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)
In July 2021, the status of the Federal Reserve's response to this recommendation had remained unchanged from their August 2018 update. In August 2018, the Board of Governors reported to us that it was developing its ERM framework. The Board added that it was establishing a Board Risk Committee (comprised of senior leaders) to oversee its ERM program and serve as the central forum for addressing Board-wide risk issues. The Board also said that it has begun to implement a number of strategic components of the ERM framework. In August 2019, the Board stated that in their view, the ERM framework they are developing would not significantly alter the management processes that the Board and System have in place under the LISCC program that continue to work effectively. The Board reported to us that it has continued to develop the ERM program with guidance of the Board Risk Committee, which meets quarterly, and continues to serve as the central forum for Board-wide risk issues and oversight of the ERM program. In August 2020, the Board added that it would take several years to develop the ERM program. In September 2021, Board staff clarified that the Board is in the process of implementing a first generation ERM program and estimated it should be completed by November 2021. They added that subsequently Board members and the Executive will review it for possible expansion to other divisions across the Board. The Board also will continue to implement strategic components of the ERM framework throughout the Board.
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)
In July 2021, the Federal Reserve told us they updated their conflict-of-interest (COFI) database, which tracks financial disclosures and conflicts in one streamlined system. They said that now COFI can store financial disclosure information for all LISCC participants, including those at Reserve Banks and at the Board. They added that updates are completed and fully implemented for Reserve Bank LISCC participants, where (1) new staff are required to complete a detailed financial disclosure form, including information that might constitute an actual or potential conflict of interest, which is entered into the COFI database; and (2) all staff are required annually to review and re-attest to their conflicts within the database, and update their conflicts within 30 days of a change to their financial disclosure profile. The Federal Reserve also told us they have not yet completed updates for Board LISCC participants. They added, the Board is still developing a processes for gathering financial disclosure information from these participants, entering this information into the COFI database, and conducting an annual review and attestation process. The Board expects to begin implementing a comprehensive financial disclosure process for Board LISCC participants in 2022.
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 has 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 is scheduled to be released, for both Board and Reserve Banks use, in 2019, but as of July 2021, we have not been updated on that system or its status. However, in July 2021 they added that the LISCC supervisory program is 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.
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 August 2018, the Board of Governors told us that their Ethics program staff and Supervision & Regulation staff are jointly assessing the current ethics programs, policies, and procedures applicable to LISCC program participants. In July 2021, the Board added that these staff are in the final stages of drafting LISCC-specific ethics guidance and conflicts of interest policies. The Board added that once the new guidance is implemented, the LISCC oversight section, in collaboration with Board Ethics program staff, will be responsible for evaluating compliance with the LISCC-specific conflicts guidance.

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