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Large Bank Supervision: Improved Implementation of Federal Reserve Policies Could Help Mitigate Threats to Independence

GAO-18-118 Published: Nov 06, 2017. Publicly Released: Dec 06, 2017.
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What GAO Found

The Board of Governors of the Federal Reserve System (Board) has not finalized and implemented its enterprise risk management (ERM) framework, and as a result, it may have limited ability to manage risks across the Large Institution Supervisory Coordinating Committee (LISCC) program. One such risk is regulatory capture, a condition that exists when a regulator acts in service of private interests, such as the interests of the regulated industry, at the expense of the public interest. GAO has previously found that regulators should be independent of inappropriate influence, including undue influence from the industry they are regulating. LISCC is a supervisory program developed by the Board to enhance the oversight of large, complex financial institutions. LISCC takes a cross-cutting approach to supervision, drawing staff from across the Federal Reserve System including the Board and four Federal Reserve Banks, and risks of regulatory capture span various aspects of the LISCC program. To help the Board manage its diverse risks, the Board has recognized the advantages of implementing an ERM, which the Office of Management and Budget (OMB) encourages all federal agencies to do. The Board began to develop an ERM framework in 2017, but it has not yet developed some of OMB's recommended key elements, such as risk identification and assessment. Completing and implementing the ERM framework should position the Board to better manage regulatory capture risks across the LISCC program.

The LISCC program has other policies to mitigate threats to independence for supervisory staff. For example, under the LISCC program, four Reserve Banks supervise the largest financial institutions with oversight from the Board, which increases the transparency and accountability of supervisory decisions and helps to ensure those decisions are free of inappropriate influence. In addition, the Federal Reserve has mechanisms for Reserve Bank staff to communicate their views directly to Board officials. However, GAO found weaknesses in some internal controls related to guidance and monitoring mechanisms. These limit the Board's assurance that policies are being implemented consistently across the LISCC program. Because of these weaknesses, the four Reserve Banks may not be mitigating regulatory capture risks and threats to supervisory independence as effectively or consistently as possible.

The Board and the four Reserve Banks have also implemented various conflict-of-interest and other ethics policies for LISCC examiners and other types of supervisory employees. While these policies are not explicitly designed to address regulatory capture, Federal Reserve officials said they use them in part for this purpose. However, GAO found weaknesses in the Federal Reserve's implementation of these policies. For example, the Federal Reserve officials said that they have policies to help mitigate threats to independence posed by the revolving door—that is, the movement of employees between the financial industry and the Federal Reserve—but they do not systematically collect employment data needed to implement these policies effectively. Without addressing this and other weaknesses, the Federal Reserve may be limited in its ability to use its ethics policies to mitigate regulatory capture.

Why GAO Did This Study

The Board of Governors created LISCC in 2010, in the wake of the financial crisis of 2007–2009, to strengthen supervision of the largest U.S. financial institutions that pose the greatest risk to the economy. However, questions have been raised about the independence of the supervisory process and the risk of regulatory capture.

GAO was asked to review regulatory capture and threats to independence in large bank supervision. This report discusses the Federal Reserve's policies for (1) managing risks of regulatory capture in the LISCC program using an ERM approach; (2) mitigating threats to supervisory independence for the LISCC program; and (3) mitigating conflicts of interest for LISCC supervisory personnel. GAO reviewed studies and Federal Reserve policies and procedures. GAO also interviewed officials and supervisory staff at the Board and the LISCC Reserve Banks.

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GAO is making six recommendations to help improve the Federal Reserve's implementation of ERM and to strengthen internal controls to more effectively mitigate risks of regulatory capture and threats to supervisory independence across the LISCC program. Although the Federal Reserve neither agreed nor disagreed with the recommendations, it identified ongoing and planned efforts to address them.

Recommendations for Executive Action

Agency Affected Recommendation Status
Board of Governors As the Board of Governors implements plans to develop an ERM framework, it should include a component to identify and assess risks of regulatory capture across the LISCC program. (Recommendation 1)
Closed – Implemented
In August 2018, the Board reported to us that it was developing an ERM framework and establishing a Board Risk Committee (comprised of senior leaders) to oversee its ERM program and address Board-wide risk issues. The Board also said that it had begun to implement a number of strategic components of its ERM framework. In September 2021, the Board reported implementing its first generation ERM program. The following May, the Board told us that it had established an ERM program for all of its operations-oriented areas and added that it expected to complete development of the ERM program for other Board divisions, including the Division of Supervision and Regulation, by the end of 2022. In February 2023, we reviewed the Board's ERM framework and found that the Board addressed key ERM elements identified by OMB guidance that we discussed in our report, including: (1) developing and implementing a planned risk management governance structure; (2) implementing a process for considering risk appetite and risk tolerance levels, where the risk appetite and risk tolerance statements include identification of risks including reputational risks (the statements do not specifically mention regulatory capture, but as described, capture would fall under the reputational risk umbrella); (3) relying on the Board's ERM team to discuss risks with staff in the Board's divisions as the basis for drafting risk profiles, which are then reviewed by the divisions and updated and revised as needed by the ERM team; and (4) adopting a general implementation timeline or next steps for the ERM team and those affected by the risk profiles. We also reviewed risk reports and risk profiles produced as part of the ERM process and found that the Board's implementation of its ERM clearly addresses reputational risk, especially regarding the supervision large financial institutions, which may result from regulatory capture. For example, in one recent risk report, the Board said its reputation is critical to its effective supervision of large financial institutions. Several risk profiles, including those for supervision of large financial institutions, also stated that the Board addressed its reputational risk exposure in response to concerns that we and the Federal Reserve's IG have had about the Board's credibility, inconsistent supervision across banks, and insufficient controls for addressing conflicts of interest and ethics functions. The ERM profiles acknowledged that reputational risk is a real possibility, and, if it occurs, the risk impact could be high. The Board's response to develop and implement its ERM will enhance its ability to look comprehensively across the Federal Reserve and identify, assess, and monitor sources of reputational risk, including the risk of regulatory capture across the system.
Board of Governors The Board of Governors should finalize and implement program-wide guidance for the LISCC Reserve Banks on implementing LISCC policies. (Recommendation 2)
Closed – Implemented
In August 2019, the Board of Governors told us that the LISCC supervisory program had taken several steps to "finalize and implement program-wide guidance for the LISCC Reserve Banks on implementing LISCC policies." The Board reported that in 2017 it had issued a near-final LISCC program manual, which they said will memorialize all aspects of the LISCC supervisory program. The Board added the updated manual will reflect the results of a self-assessment of the LISCC Program's first full year of operations under the LISCC core program model, and the initial implementation of the new Large Financial Institution Ratings Framework. The Board also said that, since the last update, the LISCC supervisory program's operating policies, procedures, and templates for the conduct of supervisory activities have been completed and implemented. In February 2021, the Board provided additional documents demonstrating that it had recently finalized the LISCC program manual and other program-wide guidance for LISCC banks. This guidance includes operating manuals for the various LISCC programs--capital program operations, dedicated supervisory team, liquidity program, monitoring and analysis, and recovery and resolution preparedness. These manuals clarify the LISCC core program operating standards through operating policies, procedures, and guidance of supervisory activities. The Federal Reserve also clarified its quality control and assurance functions by centralizing its quality control review process, centralizing independence in its quality assurance framework, and addressing LISCC oversight within its operations group. Further, to ensure compliance with the LISCC manual and supporting core program operating standards, the LISCC program also established a centralized Quality Control review process for all Reserve Banks' dedicated supervisory team supervisory activities and a Quality Control review process for each core program. These actions taken by the Board will give it reasonable assurance that LISCC policies are being implemented appropriately and effectively, thereby reducing the likelihood of regulatory capture and mitigating threats to independence.
Board of Governors The Board of Governors should finalize and implement a mechanism to monitor and regularly assess Reserve Banks' implementation of LISCC policies and procedures. (Recommendation 3)
Closed – Implemented
In August 2018, the Board of Governors told us that they assess the effectiveness of Reserve Bank supervision functions, including their adherence to System guidance, through a continuous oversight program. They added that the Board recognized that the recommendation to formalize the monitoring and assessment of the LISCC program would provide greater assurance regarding the implementation of LISCC guidance. In our recommendation, we acknowledged that the Board stated that it was "in the process of augmenting its oversight program through the development of a LISCC-specific oversight framework that is to encompass all Board and Reserve Bank LISCC activities and provide for a comprehensive assessment of program effectiveness for implementation in 2018." We also added that, "Until this framework is put into place, the Board may not have reasonable assurance that policies are being implemented appropriately and effectively." In August 2019, the Board told us that the LISCC Quality Assurance Program has been established and began conducting formal reviews in 2019. To ensure quality and consistency of work by the supervisory teams, the Board reported having embedded formal quality controls within individual processes. In July 2020, the Federal Reserve reported that on September 17, 2019, the Division of Supervision and Regulation issued its Framework for Assessing Oversight of the LISCC Supervisory Program. According to the Federal Reserve, the framework provides operational expectations and the criteria the LISCC Oversight Section (LOS) uses when evaluating the LISCC supervisory program's governance structure, program management, and program execution, as well as internal procedures that guide its operations. The agency added that during 2019, LOS completed its first annual review cycle for the LISCC supervisory program, completing three portfolio program reviews, one horizontal review, and ongoing continuous monitoring. LOS issued the inaugural LISCC supervisory program annual performance assessment in February 2020. This response will give the Board reasonable assurance that the policies are being implemented appropriately and effectively.
Board of Governors The Board of Governors should streamline its conflict-of-interest disclosure review process for participants in the LISCC program, such as by storing disclosure information in compatible electronic systems. (Recommendation 4)
Closed – Implemented
In August 2018, the Board of Governors told us that they were assessing the feasibility of integrating existing electronic systems, and began drafting guidance that develops a LISCC-specific conflicts-of-interest and examiner credential process to ensure consistency in interpreting conflicts-of-interest rules for all Board and Reserve Banks staff. They also began planning to issue guidance for the new approach to disclosure review, collecting and storing disclosure information for all LISCC participants in one electronic system, and training staff on the disclosure review process and the electronic system. Since then, agency documentation shows that the Board has updated their conflict-of-interest (COFI) database to store financial disclosure information for all LISCC participants, and fully implemented updates to COFI for Reserve Bank LISCC participants. More recently, agency documentation shows that the Board has taken steps through a service level agreement to outsource the management of COFI responsibilities to a Reserve Bank with COFI expertise. The draft agreement provides for the Reserve Bank to execute the processes for Board LISCC participants. According to the Board, in the interim, the LISCC supervisory program has manually collected financial disclosure information from Board LISCC participants. When the agreement with the Reserve Bank is in place, that data will be entered into the COFI database, and the Bank will use the data to conduct annual attestations for Board LISCC participants in the same way it is conducted for Reserve Bank LISCC participants. This response will give the Board of Governors of the Federal Reserve System reasonable assurance that the Board efficiently and effectively ensures that Board employees are free of conflict of interests in the LISCC program.
Board of Governors The Board of Governors should systematically collect and maintain information on the institutions supervisory employees work for before they are hired by the Federal Reserve and their employment destination when they leave. (Recommendation 5)
In August 2018, the Board of Governors told us that they had implemented policies intended to mitigate the risk that an employee may be influenced by prior employment or the prospect of future employment and place their private interests ahead of the organization's supervisory mission. As an example, they said that recently the Federal Reserve broadened the scope of post-employment restrictions applicable to senior examiners. They added that the Board had begun to develop a more systematic approach to collect and monitor pre- and post-employment data through the use of an electronic system. They said that this updated electronic system was scheduled to be released, for both Board and Reserve Banks use, in 2019. In July 2021 the Board told us that the LISCC supervisory program was working to establish a consistent and effective methodology for storing data related to former and future employers in a centralized location for all LISCC personnel at both the Reserve Banks and the Board. In May 2022, they explained that for Board LISCC participants, Board Ethics Program staff ask departing senior employees about the identity of future employers and, if these employees provide such information (they are not required to disclose this information), the staff save the information in the Ethics Program database. Although LISCC does not currently have access to this database, it is collecting this information for LISCC participants in a separate database, as an interim control. They added that once Board LISCC participants have been added to the COFI database, information on their future employers will be included as part of the employee's record. In August 2023, the Board told us that the LISCC Oversight (LOS) will conduct a review of the LISCC program's remediation efforts related to our recommendation, which they expect to complete in early 2024. Specifically, LOS' assessment of LISCC remediation efforts will focus on: validating the methods the Board and Reserve Banks use to collect information on prior employers for LISCC personnel; identify LISCC personnel who are departing the Federal Reserve System, including their future employer; and systematically store information on prior and future employers for LISCC personnel. We will continue to monitor the Board's progress in implementing this recommendation.
Board of Governors The Board of Governors should conduct a periodic self-assessment of ethics programs, policies, and procedures that apply to LISCC program participants. (Recommendation 6)
In May 2022, the Board said it expects to issue new ethics and conflicts of interest guidance applicable to the LISCC supervisory program. Additionally, the Board will update existing guidance (AD letter 19-5, Framework for Assessing Oversight of the LISCC Supervisory Program) to include minimum expectations for LISCC management to establish a program to manage conflicts of interest for the national program. The Board also said that the LISCC Oversight Section within the Board's Division of Supervision and Regulation, which has responsibility for reviewing all aspects of the LISCC supervisory program including conflicts of interest, will collaborate with Ethics Program staff from the Board's Legal Division to conduct periodic reviews to evaluate compliance with the LISCC-specific guidance referenced above. The frequency of reviews of the conflicts of interest program will be determined based on the risk rating the LISCC Oversight Section assigns to this program area during its annual risk assessment for the LISCC supervisory program. We will continue to monitor the Board's plans for developing the new guidance and for implementing periodic reviews of the LISCC program. In August 2023, the Board told us that it has revised its plans for issuing the new ethics and conflicts of interest guidance to the end of 2023, at which time the Board will share the final guidance with us.

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