You know the examiners are coming in a few weeks, but are you fully aware of the process involved with planning and conducting an examination and reporting the examination findings? The supervisory process can appear to be quite complex, and I often receive questions on this subject. Therefore, this commentary will detail the regulatory role and responsibilities of the Federal Reserve to foster understanding of the supervisory process.
The Federal Reserve is required to conduct a full-scope, on-site examination of its insured member banks each 12-month period, with the exception of some smaller institutions meeting certain criteria, which are examined every 18 months. However, the examination authority of the Federal Reserve allows it to examine a member bank as frequently as deemed necessary based on the condition of the bank or as a result of certain triggering events.
After the passage of the Gramm-Leach-Bliley Act, the Federal Reserve decided to continue to perform concurrent examinations for compliance and CRA. The frequency of consumer compliance and CRA examinations is linked to the size of the institution and its compliance and CRA ratings at its most recent examinations.
For institutions with less than $250 million in assets and a compliance rating of 1 or 2, the examination frequency is driven by the most recent CRA rating. An Outstanding CRA rating extends the frequency to five years, while a Satisfactory rating results in a four-year exam frequency. However, an Unsatisfactory or lower compliance rating or a Needs to Improve or lower CRA rating will automatically result in a one-year exam frequency, until the bank has returned to a satisfactory level of performance. Institutions with over $250 million in assets are examined every two years, with the same one-year frequency requirement for institutions with less than satisfactory compliance or CRA ratings.
For bank holding companies, full-scope inspections are conducted annually for organizations with more than $10 billion in assets. For holding companies under $10 billion in assets, the inspection type and frequency varies depending on asset size, complexity of the organization, and the holding company’s rating at its last inspection.
Safety and Soundness Examinations
The supervisory process has four objectives:
The supervisory process is designed to be flexible, giving bank supervisors the ability to respond to changes in the condition of the institution or market developments. To minimize regulatory burden, the supervisory process should be collaborative and efficient.
In May 2004, a joint effort of state banking commissioners and senior Federal Reserve and FDIC officials resulted in the creation of recommended practices for joint supervision of state-chartered depository institutions.1 These practices stress the importance of communication and coordination between state and federal agencies in conducting their supervisory responsibilities.
In evaluating the safety and soundness of a financial institution, assessments of its financial condition and risk management practices are conducted, as well as its compliance with all applicable laws and regulations. A comprehensive assessment of an institution also involves integrating specialty areas, such as information technology systems, trust operations, and consumer compliance, with functional risk assessments and reviews.
In order to keep pace with the rapidly changing banking environment and the risks that result, bank examinations have evolved from reliance on transaction testing in assessing a bank’s condition to a risk-focused approach. For institutions deemed to have adequate policies and procedures to identify, measure, monitor, and control their risk exposure, the level of transaction testing will be less than that for institutions where risk management is determined to be lacking.
The Federal Reserve places significant supervisory emphasis on its assessment of an institution’s risk management processes. Failure to establish procedures to effectively manage the risks associated with the banking products and services offered and to establish a strong control environment is considered unsafe and unsound conduct.
The risk-focused supervisory process relies on examiner judgment. Examiners determine the level of supervisory activities to be performed based on an institution’s size, complexity, and risk profile. More emphasis is placed on those areas posing the greatest level of risk to the institution. To make an informed risk assessment, examiners gain an understanding of an institution’s risk profile through a variety of sources. These include previous examination reports, correspondence files, surveillance activities that monitor an institution’s ongoing condition and identify outliers in comparison to an appropriate peer group, and other market data.
In addition, examiners conduct meetings with management prior to the commencement of an examination to learn about changes in policy, strategic direction, products and services, and other activities. Examiners then prepare a preliminary risk assessment of the institution and plan their supervisory activities accordingly.
Meetings with management are held during the on-site examination to gather additional information and to provide insight for the assessment of the bank’s condition. Examiners also discuss with management any supervisory concerns that arise during the examination and make recommendations for improvement to management when warranted. Frequently, supervisory concerns are resolved during the on-site examination, and there is no need for additional resolution efforts.
For larger, more complex institutions, the supervisory process includes the use of a central point of contact, or CPC, to coordinate the process and to foster ongoing communication with both the institution and other regulators, further promoting effective, efficient supervision of the institution.
Overall Conclusions Regarding Bank Condition
An examination has multiple objectives:
In reaching an overall conclusion about the condition of an institution, examiners use both objective criteria and subjective judgment. The examination process culminates in the assignment of ratings and the issuance of an exam report. This information is for management’s use, and the disclosure of supervisory ratings and other confidential supervisory information to third parties is prohibited, except in very limited circumstances. An interagency advisory was issued in February 2005 to remind banking organizations of this prohibition.2
The Matters Requiring Board Attention page of the examination report is used to clearly and succinctly detail for the board of directors the most significant issues identified during the examination. Action required on the part of both management and the board of directors is clearly noted. This page is meant to complement the full Report of Examination, which discusses in detail all of the examination findings.
When discussions and normal follow-up procedures have been unsuccessful in resolving supervisory concerns, there may be a need to take further action. Toward that end, the Federal Reserve has a broad range of enforcement powers which includes both informal and formal actions.
As I discussed in the Second Quarter 2004 issue of SRC Insights, informal enforcement actions are used to address less severe supervisory circumstances and include commitments, board resolutions, and memoranda of understanding. The Federal Reserve does not make information about informal enforcement actions available to the public.
Formal actions are used to correct practices considered to be unlawful, unsafe, or unsound. Formal enforcement actions include written agreements, cease-and-desist orders, and civil money penalties, among others. Most formal actions are made public.
By tailoring the supervisory process to focus on an institution’s risk profile and management’s ability to manage its risk, the process is more cost-effective for regulators and less burdensome to the institutions, resulting in efficient, effective supervision.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.