Bank Examination Quality:

FRB Examinations and Inspections Do Not Fully Assess Bank Safety and Soundness

AFMD-93-13: Published: Feb 16, 1993. Publicly Released: Feb 16, 1993.

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GAO reviewed the Federal Reserve Board's (FRB) bank examinations and bank holding company inspections, focusing on FRB examiners' reviews of: (1) loan quality, the loan loss reserve, and internal controls; and (2) holding company and nonbank subsidiary activities that could adversely impact the insured bank.

GAO found that: (1) FRB failure to sufficiently and systematically identify, test, and evaluate banks' internal controls has impeded examiners from assessing banks' overall operational soundness and increased the risk of bank mismanagement, waste, fraud, and abuse; (2) the FRB Examination Manual lacked minimum mandatory procedures for internal control testing and did not address some serious internal control weaknesses; (3) in 1990, FRB performed insufficient internal control reviews in about 8 of 12 banks; (4) although examiners reviewed a sufficient number of loans to assess bank management, they lacked an adequate methodology to assess the amount of bank loan reserves; (5) FRB examiners' use of standard banking averages, instead of considering specific risks from individual problem loans or the general risk conditions at individual banks to estimate the required reserves needed for specific bank portfolios and problem loans, could understate loan loss reserves and the banks' true financial condition; (6) FRB examiners failed to adequately assess the direct and indirect risks of intercompany transactions including loans to nonbank affiliates, expenses allocated to bank subsidiaries, asset transfers to banks by nonbank subsidiaries, and asset quality problems; (7) both FRB bank examinations and holding company inspections lacked adequate working paper documentation quality controls, minimum mandatory procedures for working paper preparation, and documentation of supervisory review; and (8) improved documentation controls would allow increased supervisory review and support for examiner conclusions.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: In January 1994 FRB issued SR 94-3 that provides supervisory guidance on the implementation of section 112 of the FDIC Improvement Act. SR 94-3 provides detailed instructions for a preliminary review of management and auditor reports by reserve bank personnel. The purpose of this preliminary review is to check for reporting compliance and to identify emerging internal control weaknesses. After completion of the preliminary review, all relevant information is to be forwarded to the appropriate supervisory officer for each reporting institution. Guidance for specific review of the FDICIA internal control assessments by management and auditors of the institution is provided in the Commercial Bank Examination Work Documentation program. GAO believes this guidance provides a sufficient basis for evaluation of these internal control assessments and integration into the examination process.

    Recommendation: The Chairman, FRB, should require examiners to rely on the assessments required by the Federal Deposit Insurance Corporation Improvement Act of 1991 to the extent possible, and supplement these assessments as necessary to ensure a comprehensive review of internal controls. As a basis for reliance, the Chairman should direct the examiners to use the internal control review procedures as guidance in reviewing the quality of management's and the external auditor's internal control assessments required by the act.

    Agency Affected: Federal Reserve System: Board of Governors

  2. Status: Closed - Implemented

    Comments: Rather than provide separate policies and procedures for examiners to use in reviewing internal controls depending on the size of the bank, FRB intends for its examiners to follow an internal control review approach now being developed for application at all banks. That approach calls for a risk-based control assessment and, where applicable, provides for reliance on a member bank's internal audit function after FRB examiners assess its adequacy. Based on the control risk assessment and the nature of control weaknesses identified, the examiners are expected to complete specific internal control questionnaires and related test procedures for high-risk bank activities and functions and to document their work using standard procedures. Full implementation of these policies and procedures is scheduled for late 1997.

    Recommendation: The Chairman, FRB, should require examiners to conduct independent comprehensive reviews of internal controls of banks with assets of less than $150 million.

    Agency Affected: Federal Reserve System: Board of Governors

  3. Status: Closed - Not Implemented

    Comments: FRB responded that an assessment of internal controls has already been incorporated into the CAMEL rating within each functional area, particularly in the "management" rating.

    Recommendation: The Chairman, FRB, should require that the condition of a bank's system of internal controls be added to the capital adequacy, asset quality, management, earnings, and liquidity rating as a separate critical area for rating to highlight the significance of internal controls to a bank's viability.

    Agency Affected: Federal Reserve System: Board of Governors

  4. Status: Closed - Implemented

    Comments: The FRB responded that it had recently signed a cooperative agreement with the Conference of State Bank Supervisors. Reserve banks must determine that a state has the capability to carry out responsibilities under the cooperative arrangements. This determination will be based primarily on the adequacy of the state's funding. However, FRB stated that its prior reliance on informal evaluations of state programs had served it well and that it believed that to establish a more rigid or elaborate evaluation program would be counterproductive.

    Recommendation: The Chairman, FRB, should develop a formal program to evaluate examinations performed by state banking regulators to be relied on under the Alternate Year Examination Program.

    Agency Affected: Federal Reserve System: Board of Governors

  5. Status: Closed - Not Implemented

    Comments: According to GAO's review of agency responses and actions on the internal control recommendations, FRB apparently did not make a coordinated effort to implement the recommendations.

    Recommendation: The Chairman, FRB, should coordinate the implementation of the internal control and use of state examinations recommendations with the other federal depository institution regulatory agencies to achieve uniform requirements.

    Agency Affected: Federal Reserve System: Board of Governors

  6. Status: Closed - Implemented

    Comments: In June 1994, FRB, along with OCC, FDIC, and OTS, issued the "Interagency Policy Statement on the Allowance for Loan and Lease Losses." This document establishes uniform interagency guidance for review of loan loss reserves and was analyzed in connection with the recent review of bank and thrift loan loss reserve methodologies. While GAO has some significant reservations about the policy statement, it is at least partially responsive to the recommendation.

    Recommendation: The Chairman, FRB, should develop a more specific methodology to be used by examiners for assessing loan loss reserve adequacy on a consistent and meaningful basis. This methodology should include direct consideration of the loss exposure from individual problem loans, as well as a framework for quantification of the risk factors outlined in the Examination Manual for the remainder of the portfolio.

    Agency Affected: Federal Reserve System: Board of Governors

  7. Status: Closed - Implemented

    Comments: The interagency policy statement provides guidance to institutions on maintaining an adequate loan loss reserve. However, because GAO has significant reservations about this guidance, it does not view it as being fully responsive to the recommendations on loan loss reserves.

    Recommendation: The Chairman, FRB, should require bank management to develop and implement a sound methodology for maintenance of an adequate loan loss reserve that is based on the methodology used by examiners for assessing loan loss reserve adequacy.

    Agency Affected: Federal Reserve System: Board of Governors

  8. Status: Closed - Implemented

    Comments: In 1994, FRB developed the Federal Reserve System Commercial Bank Examination Work Documentation Program, which includes standardized workpaper requirements for bank examinations. The new standards require a clear accounting of work procedures to be performed, cross-referencing to supporting documentation, reasons for not reviewing or selecting an area to be reviewed, documentation of examiner conclusions and recommendations, and the initials of the examiner and sign-off of the reviewer. The program has been required for almost 2 years. During this 2-year period, field examiner comments were received and the program was revised. The final draft of the program has been completed. The official manual should be released before the end of the year.

    Recommendation: The Chairman, FRB, should fully document all examination working papers and indicate supervisory review and concurrence by initialling or signing each working paper.

    Agency Affected: Federal Reserve System: Board of Governors

  9. Status: Closed - Implemented

    Comments: This recommendation was made primarily in connection with establishing a sound methodology for assessment of loan loss reserves. A joint interagency policy statement on loan loss reserves was issued in June 1994.

    Recommendation: The Chairman, FRB, should coordinate implementation of GAO recommendations with the other federal financial institution regulatory agencies to achieve uniform requirements.

    Agency Affected: Federal Reserve System: Board of Governors

  10. Status: Closed - Not Implemented

    Comments: FRB responded that it believed that existing policies, combined with increased emphasis on documenting the review of intercompany transactions in the workpapers, were sufficient to identify the actual and the potential adverse impact of intercompany transactions. No action in response to the recommendation appears to be planned.

    Recommendation: The Chairman, FRB, should establish minimum bank holding company inspection procedures that include assessing the actual and potential adverse impact of intercompany transactions upon the insured bank.

    Agency Affected: Federal Reserve System: Board of Governors

  11. Status: Closed - Implemented

    Comments: FRB issued a policy directive in April 1993 which establishes: (1) the requirement for a written assessment of all nonbank activities of bank holding companies; (2) criteria for required on-site inspections of nonbank subsidiaries; and (3) standards for off-site review of nonbank activities. The directive also states that for credit-extending nonbank subsidiaries that meet the on-site review criteria, examiners are to review sufficient credit files to assess the adequacy and accuracy of the internal risk identification systems.

    Recommendation: The Chairman, FRB, should establish minimum bank holding company inspection procedures that include conducting independent asset quality reviews of any nonbank subsidiary where the failure of that subsidiary would have a significant impact upon the capital of the holding company and its ability to operate as a source of strength to the bank.

    Agency Affected: Federal Reserve System: Board of Governors

  12. Status: Closed - Implemented

    Comments: FRB finalized internal control review procedures for examinations of state member banks and developed an examination module for examiners to follow in documenting their review. The approach provides for an assessment of the bank's internal and external audit function. Based on the risk assessment and identified control weaknesses, examiners will determine the depth of necessary related tests of the bank's high-risk activities. The amount of testing necessary to evaluate an activity depends on the bank's ability to identify, measure, monitor, and control its risks. Once the integrity of the bank's risk management system is verified through testing, examiners may rely on management's assessment of risks rather than performing more extensive tests. If examiners have concerns with the bank's system, they will conduct more extensive testing to more fully evaluate the bank's risk exposure for high-risk activities. Full implementation of this supervision framework is scheduled for late 1997.

    Recommendation: The Chairman, FRB, should develop comprehensive internal control review procedures for all major aspects of bank operations to be used during FRB annual on-site examinations. The procedures should identify any major risk areas in each bank's operations, identify the related significant internal controls, and require testing to assess the effective operation of the internal controls.

    Agency Affected: Federal Reserve System: Board of Governors

  13. Status: Closed - Implemented

    Comments: In October 1996, FRB began pilot testing a risk-focused supervision framework for inspection of bank holding companies. To accompany the risk-focused supervision framework, FRB has been developing examination and inspection modules for complex institutions, which will replace the work documentation program. The modules define review objectives, establish inspection procedures, and assist in documentation. Further, the modules provide a tiered approach to reviewing an institution's activities, which allows the examiner to focus on high-risk activities. Four modules are ready for field testing: loan portfolio analysis, treasury activities, trading and capital markets activities, and internal controls and audit. Additional modules are scheduled to be developed and will be field tested. Full implementation is expected in mid-1998. The modules are being automated so that examiners will be able to maintain their work on laptop computers while onsite at the institution.

    Recommendation: The Chairman, FRB, should establish minimum bank holding company inspection procedures that include consistently documenting the procedures performed and the supervisory review of the inspection working papers.

    Agency Affected: Federal Reserve System: Board of Governors

 

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