements published in regulations. • Third, the data suggest that enforcement rates are not consistent among bank regulators. In particular, the Federal Reserve appears less likely than other regulators to bring formal, serious capital enforcement actions and less likely to impose individual bank minimum capital requirements. • Fourth, the data show a near-complete absence of formal capital enforcement actions issued to the largest banks. During the study period, only 2 banks received capital enforcement actions when they were one of the 50 largest banks as measured by domestic deposits. None of the 25 largest banks received a formal capital enforcement action. Given the significant and growing number of banks subject to discretionary capital enforcement, the Article next considers the proper role of enforcement as a tool for capital regulation.16 Bank regulators, like most administrative agencies, typically can choose to establish standards through rulemaking or through individual enforcement. Some maintain that discretionary capital enforcement is necessary to allow regulators to adjust to financial innovation and changing economic conditions. In their view, discretionary enforcement allows regulators to finely tune capital requirements to account for the individual and unique risk posed by each individual bank. This Article challenges this description of discretionary capital enforcement. It argues that discretionary enforcement is not an effective way to adjust capital to account for innovation, economic change, or even the financial condition of individual banks. Capital standards established through enforcement are costly and opaque. In addition, discretionary capital enforcement is unlikely to consider the macroeconomic consequences that might occur as a result of numerous enforcement actions. In other words, discretionary capital enforcement is not a panacea. Of course, capital requirements established by rulemaking are also sometimes problematic. Capital regulations cannot account for all potential risk present at all banks. If regulations are simple enough to be understood and implemented, they 16. See infra Part III. 2012] will likely be somewhat crude measures. Moreover, by making rules clear some banks might be motivated to skirt the rules. Our system of capital regulation must then depend on both requirements established by rule and requirements established by enforcement. Nevertheless, this Article concludes that, in some respects, reliance on capital enforcement has gone too far.17 This Article recommends more robust capital rules that limit regulators’ need to set capital standards by enforcement. I. BANK CAPITAL REQUIREMENTS As previously explained, capital is the amount by which a bank’s assets exceed its deposits and other liabilities.18 Capital acts as a cushion to protect depositors and other creditors of the bank from loss.19 In the event a bank loses money or fails, the losses are born first by the shareholders and then by the depositors.20 Other things being equal, banks that hold more capital are less likely to become insolvent and inflict losses on depositors.21 While capital can stabilize a bank and insulate depositors, holding capital is not costless. First, the act of raising external capital investment can be expensive.22 Then, once a bank has raised capital by issuing stock, the stockholders expect a return on their investment. Banks can increase the expected return on equity by holding more liabilities relative to their capital—that is, by increasing their leverage.23 However, increasing leverage increases the risk posed to depositors because the relative amount of capital has decreased.24 Increasing leverage also makes a bank more prone to engage in risky behavior. When a bank has a small amount of capital and a large amount of liabilities, investors have little to lose if the bank fails but much to gain if the bank succeeds.25 Because of the costs associated with holding capital, in the absence of regulation, banks might choose to hold less capital and subject depositors to significant risk. This is particularly true when the depositors are protected by government deposit insurance. Protected depositors have little incentive to monitor their banks’ capital holdings and move their money from thinly capitalized banks.26 Recognizing the possibility that banks might hold less than optimal capital, policymakers have long set bank capital requirements.27 In the United States, four federal bank regulators have administered modern capital requirements for commercial banks. Each bank is assigned a primary federal regulator. The Office of the Comptroller of the Currency (OCC) supervises banks with national charters.28 The Board of Governors of the Federal Reserve (Federal Reserve) supervises state-chartered banks that have elected to be members of the Federal Reserve System.29 The Federal Deposit Insurance Corporation (FDIC) serves as the primary federal regulator for state-chartered banks that are not members of the Federal Reserve System.30 Finally, until recently the Office of Thrift Supervision (OTS) supervised federally insured savings banks and thrifts.31 However, the Dodd-Frank Act abolished the OTS.32 In the summer of 2011, the OCC began regulating federally chartered thrifts and the FDIC began regulating state-chartered thrifts.33 Because this Article focuses on capital enforcement between 1993 and 2010, the OTS regulations and enforcement are considered alongside the other banking regulators. The federal bank regulators enforce many of the same capital statutes and have largely similar capital regulations. Current capital regulations have two parts.34 First, capital regulations set mechanically determined numerical capital requirements. Second, capital regulations give regulators enforcement tools and discretionary authority to adjust numerical capital requirements on a bank-by-bank basis. A. Numerical Capital Requirements Banking statutes and regulations require that all banks maintain capital equal to a certain percentage of their assets. Banking regulations specify four capital ratios: a leverage ratio, a tangible equity ratio, a tier 1 risk-based capital ratio, and a total 2012] risk-based capital ratio.35 A small number of banks are also subject to capital requirements determined by models designed to account for operational and market risk.36 The leverage ratio is the most straightforward of the capital ratios. It is calculated by dividing tier 1 capital (essentially common stock, noncumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries) by the bank’s total assets.37 The regulations’ definition of the term “leverage ratio” deviates from the standard financial meaning of the term. In common parlance a leverage ratio is a debt-to-equity ratio,38 but in banking law the leverage ratio compares equity capital to assets. Generally, the higher a bank’s leverage ratio, the safer the bank.39 For example, suppose there are two banks with identical portfolios of assets worth $100 million. The first bank has $90 million in deposits and $10 million in common stock. This gives the first bank a leverage ratio of 10%.40 The second bank has $95 million in deposits and $5 million in common stock. The second bank has a leverage ratio of 5%.41 The first bank is safer than the second bank because it holds more capital (common stock) relative to its assets. Accordingly, it has a higher leverage ratio. This example assumes that both banks have identical asset portfolios. The first bank might not actually be safer if it held assets that were more risky than the second bank’s assets. However, the leverage ratio makes no adjustment for the riskiness of a bank’s assets. The tangible-equity ratio is very similar to the leverage ratio. It is calculated by dividing tangible equity by adjusted total assets. Before calculating the ratio, the bank must deduct intangible assets (including goodwill42 and investments in some subsidiaries) from assets. This deduction correspondingly reduces capital. Tangible equity (common stock, noncumulative perpetual preferred stock, and cumulative perpetual preferred stock) is then divided by the adjusted assets.43 The higher the tangible equity ratio, the safer the bank. Next, regulations establish risk-based capital ratios. As their name suggests, they are designed to more explicitly adjust for the riskiness of assets.44 To calculate 35. See infra notes 37–63 and accompanying text. 36. See infra notes 64–70 and accompanying text. 37. 12 C.F.R. § 325.2(m) ( 2011 ) (FDIC); 12 C.F.R. pt. 208, app. B (Federal Reserve); 12 C.F.R. §§ 3.6, 6.2(d) (OCC); 12 C.F.R. §§ 565.7, 567.5(a) (OTS). 38. See BLACK’S LAW DICTIONARY 926 (8th ed. 2004) (defining “leverage” as “[t]he ratio between a corporation’s debt and its equity capital”). 39. This is different from a debt-to-equity leverage ratio where a higher ratio would suggest more risk. 40. $10 million tier 1 capital / $100 million assets = 10% leverage ratio. 41. $5 million tier 1 capital / $100 million assets = 5% leverage ratio. 42. “Goodwill is an intangible asset that represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed.” 12 C.F.R. pt. 208, app. A. 43. 12 C.F.R. § 325.2 (FDIC); 12 C.F.R. § 208.41 (Federal Reserve); 12 C.F.R. § 6.2(g) (OCC); 12 C.F.R. § 565.2(f) (OTS). 44. The risk-based capital ratios were adopted as part of the U.S. implementation of international capital guidelines developed by a group of banking regulators from major industrialized countries. See BASLE COMM. ON BANKING SUPERVISION, INTERNATIONAL these ratios, assets are first sorted into four risk categories. Each category is assigned a percentage correlating with its riskiness: 0%, 20%, 50%, or 100%. For example, cash and U.S. government bonds are considered safe and fall in the 0% category. In contrast, outstanding credit card loans are considered comparatively risky and fall in the 100% category. First mortgages on residential property are classified in the 50% category.45 Next, the risk-based capital ratios require that some items normally not included as assets on the balance sheet (for example, standby letters of credit and unused lines of credit) be included in the calculation. These off-balance sheet items are assigned credit-equivalent amounts. Then, like assets, they are sorted by the risk-weighted categories.46 Once each asset and offbalance sheet item has been assigned a risk category, the amount of the item is multiplied by the appropriate risk-weight percentage. These numbers are then added to determine the total amount of risk-based assets. This becomes the denominator in the risk-based capital ratios.47 The numerators of the risk-based capital ratios are measurements of capital. For regulatory purposes capital is divided into two categories: tier 1 (core) capital and tier 2 (supplementary) capital. Tier 1 capital includes common stock, noncumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries.48 Once tier 1 capital has been determined, it can be divided by the risk-adjusted assets to determine the tier 1 risk-based capital ratio.49 Capital not included in tier 1 is tier 2 capital. Tier 2 capital includes items such as long-term preferred stock, loan-loss reserves, hybrid capital instruments, and subordinated debt.50 Total capital is calculated by adding tier 1 capital to tier 2 capital, subject to some limitations. Most importantly, tier 2 capital added cannot exceed tier 1 capital.51 Total capital is divided by the risk-adjusted assets to determine the total risk-based capital ratio.52 To illustrate how the risk-based capital ratios account for the riskiness of assets, consider the example of two banks, each with $100 million in assets, $95 million in CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS (1988), available at http://www.bis.org/publ/bcbs04a.pdf. 45. 12 C.F.R. pt. 325, app. A (FDIC); 12 C.F.R. pt. 208, app. A (Federal Reserve); 12 C.F.R. pt. 3, app. A (OCC); 12 C.F.R. § 567.6(a)( 1 ) (OTS). There are minor differences in the way regulators classify some items. See Joint Report: Differences in Accounting and Capital Standards Among the Federal Banking Agencies, 75 Fed. Reg. 47,900 (Aug. 9, 2010). 46. 12 C.F.R. pt. 325, app. A (FDIC); 12 C.F.R. pt. 208, app. A (Federal Reserve); 12 C.F.R. pt. 3, app. A (OCC); 12 C.F.R. § 567.6(a)( 2 ) (OTS). 47. 12 C.F.R. pt. 325, app. A (FDIC); 12 C.F.R. pt. 208, app. A (Federal Reserve); 12 C.F.R. pt. 3, app. A (OCC); 12 C.F.R. § 567.6 (OTS). 48. 12 C.F.R. pt. 325, app. A § I.A (FDIC); 12 C.F.R. pt. 208, app. A § II (Federal Reserve); 12 C.F.R. pt. 3, app. A § 2(a) (OCC); 12 C.F.R. § 567.5 (OTS). 49. 12 C.F.R. § 325.2(w) (FDIC); 12 C.F.R. § 208.41(h) (Federal Reserve); 12 C.F.R. § 6.2(i) (OCC); 12 C.F.R. § 565.2(h) (OTS). 50. 12 C.F.R. pt. 325, app. A § I.A (FDIC); 12 C.F.R. pt. 208, app. A § II (Federal Reserve); 12 C.F.R. pt. 3, app. A § 2(a) (OCC); 12 C.F.R. § 567.5 (OTS). 51. 12 C.F.R. pt. 325, app. A § I.A (FDIC); 12 C.F.R. pt. 208, app. A § II.A.2 (Federal Reserve); 12 C.F.R. pt. 3, app. A § 2(c)( 2 )(i) (OCC); 12 C.F.R. § 567.5(c)(1) (OTS). 52. 12 C.F.R. § 325.2(y) (FDIC); 12 C.F.R. § 208.41(j) (Federal Reserve); 12 C.F.R. § 6.2(k) (OCC); 12 C.F.R. § 565.2(j) (OTS). 2012] deposits, and $5 million in common stock. The first bank’s assets consist of $50 million in cash and $50 million in first mortgages on single-family homes. The second bank’s assets consist of $100 million in first mortgages on single-family homes. Common sense suggests that the bank with cash is less risky than the bank with only mortgages. The risk-based capital ratios account for this understanding. For the first bank, the cash would be classified in the 0% risk-weight category and the mortgages would be classified in the 50% category. Once the risk-weight categories are multiplied by the amount of assets in the category and added together, the bank would have $25 million in risk-weighted assets53 and a tier 1 risk-based capital ratio of 20%.54 The mortgages in the second bank’s portfolio would also be classified in the 50% risk-weight category, giving it risk-weighted assets of $50 million.55 The second bank’s tier 1 risk-based capital ratio would be 10%.56 Because neither bank has tier 2 capital, each bank’s tier 1 risk-based capital ratio equals its total risk-based capital ratio. As expected, the first bank has a higher tier 1 risk-based capital ratio and a higher total risk-based capital ratio. This reflects the understanding that it is less risky to hold cash than mortgages. While the capital ratios can help us gauge the riskiness of a bank, there is no clear point at which a bank becomes “risky.” For this reason, rather than simply setting required capital ratios, regulations use a stepped approach to capital by classifying banks as well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized. The capital ratios required for each classification are listed in Figure 1.57 53. (0% risk-weight category * $50 million cash) + (50% risk-weight category * $50 million mortgages) = $25 million risk-weighted assets. 54. $5 million tier 1 capital / $25 million risk-weighted assets = 20% tier 1 risk-based capital ratio. 55. 50% risk-weight category * $100 million mortgages = $50 million risk-weighted assets. 56. $5 million tier 1 capital / $50 million risk-weighted assets = 10% tier 1 risk-based capital ratio. 57. The capital ratios for each classification are established by regulation. 12 C.F.R. §§ 325.3, 325.103 (FDIC); 12 C.F.R. § 208.43 (Federal Reserve); 12 C.F.R. § 6.4 (OCC); 12 C.F.R. § 565.4 (OTS). In order to be well capitalized or adequately capitalized, a bank must meet or exceed the required percentage for each ratio. A regulator can downgrade a bank to the next lower capital category if the bank is in an unsafe or unsound condition. 12 U.S.C. § 1831o(g) (2006). In addition to the requirements listed in Figure 1, thrifts are required to maintain tangible capital (similar to tangible equity capital, but excluding noncumulative perpetual preferred stock) “equal to at least 1.5% of adjusted total assets.” 12 C.F.R. § 567.9. This capital requirement “has effectively been eclipsed by the more stringent” capital requirements. OTS, EXAMINATION HANDBOOK § 120.3 ( 2009 ), available at http://www.ots.treas.gov/_files/422017.pdf. A bank gains certain privileges, such as the ability to solicit brokered deposits, by maintaining capital sufficient to be classified as well capitalized.59 All banks, however, must maintain capital sufficient to be classified as adequately capitalized. If a bank becomes undercapitalized, the bank must submit a capital restoration plan to its regulator explaining “the steps the [bank] will take to become adequately capitalized.”60 The regulator evaluates the plan to determine whether it “is based on realistic assumptions, and is likely to succeed in restoring the [bank’s] capital” without increasing the bank’s risk.61 If a bank is significantly undercapitalized or fails to obtain approval of its capital plan, the regulator must take at least one of a variety of measures designed to prevent further declines in capital. In particular, the regulator can require the bank to sell enough stock to become adequately capitalized.62 If the bank becomes critically undercapitalized the regulator must, within ninety days, appoint a receiver or take other action to limit loss to the insurance fund.63 Although all U.S. banks are required to comply with the leverage and risk-based capital requirements, larger banks face additional capital requirements. Banks with more than $250 billion in total assets or with foreign exposures greater than $10 58. A bank is adequately capitalized if it has a 3% leverage ratio and it “is not anticipating or experiencing significant growth and has well-diversified risk, including no undue interest rate risk exposure, excellent asset quality, high liquidity, good earnings and in general is considered a strong banking organization, rated composite 1 under the Uniform Financial Institutions Rating System.” 12 C.F.R. § 325.3(b)( 1 ) (FDIC). If a bank does not have a 1 examination rating, it must maintain a 4% leverage ratio. Id. at §§ 208.43(b)( 2 ), 325.3(b)( 2 ), 565.4(b)( 2 ). “In theory, a very healthy, well-run bank with the highest possible examination rating can qualify as adequately capitalized with only 3% capital. But the real rule remains 4%—not least because a bank with only 3% capital would have difficulty obtaining such a high examination rating.” CARNELL, MACEY & MILLER, supra note 8, at 257. 59. 12 U.S.C. § 1831f(a). 60. Id. § 1831o(e)( 2 ). 61. Id. While a bank is undercapitalized, it may not increase its asset base or acquire new branches or lines of business without its regulator’s approval. Id. § 1831o(e)(3)–( 4 ). 62. Id. § 1831o(f). 63. Id. § 1831o(h)(3). 2012] billion are beginning to implement a more risk-sensitive approach for determining capital minimums.64 This approach, developed by the Basel Committee on Banking Supervision, uses banks’ internal ratings to assess credit risk. It also uses risk models developed by banks to account for operational risk (“the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events”).65 Only about ten of the largest banks are required to implement this internal rating and modeling approach.66 Even these banks cannot maintain capital less than that required by the leverage ratio, tier 1 risk-based capital ratio, and total risk-based capital ratio.67 Smaller banks, with the approval of their regulator, can elect to use this approach, but it is expected that most small banks will continue to rely solely on the traditional capital ratios.68 In addition to creditrisk capital requirements, banks with large trading accounts are required to hold capital to protect against market risk.69 The amount of capital required is typically determined using value-at-risk models developed largely by each bank. Only a small number of banks are currently subject to the market-risk capital requirements.70 In sum, the leverage ratio, tier 1 risk-based capital ratio, and the 64. 12 C.F.R. pt. 325, app. D § 21 (FDIC); 12 C.F.R. pt. 208, app. F § 21 (Federal Reserve); 12 C.F.R. pt. 3, app. C § 21 (OCC); 12 C.F.R. pt. 567, app. C § 21 (OTS). 65. Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 72 Fed. Reg. 69,288, 69,293, 69,403 (Dec. 7, 2007) (codified at 12 C.F.R. pt. 3; 12 C.F.R. pts. 208, 225; 12 C.F.R. pt. 325; 12 C.F.R. pts. 559, 560, 563, 567); BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK (2004), available at http://www.bis.org/ publ/bcbs107.pdf. 66. Mark Sobel, Deputy Assistant Sec’y, Dep’t of Treasury, Remarks at Center for European Policy Studies (Apr. 28, 2010), available at 2010 WLNR 8734614 (discussing U.S. implementation of Basel II). According to regulations, these banks had until April 1, 2011 to complete four consecutive quarters of a “parallel run” in which they calculated capital levels using models but continued to comply with the traditional risk-based capital ratios. See id. However, the financial crisis and other factors led some banks to begin their parallel run period late and miss this deadline. Victoria Tozer-Pennington, Dodd-Frank Slows Down Full Implementation of Basel II, FX WEEK (Nov. 25, 2010), http://www.fxweek.com/fxweek/news/1900819/dodd-frank-slows-implementation-basel-ii; see also Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 76 Fed. Reg. 37,620, 37,621 (June 28, 2011) (to be codified at 12 C.F.R. pt. 3; 12 C.F.R. pts. 208, 225; 12 C.F.R. pt. 325) (noting that “[t]o date, no U.S.-domiciled banking organization has entered a transitional floor period and all U.S.-domiciled banking organizations are required to compute their riskbased capital requirements using the general risk-based capital rules”). 67. Risk-Based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 76 Fed. Reg. at 37,626–29. 68. See Benton E. Gup, Introduction to the Basel Capital Accords, in THE NEW BASEL CAPITAL ACCORD 1, 8 (Benton E. Gup ed., 2004). 69. The market risk capital requirements apply only to banks “whose trading activity . . . equals . . . 10% or more of total assets [or is] $1 billion or more.” 12 C.F.R. pt. 325, app. C (FDIC); 12 C.F.R. pt. 208, app. E (Federal Reserve); 12 C.F.R. pt. 3, app. B (OCC). 70. See GEN. ACCOUNTING OFFICE, RISK-BASED CAPITAL: REGULATORY AND INDUSTRY APPROACHES TO CAPITAL AND RISK 9 (1998) (stating that the market risk capital requirement “generally pertains only to the largest 15 to 20 U.S. banks with extensive trading activity”); total risk-based capital ratio are the primary capital requirements applied to all U.S. banks. B. Discretionary Capital Requirements Although at first inspection the statutory and regulatory rules with respect to bank capital seem rather clear-cut, bank regulators actually have significant discretion to set capital requirements on a bank-by-bank basis. According to statute, “[e]ach appropriate Federal banking agency [has] the authority to establish [a] minimum level of capital for a banking institution as the appropriate Federal banking agency, in its discretion, deems to be necessary or appropriate in light of the particular circumstances of the banking institution.”71 Regulations reiterate this discretionary authority. For example, regulations state that “the FDIC is not precluded from requiring an institution to maintain a higher capital level based on the institution’s particular risk profile.”72 In other words, each regulator has broad discretion to increase capital requirements on an individual bank basis. Regulations also provide guidance about when regulators should require capital above the regulatory minimum. There are differences among the federal bank regulators in their regulatory text. According to FDIC regulations, increased capital is warranted when the financial history or condition, managerial resources and/or the future earnings prospects of a bank are not adequate, or where a bank has sizable off-balance sheet or funding risks, significant risks from concentrations of credit or nontraditional activities, excessive interest rate risk exposure, or a significant volume of assets classified substandard, doubtful or loss or otherwise criticized.73 The Federal Reserve states that higher requirements are justified when a bank is “contemplating significant expansion proposals” or when the bank has “inordinate Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975– 2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215, 345 n.543 (2002) (stating that the market risk capital requirement applies “to about twenty large banks”). Thrifts are not subject to market risk capital requirements. See James J. Croke, What Banks Need to Know About New Developments in Asset-Backed Commercial Paper, 121 BANKING L.J. 218, 284 n.9 (2004). 71. 12 U.S.C. § 3907(a)( 2 ) (2006); see also 12 U.S.C. § 1464(s)( 2 ) ( 2009 ) (stating that “[m]inimum capital levels may be determined by [the OTS] Director case-by-case”). 72. 12 C.F.R. § 325.3(a); see also 12 C.F.R. pt. 208, app. A (Federal Reserve) (noting that “the final supervisory judgment on a bank’s capital adequacy may differ significantly from conclusions that might be drawn solely from the level of its risk-based capital ratio”); 12 C.F.R. § 3.11 (OCC) (“The appropriate minimum capital ratios for an individual bank cannot be determined solely through the application of a rigid mathematical formula or wholly objective criteria. The decision is necessarily based in part on subjective judgment grounded in agency expertise.”); 12 C.F.R. § 567.3 (OTS) (“Minimum capital levels higher than the risk-based capital requirement, the leverage ratio requirement or the tangible capital requirement required under this part may be appropriate for individual savings associations.”). 73. 12 C.F.R. § 325.3(a). 2012] levels of risk.”74 The OCC notes that the “factors to be considered” in determining capital levels “will vary in each case.”75 The OCC’s regulations state that it may be appropriate to consider the “overall condition, management strength, and future prospects of the bank.”76 The OTS regulations list nine instances in which higher capital levels might be appropriate.77 In determining the appropriate level, OTS regulations recommend that the regulator consider the bank’s “overall condition, management strength, and future prospects,” as well as the bank’s “liquidity” and “financial stability.”78 While the regulatory language may be somewhat different, each regulator has significant discretion to adjust capital levels in a myriad of circumstances. When a regulator determines that a bank warrants higher capital levels, the regulator can establish that higher standard through a formal or informal enforcement action. Regulators have significant discretion in choosing between formal enforcement actions and informal enforcement actions. Banking regulations are largely silent on how the regulator should decide which enforcement mechanism to use. Recognizing that some individual bank examiners might choose different enforcement approaches, each banking agency has developed internal policies designed to encourage consistent application of enforcement tools.79 74. 12 C.F.R. pt. 208, app. A. Higher capital requirements might also be appropriate when the bank has significant interest rate risk, liquidity issues, poor earnings, portfolio risk, or risk from nontraditional activities. See id. 75. 12 C.F.R. § 3.11. 76. Id. § 3.11(c). It may also be appropriate to consider “[t]he bank’s liquidity, capital, risk asset and other ratios compared to the ratios of its peer group,” and “[t]he views of the bank’s directors and senior management.” Id. § 3.11(d), (e). 77. Id. § 567.3(b). Those circumstances include banks with high exposure to various risk, banks with “poor liquidity or cash flow,” and banks that are growing rapidly. Id. 78. Id. § 567.3(c). The regulation further recommends considering “[t]he policies and practices of the savings association’s directors, officers, and senior management as well as the internal control and internal audit systems.” Id. 79. See FDIC, DIVISION OF SUPERVISION AND CONSUMER PROTECTION, RISK MANAGEMENT MANUAL OF EXAMINATION POLICIES §§ 13.1, 14.1, 15.1 (2004) [hereinafter FDIC, RISK MANAGEMENT MANUAL], available at http://www.fdic.gov/regulations/safety/manual/manual_examinations_full.pdf; FDIC, DIVISION OF SUPERVISION AND CONSUMER PROTECTION, FORMAL AND INFORMAL ACTIONS PROCEDURES MANUAL (2005) [hereinafter FDIC, ACTIONS PROCEDURES MANUAL] (obtained through a Freedom of Information Act request; copy on file with author); FEDERAL RESERVE, COMMERCIAL BANK EXAMINATION MANUAL § 5040.1 ( 2011 ), available at http://www.federalreserve.gov/board docs/supmanual/cbem/cbem.pdf; OCC, AN EXAMINER’S GUIDE TO PROBLEM BANK IDENTIFICATION, REHABILITATION, AND RESOLUTION 28, 92–108 (2001) [hereinafter OCC, EXAMINER’S GUIDE], available at http://www.occ.gov/publications/publications-by-type/other-publications-reports/prbbnk gd.pdf; OCC, POLICIES & PROCEDURES MANUAL 5310-3 ( 2011 ) [hereinafter OCC, PPM 5310-3], available at http://www.occ.gov/static/publications/ppm-5310-3.pdf; OTS, EXAMINATION HANDBOOK § 080 ( 2011 ), available at http://www.ots.treas.gov /files/422345.pdf. 1. Formal Actions An enforcement action is classified as a “formal” action if violation of that action can serve as the basis for further administrative penalties, such as civil money penalties, the removal of bank officers, or the termination of federal deposit insurance.80 Formal actions are publicly available unless the regulator determines that publication “would be contrary to the public interest.”81 According to regulatory guidance, formal actions should be used when a bank “has significant problems, especially when there is a threat of harm to the [bank], depositors, or the public.”82 Formal actions are also used when informal actions have been ineffective.83 Regulators can use several types of formal enforcement actions to enforce capital requirements: prompt corrective action directives, capital directives, cease-and-desist orders, and written agreements. a. Prompt Corrective Action Directives By statute, bank regulators must take “prompt corrective action to resolve the problems of insured depository institutions.”84 As previously explained, bank regulators are required to take certain regulatory actions once a bank becomes undercapitalized, significantly undercapitalized, or critically undercapitalized as defined by regulation.85 Regulators can also issue a prompt corrective action directive when a bank fails to meet previously established individual bank capital requirements.86 While a bank is classified as undercapitalized, significantly undercapitalized, or critically undercapitalized, the regulator has authority to require the bank “to take any other action that the [regulator] determines will better carry out the purpose of [the prompt corrective action statute].”87 Because the purpose of prompt corrective action is to “resolve the problems of insured depository institutions at the least possible long-term loss to the Deposit Insurance Fund,”88 the regulator can require the bank to hold more than the regulatory minimum capital. 80. 12 U.S.C. § 1818(a)( 2 ), (e), (i)( 2 ) (2006). 81. Id. § 1818(u). 82. OTS, supra note 79, at § 080.6; see also OCC, EXAMINER’S GUIDE, supra note 79, at 30 (“Formal actions are appropriate when a bank has significant problems, especially when there is a threat of harm to the institution.”). 83. OCC, EXAMINER’S GUIDE, supra note 79, at 30 (stating that formal actions are used “when corrective action by the board is not forthcoming, or when informal actions are insufficient”). 84. 12 U.S.C. § 1831o(a)( 2 ). 85. See supra notes 60–63 and accompanying text. 86. 12 U.S.C. § 1831o(b)( 2 )(G). 87. Id. § 1831o(f)( 2 )(J); see also id. § 1831o(e)(5) (“The appropriate Federal banking agency may, with respect to any undercapitalized insured depository institution, take actions . . . if the agency determines that those actions are necessary to carry out the purpose of this section.”). 88. Id. § 1831o(a)( 1 ). 2012] Regulators take discretionary action, including increasing capital requirements, against an undercapitalized bank by issuing a prompt corrective action directive. Before issuing a prompt corrective action directive, the regulator must typically provide the bank with notice and opportunity to comment on the proposed action.89 However, no administrative hearing is required. Regulators can enforce prompt corrective action directives in federal district court.90 By regulation, prompt corrective action directives are ordinarily reserved for banks that are classified as undercapitalized.91 Beyond that, OCC guidance suggests that prompt corrective action directives should be issued only in the most extreme circumstances—when the regulator anticipates that the bank will be closed in the future.92 b. Capital Directives Regulators need not wait until banks become undercapitalized to take formal enforcement actions. The International Lending Supervision Act allows regulators to issue a capital directive to any bank that “fails to maintain capital at or above” the level determined to be appropriate by the regulator.93 The process for issuing a capital directive is similar to that for issuing a prompt corrective action directive. The regulator provides the bank notice and an opportunity to comment on the proposed directive. After the bank responds or the period for response expires, the regulator can issue the directive.94 No hearing is required.95 Banks cannot appeal a regulator’s decision to issue the capital directive in court.96 However, regulators can enforce capital directives in court.97 Agency guidance counsels that a capital directive is an appropriate enforcement measure when the regulator’s only concern is capital adequacy. According to the FDIC, “[a] directive is to be used solely to correct a capital deficiency and it is not intended to address other weaknesses that may be present in a bank.”98 The FDIC guidance further states that “in cases where it is possible to obtain a consent Cease and Desist Order that includes an appropriate capital provision, it is preferable to take [that] action instead of capital directive action.”99 OTS guidance advises that a capital directive is appropriate when a bank has failed to respond to informal enforcement actions designed to increase capital.100 The capital directive is rarely used.101 c. Cease-and-Desist Orders Bank regulators more commonly increase capital requirements through ceaseand-desist orders.102 Regulators have broad power to issue cease-and-desist orders to prevent any “unsafe or unsound [banking] practice.”103 While the precise contours of unsafe or unsound practices are not well defined, operating with insufficient capital is an unsafe or unsound practice.104 Regulators may also issue cease-and-desist orders if a bank violates a statute, regulation, or written agreement with the regulator.105 If the unsafe or unsound condition “is likely to cause insolvency or significant dissipation of assets or earnings of the [bank], or is likely to weaken the condition of the [bank] or otherwise prejudice the interests of its depositors,” the regulator has authority to issue a temporary cease-and-desist order.106 Temporary cease-anddesist orders are granted without the participation of the bank and are immediately effective.107 The bank may challenge the issuance of the order in federal district court.108 For unsafe or unsound practices that are less urgent, the regulator must provide the bank with notice concerning the practice.109 The bank is entitled to a hearing before an administrative law judge to determine whether an unsafe or unsound condition exists.110 However, few banks avail themselves of this right. Realizing that the regulator has broad discretion, most banks waive the hearing and consent to 2012] cease-and-desist orders rather than risk further aggravating their regulators.111 Regulators sometimes label cease-and-desist orders issued by consent as “consent orders.”112 Regulators can enforce the terms of cease-and-desist orders and consent orders in federal district court.113 In addition to directing a bank to refrain from unsafe or unsound actions, a cease-and-desist order can require the bank to “take affirmative action to correct the conditions.”114 The order may require the bank to hold capital in excess of the standard regulatory amounts. FDIC guidelines recommend that explicit capital requirements be included in the order: If inadequate capital is evident, the amount of capital needed will be stated. This amount can be a ratio, e.g., Restore a ___% capital-to-asset ratio, or a dollar amount of new capital funds or a capital level, e.g., Increase capital and reserves to not less than ___ and maintain.115 Other regulators’ guidance documents do not address the issue of what remedial measures should be included in cease-and-desist orders issued to correct inadequate capital. In general, regulators’ policies recommend using cease-and-desist orders in situations serious enough to warrant formal action, but when capital levels have not yet deteriorated to a level where a prompt corrective action directive may be used.116 d. Written Agreements Regulators are also authorized to impose conditions on banks through written agreements.117 Formal written agreements, sometimes referred to as formal agreements or supervisory agreements, are very similar to cease-and-desist orders entered by consent. Like cease-and-desist orders, written agreements can “require affirmative corrective action to address any existing violations, management or operational deficiencies, or other unsound practices,” including operating with insufficient capital.118 As with the other formal enforcement actions, a bank’s violation of a written agreement may subject the bank to administrative penalties such as fines or the removal of bank officers or directors.119 However, unlike other formal enforcement actions, written agreements cannot be directly enforced in court.120 To enforce a written agreement, a regulator must first issue a cease-and-desist order and then enforce the cease-and-desist order in court.121 Because written agreements are not enforceable in court, regulatory guidance recommends that they be used for situations less serious than those warranting cease-and-desist orders. According to the FDIC, “the use of a written agreement should normally be reserved for a bank whose problems are limited essentially to a capital deficiency that has not been caused by the unsafe and unsound practices of its management.”122 Similarly, the Federal Reserve recommends written agreements “[w]hen circumstances warrant a less severe form of formal supervisory action.”123 In spite of the fact that written agreements are not enforceable in court, OCC guidance acknowledges that “[t]he decision to utilize a Formal Agreement instead of a Consent Order is largely driven by negotiation strategy and the discretion of the delegated decision-making official.”124 2. Informal Actions In some instances, regulators may not need a formal action to persuade a bank to increase its capital. For example, a regulator might encourage a bank to increase its capital by telling the bank that it will receive a cease-and-desist order if it does not voluntarily comply. “Given the federal banking agencies’ tremendous power over insured banks . . . they have ample means of—and opportunities for—informally coercing [banks].”125 All of the federal bank regulators acknowledge that they have 2012] informal regulatory powers outside the formal tools granted by banking statutes.126 The FDIC notes that “the use of reason and moral suasion [are its] primary corrective tools.”127 An informal supervisory action may be memorialized in writing, “when moral suasion will not, by itself, accomplish the [regulator’s] goal of correcting identified deficiencies in an institution’s operations.”128 The writing may take the form of a board resolution, a commitment letter, a safety and soundness plan, or a memorandum of understanding (MOU).129 The OCC even has an informal action aimed specifically at capital—the individual minimum capital ratio letter.130 Regardless of how an informal action is styled, it is not enforceable in court. If a regulator determines that a bank has not sufficiently responded to informal action, it must take formal enforcement action before turning to the courts.131 Bank regulators do not publicly release informal enforcement actions.132 However, all regulators except the OTS release annual summary statistics concerning informal actions.133 In addition, individual banks may determine that securities laws require public disclosure of their informal enforcement actions.134 Regulatory guidance counsels that informal actions are appropriate when the problem is minor and the regulator believes that bank management is likely to resolve the issue.135 2012] OCC 441 208 1 0 0 9 2 21 682 OTS 77 0 131 0 0 1 0 51 260 Total 736 583 804 8 3 11 203 2 2350 While banks care about the title of a particular enforcement action, they are even more sensitive to individual bank minimum capital requirements included in the action. Again the data suggest that the Federal Reserve may be the most lenient. The Federal Reserve was the least likely to include an individual bank minimum capital requirement in a formal capital enforcement action. Of the 283 formal capital enforcement actions the Federal Reserve issued, only 17 contained individual bank minimum capital requirements. As shown in Figure 9, all other regulators included individual bank capital requirements in well over half of their formal capital enforcement actions.245 This finding is consistent with Professor Wellons’s general observation that the Federal Reserve only required that banks achieve the regulatory capital minimums, while the FDIC was likely to require specific increases in capital.246 245. The chi-square test of independence was statistically significant, indicating that the inclusion of individual bank minimum capital requirements was meaningfully different among regulators (χ2(3, N = 2350) = 836.25, p < 0.001, Cramér’s V = 0.60). 246. See supra notes 161–62 and accompanying text. Formal Capital Enforcement Actions 998 17 551 152 1125 283 682 260 Percentage 89% 6% 81% 58% For actions containing individual bank minimum capital requirements, the mean leverage ratio and tier 1 risk-based capital ratio imposed varied depending on the regulator issuing the action (Figure 10).247 There was little difference among the means of the required total risk-based capital ratios.248 In general, the Federal Reserve and the OTS had the lowest average individual bank capital requirements. 247. One-way analysis of variance (ANOVA) tests suggest that the mean leverage ratios and tier 1 risk-based capital requirements imposed vary significantly among regulators (Leverage: F(3, 1686) = 31.29, p < 0.001; Tier 1 Risk-Based Capital: F(3, 476) = 32.91, p < 0.001). The ANOVA test, however, may not accurately analyze these data. The ANOVA test assumes that each group has an equal variance. This assumption was violated here. Bartlett’s test for equal variances finds significant differences among the variances for both leverage and tier 1 risk-based capital requirements (Leverage: χ2(3) = 67.50, p < 0.001; Tier 1 RiskBased Capital: χ2(3) = 42.16, p < 0.001). ANOVA also assumes that the number of observations per group is roughly equal. Here, however, the group sizes varied widely. The FDIC had 993 actions containing a leverage ratio, but the Federal Reserve had only 14. Similarly, the OCC had 292 actions containing a tier 1 risk-based capital ratio, but the Federal Reserve had only 4. For these reasons, ANOVA may indicate significance where none exists. See ALAN C. ACOCK, A GENTLE INTRODUCTION TO STATA 189–90 (2d ed. 2008); ROBERT M. LAWLESS, JENNIFER K. ROBBENNOLT & THOMAS S. ULEN, EMPIRICAL METHODS IN LAW 285 (2010). 248. With respect to the total risk-based capital ratios, ANOVA does not show a significant difference in the means among regulators (F(3, 1061) = .51, p = 0.68). Again, however, not all of the assumptions of ANOVA are true. Bartlett’s test for equal variances finds significant difference among the variances in total risk-based capital requirements (χ2(3) = 20.16, p < 0.001). The number of observations also varied widely. The FDIC had 599 actions with total risk-based capital requirements while the Federal Reserve had only 5. 2012] In sum, when compared with the other federal bank regulators, the Federal Reserve was more likely to use written agreements—the least serious of the formal capital enforcement actions.249 The Federal Reserve was also the least likely to include an individual bank capital requirement. When the Federal Reserve did include an individual bank capital requirement, the requirement was, on average, lower than the requirements imposed by the FDIC and the OCC. Although this suggests that the Federal Reserve was less likely to aggressively regulate bank capital, the analysis presented here does not account for the condition of each bank receiving a formal capital enforcement action. Without data about each bank’s financial condition at the time it received an order, it is impossible to conclusively say the Federal Reserve is more lax. It is possible that the Federal Reserve’s lower incidence of enforcement simply reflects the better financial condition of the banks it regulates.250 Another possible explanation is that the Federal Reserve, as the federal regulator for bank holding companies and financial holding companies, prefers to enforce capital requirements at the holding company level rather than the individual bank level.251 It might also be that the Federal Reserve often elects to require banks to submit to increased capital requirements in the capital plans required by many formal enforcement actions.252 Because the capital plans submitted are generally not publicly available, it is difficult to assess 249. Unlike other formal actions, written agreements cannot be enforced in court. See supra note 131 and accompanying text. 250. If it were found that the banks regulated by the Federal Reserve were more financially stable, that stability might be due to the quality of regulation, selection bias among banks who choose to be members of the Federal Reserve System, or other factors. 251. In 2009, the Federal Reserve issued more formal enforcement actions (of all types, including capital) to bank holding companies than to individual banks. William J. Brown, Formal Enforcement Actions Issued Against Institutions—What Do Today’s Numbers Say?, SRC INSIGHTS (Fed. Reserve Bank of Phila.), Fourth Quarter 2009, at 9. However, when a Federal Reserve Bank of Philadelphia study summarized the requirements contained in the 2009 formal enforcement actions, it did not mention individual bank capital requirements. Id. Thus, it is likely that even the orders issued to holding companies do not contain specific capital requirements. 252. The author’s informal discussions with bank regulators and attorneys suggest that this explanation is the most plausible. enforcement efforts through capital plans. At any rate, the stark differences in capital enforcement strategies among regulators raise questions about the consistency of capital enforcement. 5. Enforcement and Large Banks Lastly, the formal capital enforcement study allows us to see whether the largest banks received formal capital enforcement actions. Capital enforcement efforts at large banks are important. While there are about 8000 banks in the United States, the largest banks control a significant part of the banking industry. The 10 largest banks253 in the United States, as measured by domestic deposits, hold 42% of all domestic deposits.254 The 50 largest banks hold 63% of the domestic deposits.255 Press reports suggest that several of the largest banks have experienced capital stress during the study time period. In fall 2008, Washington Mutual (the sixthlargest bank as measured by domestic deposits256) failed.257 Wachovia (the thirdlargest bank as measured by domestic deposits258) was on the brink of failure until it was purchased by Wells Fargo.259 These events caused regulators to question whether the largest banks held enough capital.260 In hopes of quelling any capital concerns, Treasury summoned the chief executive officers of JP Morgan, Wells Fargo, Citigroup, Bank of America, State Street Corporation, and Bank of New York Mellon to its offices and convinced them to accept billions of dollars in capital from the federal government.261 Thereafter, regulators spent three months scouring the books of the 19 largest bank holding companies conducting “stress tests” to determine whether these holding companies had enough capital to withstand the economic downturn.262 As a result of the stress tests, regulators 2012] announced that Bank of America, Wells Fargo, Citigroup, and others needed to raise even more capital.263 At least one of these banks would have failed but for the government’s capital assistance.264 Given this apparently high level of capital stress at large banks, one might expect that the regulators would have issued formal capital enforcement actions and individual bank minimum capital requirements to these banks. To determine whether the largest banks received formal capital enforcement actions during the study period, it was first necessary to identify the largest banks. The FDIC maintains lists of the largest 50 banks as measured by domestic deposits on June 30 of each year.265 These lists were crosschecked with the data from the formal capital enforcement study to determine whether any banks that appeared on the Top 50 lists received formal capital enforcement actions. Only 2 banks received formal capital enforcement actions while they appeared on the FDIC’s Top 50 list. Providian National Bank entered a written agreement with the OCC on November 21, 2001.266 The written agreement did not impose individual bank minimum capital requirements.267 That year, Providian National Bank was listed as the forty-eighth-largest bank as measured by domestic deposits.268 The second bank, Colonial Bank, consented to a cease-and-desist order issued by the FDIC on June 15, 2009.269 The order required that Colonial maintain an 8% leverage ratio and a 12% total risk-based capital ratio.270 On June 30, 2009, the FDIC listed Colonial Bank as the forty-seventh-largest bank as measured by domestic deposits.271 The study did not find any formal capital enforcement actions for the largest of the large banks. There were no formal capital enforcement actions for Washington Mutual even though it failed. There were no formal capital enforcement actions for Wachovia even though it narrowly escaped failure. There were no formal capital enforcement actions for Bank of America, Wells Fargo Bank, or Citibank, even though their holding companies failed the regulators’ stress tests and were instructed to raise capital.272 While the dearth of formal capital enforcement actions issued to large banks is surprising, it is, nevertheless, consistent with the findings of the Wellons Study. The Wellons Study found no prompt corrective action directives issued to large banks.273 Likewise, the formal capital enforcement action study found no prompt corrective action directives issued to large banks. The reasons for the apparently low level of formal capital enforcement against the largest banks are not readily apparent. It may be that the largest banks were more likely to maintain adequate capital levels without prodding from their regulators. Because the formal capital enforcement action study did not capture financial data about the banks receiving actions, it is impossible to determine whether the banks receiving actions were the least healthy banks. The Peek-Rosengren Study, however, does discount bank health as the primary explanation for the low level of formal capital enforcement actions issued to large banks. It compared the leverage ratios of banks receiving formal enforcement actions with the size of the banks.274 The Peek-Rosengren Study concluded that “[s]maller institutions were more likely than larger institutions to receive their formal actions while their leverage ratios were still relatively high.”275 Of course, a high leverage ratio is not necessarily indicative of less risk. It may be that large banks with low leverage ratios are safer than small banks with similar leverage ratios because large bank assets are more diversified.276 Indeed, data maintained by the FDIC for all insured institutions show that large banks, on average, operate with lower leverage ratios than smaller banks. For example, in the fourth quarter of 2010, banks with assets of more than $10 billion on average maintained leverage ratios of 8.63%, while banks with assets of less than $100 million on average maintained leverage ratios of 11.28%.277 The Peek-Rosengren Study, however, also compared the percentage of nonperforming loans receiving formal enforcement actions with bank size. It concluded that “small banks were more than twice as 2012] likely as large banks to receive their formal actions before their nonperforming loans reached 2 percent of assets.”278 In other words, regulators appeared more willing to issue actions to small banks when there was only some evidence of problem loans. Recent regulator comments also discount the theory that large banks were healthier than small banks. In 2009 FDIC Chairman Sheila Bair stated that, “[o]ver the past 18 months, large banks, as a group, have posed much greater risks to the banking system than small banks have.”279 Regulators were nervous enough about the capital at the largest banks to conduct stress tests and provide government capital to some of the largest bank holding companies.280 It is, therefore, possible that regulators believed some of the largest banks should raise capital, but nevertheless chose not to use formal capital enforcement actions against those banks. Perhaps regulators worried that public capital enforcement actions against large banks would cause a widespread banking panic. Perhaps the large banks had more influence with regulators and were more successful in negotiating non-public enforcement actions.281 Perhaps regulators believed that for large banks, capital is best set through risk modeling that may not translate well into formal capital enforcement actions.282 Perhaps regulators believed that they had other more efficient or appropriate tools for regulating large banks, such as providing capital through the Troubled Asset Relief Program. Sorting out these and other possible explanations for the low number of formal capital enforcement actions aimed at large banks is beyond the scope of this study. III. RULES OR DISCRETION While the formal capital enforcement action study leaves some unanswered questions, one trend is clear: banks are increasingly subject to discretionary capital enforcement. In the current regulatory environment, a significant number of banks have capital requirements that are set by discretionary capital enforcement actions rather than by statute or regulation. Consequently, the time is ripe to re-examine the role of discretion in capital enforcement. Should capital be regulated by rule or by discretionary enforcement? The rule versus discretionary enforcement choice is not unique to bank regulators.283 Legal scholarship has addressed the rule versus discretion question on a number of fronts. Should automobile safety be promoted through rules or discretionary recalls?284 “How much discretion should a trial judge have to design procedures for a given lawsuit?”285 Should the regulators control emissions from diesel engines by rule or by bringing suit against engine manufacturers?286 Should the securities markets be governed by specific requirements or broader principles that are enforced through discretionary prosecution?287 Still, little has been done to determine the proper role of discretion in bank capital regulation. This Part explores the traditional arguments for regulatory discretion in setting capital requirements. It then explains why, even assuming regulators are conscientious in assessing individual bank risk, the recent increase in individual bank capital requirements is problematic. A. The Tradition of Discretion The traditional justification for allowing regulators discretion to adjust individual bank capital requirements is that mechanically determined numerical capital requirements are insufficient to safeguard deposits in a dynamic and complex banking industry. Certainly the current leverage and risk-based capital ratios are only an approximation of the riskiness of an individual bank. Current regulations miscategorize some assets and ignore some off-balance-sheet items.288 These (and other) deficiencies may lead banks to attempt to game the capital requirements.289 However, revising the mechanical capital requirements to perfectly 2012] capture the riskiness of every bank is probably impossible. Even if perfect mechanical capital requirements could be developed, they would probably be unworkably complex and confusing.290 The realization that mechanical capital standards are imprecise leads some to conclude that mechanical numerical standards should not be codified. According to Treasury Secretary Timothy Geithner: [T]he financial markets are dynamic, and it is imperative that regulatory capital requirements be able to adapt quickly to innovation and to changes in accounting standards and other regulations. Placing fixed, numerical capital requirements in statute will produce an ossified safety and soundness framework that is unable to evolve to keep pace with change and to prevent regulatory arbitrage.291 Others take Secretary Geithner’s argument even further, rejecting written “detailed mechanical formulas” in regulations as well as statutes.292 For example, Professor Arturo Estrella favors an approach where bank regulators exercise significant supervisory judgment in setting capital requirements. Professor Estrella notes that “not only is the institution of banking an evolving response to economic conditions, but evolving economic conditions are in turn profoundly affected by the institution of banking.”293 He worries that an “inflexible regulatory” system will require changes “with increasing frequency,” and that such changes will not keep pace with the banking industry.294 Similarly, S. Raihan Zamil, the International Monetary Fund’s Banking Policy and Supervision Advisor to Bank Indonesia, argues that discretionary determination of capital standards for individual banks is “particularly critical during an expansionary [economic] cycle, when a combination of relaxed loan origination standards and easy credit allows marginal borrowers to refinance—rather than to repay—their debt obligations, which leaves the impression of low default risk.”295 For those who favor regulatory discretion, an increase in individual bank capital requirements is not troubling; it merely signals a change in circumstances that possible under Basel I, but concluding that “there is very little empirical work that quantifies the practice”); Patricia A. McCoy, Musings on the Seeming Inevitability of Global Convergence in Banking Law, 7 CONN. INS. L.J. 433, 450–56 (2001). 290. Duncan E. Alford, Basle Committee International Capital Adequacy Standards: Analysis and Implications for the Banking Industry, 10 DICK. J. INT’L L. 189, 217 (1992). 291. Letter from Timothy F. Geithner, Secretary of the Treasury, to Keith Ellison, U.S. House of Representatives (Jan. 11, 2010), available at http://ellison.house.gov/images/ stories/Documents/2010/01-11-10_Treasury_Letter.pdf. Secretary Geithner supports including numerical requirements in regulatory, as opposed to statutory, text. See Leonhardt, supra note 3, at 36 (“‘We don’t know where the next crisis is going to come from,’ Geithner told me. . . . ‘So we want to build a much bigger cushion into the system against . . . basic human limitations. I don’t want a system that depends on clairvoyance or bravery.’”). 292. Arturo Estrella, Formulas or Supervision? Remarks on the Future of Regulatory Capital, FRBNY ECON. POL’Y REV., Oct. 1998, at 191, 195. 293. Id. at 194. 294. Id. at 195. 295. S. Raihan Zamil, Judgment Day, FIN. & DEV., Sept. 2010, at 44, 46 (emphasis omitted). regulators identify as risky and seek to correct. For example, regulators explain that “[h]istorically, enforcement actions increase as one would expect during periods of economic stress.”296 During the current economic downturn some banks undoubtedly experienced a decline in asset values297 and consequently a decline in capital ratios. If capital levels at troubled banks dropped dangerously low, it would be unsurprising for regulators to bring capital enforcement actions against those banks. If regulators expected more losses, they might impose individual bank minimum capital requirements.298 B. The Dangers of Discretion Regulatory discretion, however, is far from perfect. The very nature of discretionary enforcement and individual bank capital requirements may exacerbate problems in the banking industry as a whole. 1. Regulatory Ability Proponents of regulatory discretion likely put too much faith in regulators’ ability to fine-tune capital requirements to account for innovation, economic conditions, and individual bank concerns. This misplaced faith in regulatory discretion leads to inadequate statutory and regulatory capital requirements. As an initial matter, it is not clear that regulators appropriately use their discretion to respond to innovation. The formal capital enforcement action study shows very low rates of capital enforcement actions between 1994 and 2007.299 This low capital enforcement action rate cannot be attributed to a lack of innovation in the banking industry. During the same time period, the use of private-label mortgage-backed securities exploded, a sizeable subprime mortgage market developed, and credit default swaps and collateralized debt obligations became common.300 Although regulators had the authority to adjust capital requirements for 2012] banks engaging in these risky activities, regulators rarely used it.301 It appears that regulators failed to appreciate the risk and adjust capital requirements accordingly.302 It is also not clear that regulators appropriately use discretion to respond to economic conditions. Discretionary capital enforcement is prone to regulatory cycles. In other words, regulators are prone to underregulate during economic expansions and overregulate during (and immediately following) economic downturns.303 According to Professor Alan White, “[w]hen [economic conditions] are good . . . there’s a tendency to believe that they’ll just remain good, and regulation gets lax when it should get tough.”304 Professor White’s observation is consistent with the capital enforcement action study which shows few enforcement actions between 1993 and 2007, a period of economic expansion.305 Now that the economy is no longer expanding, some bankers believe that regulators, feeling political heat, are overreacting to the current economic downturn.306 While the formal capital enforcement action study cannot confirm this claim,307 it does not the Home Mortgage Foreclosure Crisis, 10 LOY. J. PUB. INT. L. 149, 158–59 ( 2009 ); Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Speech at the Federal Reserve System’s Sixth Biennial Community Affairs Research Conference: Financial Innovation and Consumer Protection (Apr. 17, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090417a.htm. 301. See supra Figure 4 and accompanying text; see also Ezra Klein, Don’t Trust the Regulators; Financial Reform Can’t Be Left to Those Who Failed Us Before, NEWSWEEK, Apr. 12, 2010, at 20 (“‘The story the regulators want to tell,’ says Richard Carnell, a former assistant secretary of the Treasury for financial markets, ‘[is] that they just needed more tools. But they can set capital requirements now. They had ample tools, and they lacked the prescience and will to use them.’” (alteration in original)). 302. See Hopkins, Regulatory Actions Hit a Record Level in ’09, supra note 183, at 1 (quoting economist Chris Low as stating that “[t]he regulators were asleep for 10 years during the [economic] boom”); Leonhardt, supra note 3, at 36 (“When times were good over the previous decade, Fed officials—and not just Alan Greenspan—neglected to use the powers they did have.”). 303. A variety of articles discuss the phenomenon of regulatory cycles. See, e.g., John C. Coffee, Jr., Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight, 111 COLUM. L. REV. 795, 815–22 ( 2011 ); Erik F. Gerding, The Next Epidemic: Bubbles and the Growth and Decay of Securities Regulation, 38 CONN. L. REV. 393, 423–24 (2006); Larry E. Ribstein, Bubble Laws, 40 HOUS. L. REV. 77 ( 2003 ); David Zaring, A Lack of Resolution, 60 EMORY L.J. 97, 117–20 (2010). 304. Joe Adler, In Reports on Failures, Regulators Also Fail: IGs Find Examiners Uncover Problems, But Don’t Fix Them, AM. BANKER, Apr. 15, 2009, at 1. 305. See supra Figure 2. 306. Hopkins, Regulatory Actions Hit a Record Level in ’09, supra note 183, at 1 (“‘There is a consistent comment for regulators that the pendulum has swung too far,’ said Diane Casey-Landry, senior executive vice president and chief operating officer of the American Bankers Association. ‘No one is asking for easy supervision, but we need a balance. The pendulum has swung too far, and it’s inhibiting not only banks’ ability to lend, but to manage their business.’”). 307. Because the formal capital enforcement study did not consider data about the financial condition of the banks subject to enforcement actions, the study cannot tell whether regulators have increased their capital standards during the financial crisis. The study also does not attempt to determine the optimal bank capital requirements. Therefore, it is negate it either. At a minimum, the study shows a procyclical increase in enforcement actions.308 Next, it is not appropriate to think of bank examiners as carefully adjusting each bank’s capital requirements after considering each and every circumstance that might make that bank unique. To see why, consider the analogous situation of an insurance adjustor handling a claim after a multiple-car traffic accident.309 In deciding which party should pay for the accident, the adjustor might turn to tort law. Tort law, however, is complicated and nebulous. Professor H. Laurence Ross explained that instead of carefully studying the particular circumstances of each accident, insurance adjusters develop rules of thumb to process claims.310 For example, adjusters adopt a rule that in rear-end collisions, the driver in the back car is liable.311 The rules of thumb are more easily administered and usually lead to the same result that a complete tort law analysis would achieve. Thus, the rules of thumb are an efficient way to process a myriad of claims. If, however, the case is extraordinarily large or particularly unique, adjusters may have to abandon the rules of thumb and return to the traditional tort law analysis.312 Bank regulators, like insurance adjusters, are tasked with evaluating individual bank circumstances in light of a complicated and sometimes nebulous body of law.313 They are guided by regulatory capital ratios and minimums, but they are empowered to take any action necessary to preserve “safety and soundness.”314 Because there is no regulatory formula for assessing safety and soundness, regulators develop rules of thumb to evaluate the capital adequacy of each bank. The internal regulatory policies memorialized in handbooks and manuals are rules of thumb; they do not have the legal effect of statutes or regulations.315 In addition, regulators likely use rules of thumb that are not memorialized in publicly available material. The individual bank minimum capital requirements contained in the formal capital enforcement actions seem to hint that regulators employ non-public rules of thumb. Although regulators have virtually unbounded discretion in choosing how to express an individual bank minimum capital requirement, regulators most often include a leverage ratio—the most simple of the regulation-defined capital measurements.316 Similarly, the different approaches to capital enforcement among regulators suggest that different regulators may have impossible to determine whether current regulators are overzealous. 308. See supra Part II.C.2. Professor David Zaring found that regulators’ decisions to close financial institutions follow a similar procyclical pattern. Zaring, supra note 303. 309. See H. LAURENCE ROSS, SETTLED OUT OF COURT: THE SOCIAL PROCESS OF INSURANCE CLAIMS ADJUSTMENTS 96–101 (1970). 310. Id. at 99. 311. Id. at 98–99. 312. See id. at 135. 313. Others have noted that “rules of thumb” appear in many areas. See, e.g., Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does–Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 EMORY L.J. 83 (2002); Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 24–27 ( 2003 ); Hillary A. Sale, Judging Heuristics, 35 U.C. DAVIS L. REV. 903 (2002). 314. See supra Part I. 315. See supra note 79 and accompanying text. 316. See supra notes 218–20 and accompanying text. 2012] adopted different rules of thumb concerning capital adequacy.317 Finally, the near absence of enforcement actions issued to the largest banks may indicate that regulators depart from rules of thumb when the safety and soundness of a very large bank is at issue.318 Rules of thumb allow bank regulators to efficiently evaluate capital adequacy concerns at more than 7000 banks. But, as with capital regulations themselves, rules of thumb likely result in incorrect assessments in at least some cases.319 This is not to suggest that bank regulators are lazy, daft, or corrupt. Rather, it is to suggest that predicting the long-term economic consequences of financial innovations is difficult business. Even the brightest regulators (especially those regulators focusing only on the financial condition of a single bank) may overlook potential problems. Then, when facing previous mistakes, they may overreact. Moreover, fine-tuning capital requirements for each of the more than 7000 U.S. banks is a daunting task. A system that expects regulators to use their discretion to instantly react to innovations and changes occurring at an individual-bank level expects too much. Unrealistic expectations about discretionary enforcement are problematic not only because the discretionary regulation itself falls short, but also because the expectations divert attention from establishing sufficient statutory and regulatory standards. Congress has declined to put stringent capital requirements in banking statutes, instead relying on regulators to correct capital problems through administrative rulemaking. For example, the prompt corrective action statute, adopted in 1991, relies on bank regulators to establish minimum capital levels.320 Similarly, the Dodd-Frank Act delegates the duty of establishing capital requirements to bank regulators.321 Unlike prior banking statutes, the Dodd-Frank Act does provide some guidance about the appropriate capital ratios; it specifies that new capital requirements must not be lower than previously established regulatory requirements.322 However, the clear suggestion from Congress was that regulators should establish higher capital requirements—higher requirements that Congress itself was unwilling to establish. In promulgating regulations, bank regulators show that they also rely on the false promises of discretionary enforcement. As explained in Part I, regulations 317. See supra Part II.C.4 (discussing the enforcement rates of different regulators). 318. See supra Part II.C.5 (discussing formal capital enforcement actions issued to the largest banks). 319. Cf. Mark Seidenfeld, Why Agencies Act: A Reassessment of the Ossification Critique of Judicial Review, 70 OHIO ST. L.J. 251, 260 n.22 ( 2009 ) (“In any case, regulators sometimes are not aware and have not evaluated the rules of thumb they use to optimize them for the decisions they face, and psychologists have demonstrated that individuals often use biased (i.e., non-optimal) rules of thumb.”). 320. See 12 U.S.C. § 1831o(b)( 2 )(G) (2006). 321. The Dodd-Frank Act requires the “Federal banking agencies [to] establish minimum leverage capital requirements on a consolidated basis for insured depository institutions.” 12 U.S.C.S. § 5371(b)( 1 ) (LexisNexis 2010); see also 156 CONG. REC. S5891 (daily ed. July 15, 2010) (statement of Sen. Judd Gregg) (“It isn’t constructive for the Congress to set arbitrary capital rules. That should be left to the regulators.”). 322. 12 U.S.C.S. § 5371(b)( 1 ). provide numerical minimum capital ratios but leave regulators significant discretion to adjust capital requirements on an individual-bank basis. Statements from bank regulators show that they believe the minimum capital ratios established by regulation are insufficient. A recent report from the federal bank regulators to Congress states: The federal banking agencies have substantially similar capital adequacy standards. These standards employ a common regulatory framework that establishes minimum leverage and risk-based capital ratios for all banking organizations (banks, bank holding companies, and savings associations). The agencies view the leverage and riskbased capital requirements as minimum standards, and most institutions are expected to operate with capital levels well above the minimums, particularly those institutions that are expanding or experiencing unusual or high levels of risk.323 Rather than adopt regulations that set generally applicable capital requirements, regulators seem to be relying on discretionary enforcement to ensure that most banks have capital well above the regulatory requirements. We are left with a regulatory structure that relies on discretion to establish capital requirements for many banks. Because numerical capital requirements are not established by statute and are set intentionally low by regulations, when discretion fails, capital regulation becomes ineffective. Instead, policymakers should recognize the shortcomings of regulatory discretion and develop statutes and regulations with conservative capital requirements. 2. Ambiguity and Cost The second problem with discretionary capital enforcement is that it leads to ambiguous capital requirements that are costly for banks to implement. When capital requirements are established by statute or regulation, a bank can readily identify the amount of capital it should maintain to satisfy the law. When regulators set capital requirements through formal or informal capital enforcement actions, banks have a difficult time assessing the amount of capital their regulators might require. This can be costly not only for a bank receiving an enforcement action, but also for the economy as a whole. Regulation by enforcement is generally thought to be more costly than regulation by rule.324 Regulators expend significant resources examining banks to determine the amount of capital required.325 Although most formal capital enforcement actions are entered by consent, they are still expensive. Such an action 323. Joint Report: Differences in Accounting and Capital Standards Among the Federal Banking Agencies, 75 Fed. Reg. 47,900, 47,901 (Aug. 9, 2010) (emphasis added). 324. See Edward Brunet, Blending State and Federal Administrative Law, 75 CORNELL L. REV. 366, 366 ( 1990 ) (book review) (noting that “adjudication is a comparatively costly mode of regulation”). 325. Although careful regulatory examinations would still be required with clear capital rules, the effort spent by regulators might be more efficiently directed with clear rules. 2012] can cost a “$100 million community bank . . . between $750,000 and $1 million in additional expenses, including hiring outside consultants, regulatory counsel and increased FDIC insurance premiums.”326 In addition, banks faced with higher capital requirements bear the costs of raising additional capital or shrinking asset portfolios.327 Raising capital after receiving a formal capital enforcement action can be particularly difficult.328 Some investors may worry that future losses could lead to enforcement actions, additional capital issuances, or even bank closure.329 Other investors might prefer to delay investment until a bank has failed, hoping to get a better deal from the FDIC.330 Discretionary capital enforcement also leads to ambiguous rules.331 As the number of banks subject to capital enforcement actions increases, ambiguity increases. Some bankers complain that current capital requirements are indecipherable. According to one observer: Ask a bank CEO which capital standards his regulators care most about, and what minimum levels they’re insisting on, and he’ll look as if you’d ask him to count to 100 in Mandarin. He won’t have a clue. But you can’t blame the poor guy. These days, banks don’t know what capital standards they’re supposed to be operating under. Yes, regulators have published official numbers. But in the wake of the financial crisis, they’re also whispering new, much higher, “guidance” that they’re “encouraging” bankers to follow. What’s a banker supposed to do?332 Others have described individual bank capital requirements as “arbitrary,” “frustrating,” and “confusing.”333 Banks can glean some information by carefully reviewing formal capital enforcement actions. However, this time consuming process does not reveal any precise rules of thumb that regulators employ. Formal enforcement actions do not explain, for example, why regulators might choose to require a 12% leverage ratio instead of a 10% leverage ratio. Furthermore, past enforcement actions do not necessarily predict regulators’ future enforcement actions. Regulators might adjust their rules of thumb to account for changing conditions or newly discovered information. At best, a review of existing actions, like this Article, provides only a general picture of regulators’ past enforcement efforts.334 Uncertainty created by enforcement can lead to a misallocation of credit and capital. If banks have only a vague notion about the amount of capital their regulators might require, banks will have difficulty planning to meet those requirements.335 Particularly during an economic downturn (when banks fear increased capital enforcement actions), banks may respond to ambiguous capital requirements by holding more capital than necessary.336 In order to accommodate this capital hoarding, banks may restrict credit in an inefficient manner.337 333. Chris Serres, Tough Times Prod Tougher Oversight of State Banks; Regulators Are Changing How They Define Healthy Institutions, Forcing Some Hard Adjustments, STAR TRIB. (Minneapolis), Aug. 1, 2009, at 01D (“We’ve read a few out-of-state (enforcement actions) that call for a 12 percent ratio . . . . We all as an industry have to play by the rules. But in the interim, it’s a little confusing.” (omission in original) (quoting Adam Dittrich, President and CEO, Americana Bank)); Why Healthy Banks Need to Raise More Capital Than Ever, BANK SAFETY & SOUNDNESS ADVISOR, July 19, 2010, at 1 (“[Tad Gage, executive vice president of Capital Insight Partners in Chicago] says the situation is frustrating for bankers. ‘What is the [capital] standard? There doesn’t seem to be one.’”); Brown, supra note 332 (“[R]egulators seem to be making up minimum capital ratio requirements, that vary from bank to bank, as they go along. It is a picture of total arbitrariness, the exact opposite of what smart regulation is supposed to be about.”); Stuart Dobson, How to Fix the So Called Banking Crisis in the U.S., COM. NOTE BROKERS (June 28, 2010), http://www.commercialnotebrokers.com/blog/how-to-fix-the-so-called-bankingcrisis-in-the-u-s/. 334. The problem is even more acute when regulators set capital requirements using informal, rather than formal, actions. Then banks must rely on communication with their regulator and gossip collected from bank peers and industry publications. 335. See Norton, supra note 229, at 1357. According to Professor Norton: In the capital adequacy area . . . regulatory transparency is of particular importance. With the inherent definitional problems with bank capital, the assessment complexities involved with bank capital adequacy, and the confidentiality and subjectivity surrounding capital adequacy on the examination level, it is difficult, without open and uniform regulations, for all affected parties to be able to assess intelligently and prudently the impact of such supervisory practices. Id. 336. See Justin Baer & Francesco Guerrera, Regulators Tell Banks to Retain Their Funds, FIN. TIMES (London), Mar. 10, 2010, at 1 (reporting that regulators urged banks to hold capital until the banks learned whether capital requirements would be increased); David Reilly, Don’t Bank on Lenders Just Yet, WALL ST. J., June 28, 2010, at C10 (“Until there is 2012] It is difficult to determine whether the recent increase in discretionary capital enforcement has contributed to a misallocation of credit. There is evidence that banks have tightened lending standards and restricted the flow of credit during the current economic crisis.338 Some attribute the tight credit at least partly to capital enforcement actions.339 However, banks are probably also motivated by a general angst about their deteriorating loan portfolios and poor economic conditions.340 Untangling the precise credit impact of capital enforcement actions and individual bank minimum capital requirements would likely be difficult. At any rate, a significant amount of discretionary capital enforcement activity is costly for banks and has the potential to confuse capital standards and misallocate greater clarity on capital, banks are unlikely to return cash to shareholders and might remain wary of lending too aggressively.”). Because raising capital is costly, and can be even more costly during economic downturns, most banks would prefer to maintain capital levels rather than attempt to raise external capital when required by their regulators. See id. 337. See David Enrich, Robin Sidel & Deborah Solomon, Fed Sees Up to $599 Billion in Bank Losses, WALL ST. J., May 8, 2009, at A1; Heather Scoffield, Leaders Launch New Push in Face of Global Recession, GLOBE & MAIL (Toronto), Nov. 10, 2008, at B1 (stating that “[i]f leaders can show financial institutions that they don’t plan to increase capital requirements during the downturn . . . then banks don’t have to hoard, and can start lending again”). There is some debate among economists about whether a bank’s mix of debt and capital influences the bank’s lending decisions. Those who believe that capital has little effect on lending often root their view in the Modigliani-Miller theorem, which holds that in a perfect market, a company’s decision to use debt or equity financing will have no effect on the company’s profits. See generally Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261 (1958) (establishing the Modigliani-Miller theorem); Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig & Paul Pfleiderer, Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive 2 (Rock Ctr. for Corp. Governance at Stanford Univ., Working Paper No. 86, 2011), available at http://ssrn.com/abstract=1669704 (arguing that bank “equity requirements need not interfere with any of the socially valuable activities of banks, including lending”); Skander J. Van den Heuvel, Does Bank Capital Matter For Monetary Transmission?, 8 FRBNY ECON. POL’Y REV. 259, at 259 (2002) (noting that under the Modigliani-Miller theorem “the bank will always be able to find investors willing to finance any profitable lending opportunities, the level of bank capital is irrelevant to lending”). Many economists, however, reject the Modigliani-Miller assumption of perfect markets and conclude that higher capital requirements lead to less lending. Indeed the Peek-Rosengren Study found that banks that received formal capital enforcement actions trimmed their asset portfolios and reduced lending after receiving the action. Peek & Rosengren, supra note 136, at 21–23; see also Joe Peek & Eric Rosengren, Bank Regulation and the Credit Crunch, 19 J. BANKING & FIN. 679 (1995); Joe Peek & Eric S. Rosengren, Crunching the Recovery: Bank Capital and the Role of Bank Credit, in REAL ESTATE AND THE CREDIT CRUNCH, FED. RESESERVE BANK OF BOS. CONFERENCE SERIES NO. 36, 151, at 151–71 (Lynn E. Browne & Eric S. Rosengren eds., 1992). 338. Michael R. Crittenden & Tom Barkley, Regulators to Banks: Loan to Small Firms, WALL ST. J., Feb. 6, 2010, at B4. 339. See Brown, supra note 332. 340. See Julie Andersen Hill, Bailouts and Credit Cycles: Fannie, Freddie, and the Farm Credit System, 2010 WIS. L. REV. 1, 6–9 (discussing lending and credit cycles). credit. Meaningful capital standards set by statute or regulation would be less costly and more transparent.341 3. Myopia Finally, discretionary capital enforcement is dangerous because it encourages a regulatory myopia that focuses on the financial condition of individual banks. Bank regulators have two primary responsibilities: ( 1 ) ensuring that the banking system as a whole operates efficiently, and ( 2 ) ensuring that individual banks are safe and sound. This is most clearly seen with the Federal Reserve, which administers monetary policy and acts as a central bank in addition to supervising some banks and bank holding companies.342 While the other federal regulators are sometimes thought to focus more on the safety and soundness of individual banks, they also are often expected to consider the function of the banking system as a whole. For example, the mission of the FDIC is “to maintain stability and public confidence in the nation’s financial system by: insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.”343 Often the responsibilities of overseeing individual and collective bank health are complimentary—that is, by keeping individual banks safe, regulators promote health in the entire banking system. Sometimes, however, there is tension between these two responsibilities.344 For example, during an economic downturn a regulator might reasonably require an individual bank to increase its capital ratios.345 After all, increased capital ratios will make that bank more able to bear loan losses. However, to achieve the higher capital ratio the bank might reduce lending.346 Taken alone this action is probably not significant. But if each regulator raises capital levels and each bank responds by restricting lending, the collective 2012] action might exacerbate economic downturns and destabilize the overall banking system.347 The trouble is that formal capital enforcement actions typically germinate during a bank examination. During the bank examination, a team of bank examiners makes a determination about whether the bank has sufficient capital and considers what remedial measures might be appropriate.348 Yet, these bank examiners, who are tasked with evaluating the capital levels of individual banks, have little incentive to consider the macroeconomic impact of their decisions. An examiner may be criticized if the bank he or she examined ultimately fails, but an individual examiner is unlikely to be blamed for the state of the economy or the banking system as a whole. Regulators might note that field office examiners are generally not given authority to issue formal capital enforcement actions. According to the FDIC, “[a]ll FDIC formal enforcement actions are reviewed by a number of high-level FDIC officials both prior and subsequent to their initiation.”349 While review above the field-examiner level is certainly helpful, it likely does not ameliorate the problem. At the FDIC, the “high-level” official reviewing and approving a formal enforcement action is often a regional director or regional counsel.350 FDIC decision making proceeds to the Washington office of the regulator primarily when the regulated bank requests a hearing on the matter.351 This means that, as a practical matter, regulatory officials with broad powers and responsibilities approve only a tiny fraction of formal capital enforcement actions.352 Regulatory decisions about formal enforcement actions are made mostly by those whose principal task is ensuring individual bank safety and soundness. Although the formal capital enforcement action study does not conclusively show that regulators have increased capital requirements through discretionary enforcement, it does raise concerns about regulatory myopia. The study shows a striking increase in the number of banks subject to individual bank minimum capital requirements. These requirements are implemented by examiners whose duty is to consider the health of individual banks.353 In contrast, legislative and 347. See generally Ben Bernanke & Mark Gertler, Agency Costs, Net Worth, and Business Fluctuations, 79 AM. ECON. REV. 14 (1989) (describing the “credit multiplier” effect). 348. See FDIC, ACTIONS PROCEDURES MANUAL, supra note 79, at 1-7 (“The FDIC’s first line of supervision is the field examiner staff. The . . . manuals of examination policy require examiners to describe any problems detected during examinations of financial institutions and to recommend appropriate corrective action.”); OCC, PPM 5310-3, supra note 79, at 11 (“Generally, the [Examiner in Charge] is responsible for initially recommending the use of an enforcement action to address problems and concerns identified in assigned banks.”). 349. Guidelines for Appeals of Material Supervisory Determinations, 73 Fed. Reg. 54,822, 54,824 (Sept. 23, 2008). 350. FDIC, ACTIONS PROCEDURES MANUAL, supra note 79, at 5-24 to 5-29, 6-12 to 6-15. 351. For example, Washington office approval is required if a bank requests a hearing on a cease-and-desist order or if a bank appeals the issuance of a prompt corrective action directive. Id. 352. See supra note 202 and accompanying text. 353. See supra Part I.B.1 (explaining the regulatory process for formal capital enforcement actions). rulemaking processes force regulators to consider and publicly address how increased capital requirements could affect overall lending and economic recovery. Because rulemaking considers a wider variety of interests, it should be the preferred method of setting capital requirements. C. Balancing Rules and Discretion Given the problems associated with discretionary capital enforcement, it makes sense to consider the appropriate balance between capital regulation by rule and capital regulation by enforcement. Both types of regulation have appeal. Rules are clear, provide certainty, and can be crafted to consider macroeconomic concerns. On the other hand, enforcement has some capacity to identify and correct truly unique situations at individual banks. In addition, regulation by enforcement might discourage banks from deliberate attempts to skirt regulations established by rule. What then is the appropriate balance? Part III.B suggests that in some respects reliance on discretionary enforcement may have gone too far. As regulators adopt new capital rules, efforts should be taken to define by rule some items previously left for discretionary enforcement. First, regulations should include real capital minimums. There is little sense in adopting minimum rules if every bank is required to maintain more than the minimum amount of capital all of the time.354 Unless the regulatory rules have some application, they do not provide clarity or certainty. Second, to the extent regulators rely on rules of thumb to assess capital adequacy, these rules of thumb should be included in regulation or at least publicly disclosed to banks.355 Unless banks have a clear understanding of capital rules, they may hoard capital and restrict lending,356 or they may undercapitalize and force regulators to undertake expensive enforcement actions.357 Both scenarios make bank regulation unnecessarily costly. Moreover, if regulators disclose rules of thumb, banks and policymakers can more effectively identify differences in capital enforcement among regulators. Third, regulations should be designed to adjust to changing economic conditions without relying on discretionary enforcement. Regulators have been nearly universal in their calls for countercyclical capital requirements—that is, capital requirements that are lower during economic downturns and higher during economic booms.358 While it might be tempting to rely on discretionary 354. See supra note 323 and accompanying text (discussing regulator statements that most banks should maintain capital in excess of regulatory capital ratios). 355. See supra Part III.B.1 (discussing regulators’ use of rules of thumb). 356. See supra notes 335–37 and accompanying text. 357. See supra notes 324–26 and accompanying text. 358. Modernizing Bank Supervision and Regulation—Part I: Hearing Before the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 64, 86 (2009) (statements of Sheila C. Bair, Chairman, FDIC and Scott M. Polakoff, Acting Dir., OTS); Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Financial Regulation and Supervision After the Crisis: The Role of the Federal Reserve, Speech at the Federal Reserve Bank of Boston 54th Economic Conference (Oct. 23, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20091023a.htm. 2012] enforcement to adjust capital in light of economic conditions, the Dodd-Frank Act requires that regulators “seek to make the capital standards . . . countercyclical so that the amount of capital required to be maintained by an insured depository institution increases in times of economic expansion and decreases in times of economic contraction, consistent with the safety and soundness of the insured depository institution.”359 It is wise to put countercyclical requirements in regulations. Countercyclical capital requirements are meant to address macroeconomic concerns.360 They can help maintain lending during an economic downturn, even as banks experience losses. Bank examiners making decisions about individual bank health and imposing discretionary enforcement are not well positioned to consider or implement policies guided by macroeconomic concerns.361 In drafting regulations, regulators should be mindful that the discretionary enforcement authority granted to examiners under their safety and soundness mandate is not allowed to overshadow countercyclical regulations. Fourth, if regulators believe that capital at the largest banks should be regulated differently, then regulations should specify which banks will be treated differently. Regulations should also provide the different capital requirements for each class of banks. Again, this would allow banks to plan to meet capital requirements. Furthermore, it would deflect criticism leveled by some smaller banks that “regulatory practices . . . often seem to disadvantage [community banks] and favor much larger institutions or even non-banks”362 for no apparent reason. Of course, even with more comprehensive regulations, there will still be a role for capital enforcement. Banks should still receive formal capital enforcement actions when their capital levels drop below levels specified in regulations. Moreover, regulators should still retain the power to issue discretionary actions and impose individual bank minimum capital requirements. These actions, however, should be limited to the small number of extraordinarily unique banks. If regulations were properly crafted, it would be unnecessary for regulators to issue hundreds of actions containing individual bank minimum capital requirements per year. Effective capital regulation relies on a mix of regulation by rule and regulation by enforcement. The formal capital enforcement action study presented in this 359. 12 U.S.C. § 3907(a)( 1 ) (2010). 360. See generally COMM. OF EUR. BANKING SUPERVISORS, POSITION PAPER ON A COUNTERCYCLICAL CAPITAL BUFFER ( 2009 ); FIN. SERV. AUTH., THE TURNER REVIEW: A REGULATORY RESPONSE TO THE GLOBAL BANKING CRISIS 53–62 ( 2009 ); MARKUS BRUNNERMEIER, ANDREW CROCKET, CHARLES GOODHART ET AL., THE FUNDAMENTAL PRINCIPLES OF FINANCIAL REGULATION 29–38 ( 2009 ); Charles W. Calomiris, Financial Innovation, Regulation, and Reform, 29 CATO J. 65, 80–84 (2009). 361. See supra Part III.B.3. 362. The Condition of Financial Institutions: Examining the Failure and Seizure of an American Bank: Hearing Before the Subcomm. on Fin. Insts. & Consumer Credit of the H. Comm. on Fin. Servs., 111th Cong. 64 (2010) (written testimony of Jeff Austin III, Chairman-Elect, Texas Bankers Ass’n). Article examines capital enforcement efforts as never before. It shows that an increasing number of banks are subject to capital enforcement actions. These actions often include individual bank minimum capital requirements that are significantly higher than the capital requirements established by regulations. The study suggests that different bank regulators may not have similar standards for selecting a type of action or imposing higher individual bank minimum capital requirements. Moreover, the study shows a near complete absence of capital enforcement actions issued to the largest banks. Because discretionary capital enforcement actions now appear to be a significant part of capital regulation, policymakers should carefully address the proper role of discretion in setting capital requirements. In general, rulemaking should be favored over discretionary enforcement because rulemaking is less costly, more transparent, and more likely to consider macroeconomic concerns. Nevertheless, discretionary capital enforcement may still be necessary to effectively regulate banks that do not meet the regulatory requirements or to set capital requirements for banks that are truly unique. Hearing Before the S. Comm. on Banking, Hous., and Urban Affairs, 112th Cong . 47 ( 2011 ) MEASUREMENT, STANDARDS AND MONITORING ( 2010 ), available at http://www.bis.org/publ/bcbs188.pdf. However, because Basel III focuses on internationally regulation for the thousands of U.S. banks that are not internationally active . Walsh, supra. 7 . George G . Kaufman, Capital in Banking: Past, Present and Future, 5 J. FIN . SERVICES RES . 385 , 385 ( 1991 ). 8. RICHARD SCOTT CARNELL , JONATHAN R. MACEY & GEOFFREY P. MILLER , THE LAW OF BANKING AND FINANCIAL INSTITUTIONS 252-53 (4th ed. 2009). 9. See infra Part I.A. 10. See infra Part I.B . 11 . 12 U.S.C. § 1818(b)(1) ( 2006 ). 12 . See Jean-Charles Rochet , Rebalancing the Three Pillars of Basel II, FRBNY ECON . POL'Y REV ., Sept . 2004 , at 7. 13. See infra Parts II.A and II.B (discussing existing academic studies of capital enforcement) . 14. See infra Part I. 15. See infra Part II. 17 . See infra Part III.C. 18 . Kaufman, supra note 7, at 385. 19. CARNELL, MACEY & MILLER, supra note 8 , at 252- 53 . 20 . Id . 21 . Id . 22 . See Robert Reilly & Aaron Rotkowski, The Discount for Lack of Marketability: Update on Current Studies and Analysis of Current Controversies, 61 TAX LAW . 241 , 265 ( 2007 ) (discussing the potential accounting, legal, administrative, and underwriting costs associated with raising external capital) . 23. CARNELL, MACEY & MILLER, supra note 8 , at 43-45; STEPHEN G. CECCHETTI, MONEY , BANKING , AND FINANCIAL MARKETS 102- 03 (2d ed. 2006 ). 24. CARNELL, MACEY & MILLER, supra note 8 , at 43-45; CECCHETTI, supra note 23, at 102- 03 . 25. CARNELL, MACEY & MILLER, supra note 8 , at 282. 26. Patricia A . McCoy , The Moral Hazard Implications of Deposit Insurance: Theory and Evidence, in 5 CURRENT DEVELOPMENTS IN MONETARY AND FINANCIAL LAW 417 , 422 (Int'l Monetary Fund Legal Dep't ed., 2008 ). 27 . See generally Sandra L. Ryon , History of Bank Capital Adequacy Analysis (FDIC Working Paper No. 69-4 , 1969 ) (discussing historical development of bank capital requirements in the United States) . 28 . About the OCC , OCC, http://www.occ.treas.gov/aboutocc.htm. 29. BD. OF GOVERNORS OF THE FED . RESERVE SYS. , THE FEDERAL RESERVE SYSTEM: PURPOSES & FUNCTIONS 59- 60 (9th ed. 2005 ). 30. Who is the FDIC? , FDIC http://www.fdic.gov/about/learn/symbol/Whois insured. 31. See Functions and Responsibilities of the Director of the Office of Thrift Supervision , 12 C.F.R. § 500 .1 ( 2009 ). 32 . 12 U.S.C.S. §§ 5401 - 52 (LexisNexis 2010 ). 33 . Id . §§ 311 - 12 . 34 . The Basel Committee on Banking Supervision has identified three “pillars” of CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK 2 ( 2006 ) (comprehensive version) , available at http://www.bis.org/publ/bcbs128.pdf. Discussion of the role of market discipline and public disclosures is beyond the scope of this Article. 89. In urgent circumstances, the regulator can issue an immediately effective prompt corrective action directive . 12 C.F.R . §§ 325 .105( b ), 308 .201 ( 2009 ) (FDIC); 12 C.F.R . §§ 208.45( b ), 263 .202( a)(2) (Federal Reserve); 12 C.F.R . § 6 .21 (OCC); 12 C.F.R . § 565 . 7 (OTS) . 90 . 12 U.S.C. § 1818(i); 12 C.F.R . § 308 . 204(a) (FDIC); 12 C.F.R . § 263 .205( a ) (Federal Reserve); 12 C.F.R . § 6 .25( a) (OCC); 12 C.F.R . § 565 . 10(a) (OTS ). 91 . See generally 12 U.S.C. § 1831o. 92 . See OCC , PPM 5310-3 , supra note 79, at 5 (noting that a prompt corrective action receivership”) . 93 . 12 U.S.C. § 3907 ( b)(2)(A ). 94 . 12 C.F.R. § 325 .6 ( FDIC ); 12 C.F.R . § 263 .83 ( Federal Reserve) ; 12 C.F.R. §§ 3 . 15 - 21 (OCC); 12 C.F.R . § 567 .4 ( OTS ). 95 . See FDIC v. Bank of Coushatta , 930 F.2d 1122 , 1126 ( 5th Cir . 1991 ). 96 . See id. at 1129; see also John C. Deal, Banking Law is Not for Sissies: Judicial Review of Capital Directives , 12 J.L. & COM . 185 ( 1993 ); Keith R. Fisher, Michael Roster, Basel ,” 13 FORDHAM J. CORP. & FIN . L. 139 , 175 ( 2008 ). 97 . 12 U.S.C. § § 1818(i)(1), 3907(b)(2)(B)(ii). 98 . FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 - 11 ; see also OCC, PPM 5310-3 , supra note 79, at 21 . 99. FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 - 11 . 100 . See OTS , supra note 79, at §§ 80 .8. 101. OCC, PPM 5310-3, supra note 79, at 21; LISSA L. BROOME & JERRY W. MARKHAM , REGULATION OF BANK FINANCIAL SERVICE ACTIVITIES 581 (4th ed. 2011 ). 102 . See Joseph T. Lynyak III , The Failing Bank Scenario-An Explanation and Suggested Analysis for a Bank's Board of Directors and Management, 126 BANKING L .J. 771 , 774 n. 7 ( 2009 ). 103 . 12 U.S.C. § 1818(b)(1) ( 2006 ). 104 . See id. §§ 1467 , 3907 (b)(1); FDIC, ACTIONS PROCEDURES MANUAL , supra note 79, at § 4-4 . 105 . 12 U.S.C. § 1818(b)(1 ). 106. Id . § 1818(c)(1 ). 107. Id . 108 . Id . § 1818(c)(2 ). 109. Id . § 1818(b)(1) . 110. See id. 111 . See James M. Rockett , Confronting a Regulatory Crisis: A View from the Trenches During Troubled Times , 126 BANKING L.J. 307 , 312 ( 2009 ) ; see also FDIC , ACTIONS PROCEDURES MANUAL, supra note 79 , at § 5 -5 (“To eliminate the need for time-consuming consent Order.”). 112. OCC, PPM 5310-3 , supra note 79, at 18-19; Rockett, supra note 111, at 312 . 113. 12 U.S.C. § 1818(i) . 114 . Id . § 1818(b)(1) . 115. FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 -4; see also FDIC, ACTIONS PROCEDURES MANUAL, supra note 79 , at § 5 -8 (“If the amount [of capital] justified based on the institution's condition . ”) . 116 . See FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at §§ 15 . 1 -1 to 15.1-14; FEDERAL RESERVE , supra note 79, § 5040 .1, at 1-2; OCC, PPM 5310-3, supra note 79, at 18- 21 ; OTS, supra note 79, at §§ 080 . 1 -.9. 117. See 12 U.S.C. § § 1818(b)(1), 1818(e)(1)(A)(i)(IV), 1818(i)(2)(A)(iv), 1818(u)(1)(A); see also 12 C.F .R. § 325 . 2(z) (FDIC). 118 . OTS, supra note 79, at §§ 080 . 7 -.8; see also FEDERAL RESERVE, supra note 79, § 5040. 1, at 3 (“The provisions of a written agreement may relate to any of the problems found at the bank . . . .”). 119 . See 12 U.S.C. § § 1818(b)(1), 1818(e)(1)(A)(i)(IV), 1818(i)(2), 1818(u)(1)(A); see also 12 C.F.R . § 325 . 2(z) (FDIC). 120 . CARNELL, MACEY & MILLER, supra note 8 , at 649; BROOME & MARKHAM, supra note 101, at 580-81 . 121 . See 12 U.S.C. § § 1818(b ), (i) . 122. FDIC, RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 - 11 ; see also CARNELL, MACEY & MILLER, supra note 8 , at 649 ( “[I]f the agency doubts that a written agreement will proceeding without attempting to secure a written agreement . ”) . 123 . FEDERAL RESERVE , supra note 79, § 5040 .1, at 3. 124. OCC, PPM 5310-3, supra note 79, at 19-20 (“ Often the semantic title difference is Formal Agreement .”). 125 . CARNELL, MACEY & MILLER, supra note 8 , at 644; see also Jerry L. Mashaw, Administrative Law , 57 U. PITT. L. REV . 405 , 420 - 21 ( 1996 ) (noting that “banking regulatory eyebrows,” as they can through formal regulation). 126 . FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 - 1 ; FEDERAL RESERVE, supra note 79 , § 5040 .1, at 6; OCC, PPM 5310-3, supra note 79, at 4; OTS, supra note 79, at § 080.5 . 127. FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 15 . 1 - 1 . 128. FDIC, ACTIONS PROCEDURES MANUAL, supra note 79 , at § 3- 2 . 129. FEDERAL RESERVE , supra note 79, § 5040 .1, at 6; OCC, PPM 5310-3, supra note 79, at 18; OTS, supra note 79, at § 080 .6; Rockett, supra note 111, at 311. FDIC guidance MANAGEMENT MANUAL, supra note 79 , at § 13 . 1 - 1 . 130 . See Federal and State Enforcement of Financial Consumer and Investor Protection Laws: Hearing Before the H . Comm. on Fin. Servs., 111th Cong . 65 - 66 ( 2009 ) (written testimony of John C. Dugan, Comptroller of the Currency); OCC , ANN. REP. 41 ( 2009 ); OCC , ANN. REP. 35 ( 2008 ). 131. FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 13 . 1 - 1 ; FEDERAL RESERVE, supra note 79 , § 5040 .1, at 6; OCC, PPM 5310-3, supra note 79, at 18; OTS, supra note 79, at § 080.5 . 132. FDIC, ACTIONS PROCEDURES MANUAL, supra note 79 , at § 1- 4 . 133 . See FDIC , ANN. REP . 26 ( 2009 ); FEDERAL RESERVE, 96 ANN. REP . 109 ( 2009 ); OCC, ANN. REP . 40 ( 2010 ). 134. FEDERAL RESERVE , supra note 79, § 5040 .1, at 6. 135. FDIC , RISK MANAGEMENT MANUAL, supra note 79 , at § 13 .1 -1 (stating that where they warrant formal administrative action”); FEDERAL RESERVE , supra note 79, § 5040. 1, at 6 (“Informal supervisory tools are used when circumstances warrant a less severe form of action . . . .”); OCC, PPM 5310-3 , supra note 79, at 4 (“When a bank's overall 253. As of June 30, 2010 , the ten largest banks as measured by total domestic deposits http://www2.fdic.gov/sod/ (linking to Summary Tables, which provides a table for the Top 50 Commercial Banks and Savings Institutions by Deposits) (June 30, 2010 report) . 254 . The 10 largest banks hold $3.25 trillion of the $7.75 trillion domestic deposits . Id . 255 . The 50 largest banks hold $4.89 trillion of the $7.75 trillion domestic deposits . Id. 256. Id. (June 30, 2008 report) . 257. Peter S. Goodman & Gretchen Morgenson , Saying Yes to Anyone, WaMu Built Empire on Shaky Loans , N.Y. TIMES , Dec. 28 , 2008 , at A1; Sidel et al., supra note 232 , at A1. 258. Summary of Deposits, supra note 253 (June 30 , 2008 report) . 259. David Enrich & Dan Fitzpatrick , Wachovia Chooses Wells Fargo, Spurns Citi, WALL ST. J. , Oct. 4 , 2008 , at A1. 260. Sudeep Reddy , Bernanke Eases Bank-Nationalization Fears, WALL ST . J., Feb . 25 , 2009, at A2. 261. HENRY M. PAULSON , JR., ON THE BRINK: INSIDE THE RACE TO STOP THE COLLAPSE OF THE GLOBAL FINANCIAL SYSTEM 358-68 ( 2010 ) (describing the meetings that lead to the Emergency Economic Stabilization Act of 2008 , Pub. L. No. 110 - 343 , 122 Stat. 3765 . 262. BD. OF GOVERNORS OF THE FED . RESERVE SYS. , THE SUPERVISORY CAPITAL ASSESSMENT PROGRAM: DESIGN AND IMPLEMENTATION ( 2009 ); David Wessel, Capital: What Testing Banks Will Tell Us About Their Health , WALL ST. J., May 7 , 2009 , at A2. 263. BD. OF GOVERNORS OF THE FED . RESERVE SYS. , THE SUPERVISORY CAPITAL ASSESSMENT PROGRAM: OVERVIEW OF RESULTS 9 ( 2009 ); Damian Paletta & Deborah Solomon , More Banks Will Need Capital WALL ST. J. , May 5 , 2009 , at A1; Deborah Solomon , David Enrich & Damian Paletta , Banks Need at Least $65 Billion in Capital, WALL ST. J. , May 7 , 2009 , at A1. 264. See generally NEIL M. BAROFSKY, SPECIAL INSPECTOR GENERAL FOR THE TROUBLED INC. ( 2011 ) (describing Citigroup's financial condition and the government's effort to prevent its failure) . 265. Summary of Deposits, supra note 253 . The list for 1993, the first year for which significant overlap on the Top 50 lists from year to year, it is likely that little is lost by the unavailability of the 1993 list. 266 . In re Providian Nat'l Bank, Order No. OCC-2001-98 (Nov. 21 , 2001 ). 267 . Id . 268 . Summary of Deposits, supra note 253 (June 30 , 2001 report) . 269. In re Colonial Bank, Order No. FDIC-09-125b (June 15 , 2009 ). 270 . Id . 271 . Summary of Deposits, supra note 253 (June 30 , 2009 report). In 2008 , Colonial Bank was the forty-ninth-largest bank . Id. (June 30, 2008 report) . 272. Although the largest banks did not receive formal capital enforcement actions, they N.A. , Order No. OCC-2010-239 (Dec. 7 , 2010 ) (written agreement concerning “the organizations”); In re Bank of America, N.A. , Order No. OCC-2005-10 (Feb. 9 , 2005 ) No. OCC- 2003 -77 (July 28 , 2003 ) (written agreement concerning complex financial transactions with Enron) . 273. See supra notes 163-64 and accompanying text. 274. See Peek & Rosengren, supra note 136 , at 19 . 275. Id . 276 . See generally Geoffrey P. Miller , Legal Restrictions on Bank Consolidation: An Economic Analysis , 77 IOWA L. REV. 1083 ( 1992 ) (arguing that geographic diversification of assets at large banks promotes safety and soundness) . 277 . Quarterly Banking Profile Time Series Spreadsheet: Ratios by Asset Size Group, FDIC , http://www2.fdic.gov/qbp/timeseries/RatiosByAssetSizeGroup.xls (last visited Aug . 19, 2011 ). The differences are less for other capital measures . In the fourth quarter of 2010 , banks with assets of more than $10 billion had an average tier 1 risk-based capital ratio of 12.23% compared with 12.71% for banks with assets of less than $100 million . Id. 278 . Peek & Rosengren, supra note 136, at 18 . 279. Binyamin Appelbaum , Big Banks to Pay Larger Share of FDIC Levy-Fees to Replenish Fund Altered After Protest by Small Institutions, WASH . POST, May 23 , 2009 , at A13. 280. See supra notes 261-65 and accompanying text. 281 . See generally Joseph J. Norton , A Perceived Trend in Modern International Financial Regulation : Increasing Reliance on a Public-Private Partnership, 37 INT'L LAW. 43 , 50 - 51 ( 2003 ) (“The safety and soundness of elite banks is enormously important to the crisis. See Dan Fitzpatrick , U.S. Regulators to BofA: Obey or Else, WALL ST . J., July 16 , 2009, at C1. 282. In conjunction with the stress tests conducted on the 19 largest bank holding Fitzpatrick , Fed Poised to Ease Its Grip on Banks, WALL ST . J., Mar . 18 , 2011 , at C1. This type of restriction is commonly seen in formal capital enforcement actions . 283 . 32 CHARLES ALAN WRIGHT & CHARLES H. KOCH , JR., FEDERAL PRACTICE & PROCEDURE: JUDICIAL REVIEW OF ADMINISTRATIVE ACTION § 8123 ( 2006 ) (“The choice decision of rulemaking is generally left to the agency . ” (footnote omitted)) . 284 . See generally JERRY L. MASHAW & DAVID L. HARFST, THE STRUGGLE FOR AUTO SAFETY (1990); Jerry L. Mashaw & David L. Harfst , Regulation and Legal Culture: The Case of Motor Vehicle Safety, 4 YALE J. ON REG . 257 ( 1987 ). 285 . Robert G . Bone, Who Decides? A Critical Look at Procedural Discretion, 28 CARDOZO L. REV . 1961 , 1962 ( 2007 ). 286. Andrew P. Morriss , Bruce Yandle & Andrew Dorchak , Choosing How to Regulate, 29 HARV. ENVTL . L. REV. 179 ( 2005 ). 287 . See ROBERTA S. KARMEL, REGULATION BY PROSECUTION: THE SECURITIES AND EXCHANGE COMMISSION VS. CORPORATE AMERICA ( 1982 ) ; Jonathan R. Macey , Wall Street in Turmoil: State-Federal Relations Post-Eliot Spitzer, 70 BROOK. L. REV. 117 , 128 - 30 ( 2004 ); James J. Park , The Competing Paradigms of Securities Regulation , 57 DUKE L.J. 625 ( 2007 ); the Next Decade, 7 YALE J. ON REG . 149 , 149 ( 1990 ). 288 . See generally David Jones, Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues , 24 J. BANKING & FIN. 35 ( 2000 ). 289 . See DANIEL K. TARULLO , BANKING ON BASEL: THE FUTURE OF INTERNATIONAL FINANCIAL REGULATION 80-82 ( 2008 ) (cataloguing various types of regulatory arbitrage 296 . Hopkins , Regulatory Actions Hit a Record Level in '09, supra note 183, at 1 (quoting Kevin Murkri , OCC spokesman) . 297 . The current financial crisis is attributable, at least partly, to decreasing real estate securities. See generally Douglas W. Arner, The Global Credit Crisis of 2008: Causes and Consequences , 43 INT'L LAW . 91 ( 2009 ). All of these items would negatively impact a bank's balance sheet . 298. See , e.g., The Condition of Financial Institutions: Examining the Failure and Credit of the H . Comm. on Fin. Servs., 111th Cong . 101 ( 2010 ) (written testimony of quality to hold higher capital levels to compensate for their risk profile . ”) . 299 . See supra Figure 2 and accompanying text . 300. See Eric Bruskin, Anthony B. Sanders & David Sykes , The Nonagency Mortgage SECURITIES 5 , 9 - 10 ( Frank J. Fabozzi , Chuck Ramsey & Michael Marz eds., 2d ed. 2000 ); Frank Partnoy & David A. Skeel , Jr., The Promise and Perils of Credit Derivatives , 75 U. CIN. L. REV . 1019 , 1019 - 23 ( 2007 ); Christopher L. Peterson, Fannie Mae, Freddie Mac, and 326. What an Enforcement Order Will Cost Your Bank , BANK SAFETY & SOUNDNESS ADVISOR , Nov. 22 , 2010 , at 1. For larger banks, enforcement actions are probably even more costly. See id. at 5 (noting that a $348.6 million community bank spent between $1 million and $2 million on a cease-and-desist order ). 327 . See Cocheo, supra note 215 , at 27 , 32 . 328. See Cheyenne Hopkins, Regulators Order an Ohio Thrift , Parent to Improve, AM. BANKER , Aug. 14 , 2008 , at 3 (“[I]n the current [poor economic] environment, [cease-and- desist] orders could make it more difficult for . . . thrift[s]” to raise capital.). 329 . See Steve Cocheo, Stack That Capital: Period of Turmoil Has Banks Looking for Capital Where and How They Can Find It , A.B.A. BANKING J. , Sept . 2008 , at 26 . 330. During 2008 and 2009, the FDIC often entered loss-sharing agreements with the U.S. on Hook for Billions, WALL ST . J., Aug . 31 , 2009 , at A1. These agreements often Brian Olasov , Help Salvageable Banks, AM. BANKER, May 25 , 2010 , at 8 (“[I]nvestors prefer to negotiate over the carcass of an institution post-failure . ”) . 331 . See Lars Noah, Administrative Arm-Twisting in the Shadow of Congressional Delegations of Authority , 1997 WIS. L. REV. 873 , 936 (“ Undue reliance on individualized exercise of agency discretion.”) (citations omitted) . 332 . Tom Brown, Confusion Reigns About Banks' Minimum Capital Requirements, SEEKING ALPHA (Nov. 17 , 2009 ), http://seekingalpha.com/article/173735-confusion-reigns- about-banks-minimum-capital-requirements (emphasis omitted). 341. Indeed, if regulators are using rules of thumb to evaluate capital levels, there seems to be little lost in informing banks of those rules of thumb . 342. See BROOME & MARKHAM, supra note 101, at 134-35, 156 . 343. FDIC Mission, Vision, and Values, FDIC (May 4 , 2009 ), http://www.fdic.gov/ about/mission/index.html. 344. See Anna Gelpern, Financial Crisis Containment , 41 CONN. L. REV. 1051 , 1075 ( 2009 ); Richard J. Herring, The Known, the Unknown, and the Unknowable in Financial Policy: An Application to the Subprime Crisis, 26 YALE J . ON REG . 391 , 401 - 02 ( 2009 ); Financial Regulation , 39 U. MEM. L. REV . 881 , 883 - 84 ( 2009 ) (“In the wake of the current Enforcement of Systemic Risk Regulation , 43 CREIGHTON L. REV. 993 , 996 ( 2010 ) (“The 2008 Financial Crisis , however, challenged the assumption that systemic risk could be 'micro-prudential' approach to regulation ). ”). 345. See supra notes 297-98 and accompanying text. 346. See Joe Peek & Eric Rosengren, The Capital Crunch: Neither a Borrower Nor a Lender Be , 27 J. OF MONEY, CREDIT & BANKING 625 , 625 - 26 ( 1995 ); Is 12 the New 10?, supra note 214 , at 1. But see supra note 337 and accompanying text.


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Julie A. Hill. Bank Capital Regulation by Enforcement: An Empirical Study, Indiana Law Journal, 2012,