FDICIA outlines a system of bank supervision based on capital. This paper examines two of the assumptions behind this supervisory system. These are that banks will engage in more risky behavior as capital declines, and that reported capital ratios are leading indicators that accurately reflect a bank's condition. ; Studies of bank failures during the 1980s have failed to clearly demonstrate that bank supervisors allowed troubled banks to engage in such risky activities as paying excessive dividends or excessive growth. In addition, historical studies show that capital tends to be a lagging--not a leading--indicator of bank problems, which is further complicated by the incentives troubled banks have to under-report loan losses. This paper concludes that capital-based supervision cannot be viewed as a substitute for traditional supervisory practices, and that improved methods of analyzing the accuracy of reserves will be important to enhancing the effectiveness of capital-based supervision.
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