oversight

Bank and Thrift Examinations: Adoption of Risk-Focused Examination Strategies

Published by the Government Accountability Office on 1997-10-08.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Financial Institutions and
                          Consumer Credit, Committee on Banking and Financial
                          Services, House of Representatives


For Release on Delivery
Expected at
10:00 a.m., EDT
                          Bank and Thrift
on Wednesday
October 8, 1997           Examinations

                          Adoption of Risk-Focused
                          Examination Strategies
                          Statement of Thomas J. McCool
                          Director, Financial Institutions and Markets Issues
                          General Government Division




GAO/T-GGD-98-13
Summary

Bank and Thrift Examinations: Adoption of
Risk-Focused Examination Strategies

              Bank supervision and examination today show evidence of lessons learned
              from the bank and thrift crises of the 1980s and early 1990s. These
              procedures are the primary basis for federal regulatory agencies to assess
              the risks that banks and thrifts assume and to take actions to maintain a
              safe and sound banking system and protect deposit insurance funds.

              One critical lesson of the earlier crises was that excessive regulatory
              forbearance contributed to the extent of the crises. The Federal Deposit
              Insurance Corporation Improvement Act of 1991 (FDICIA) based regulatory
              practices on a simple principle: if a depository institution fails to operate
              in a safe and sound manner, it should be subject to timely and forceful
              supervisory response, including, if necessary, prompt closure. FDICIA also
              required that banks reform their corporate governance and accounting
              practices and that the regulatory agencies improve their supervision of
              insured banks and thrifts. In a November 1996 report, however, GAO noted
              that questions remain about the effectiveness of FDICIA’s trip-wire
              provisions which are intended to limit regulatory discretion. As
              implemented, the trip-wire that enables regulatory action at early stage of
              problems in a bank does little to limit regulatory discretion.

              In several reports in the early 1990s, GAO also noted limitations in the
              safety and soundness examinations conducted by the regulatory agencies.
              The limitations included a lack of comprehensive internal control
              assessments, insufficient review of loan quality and loan loss reserves,
              weaknesses related to insider lending, and insufficient assessment of bank
              holding company activities with insured bank subsidiaries. GAO
              recommended actions to address these weaknesses, as well as weaknesses
              in the documentation of the analysis that underlies the examination report
              and in the supervisory review of examinations.

              Regulators have made a number of changes in an effort to improve their
              examinations. The changes respond, in part, to the dynamic banking
              environment in which institutions can rapidly reposition risk exposures.
              To ensure that banks and thrifts have the managerial ability and internal
              control structure to effectively manage risk, the examination process is
              evolving to put greater emphasis on risk management and internal
              controls. An institution’s sensitivity to market risk is now a separate
              component in its supervisory rating, for example. In general, these
              changes appear appropriate and consistent with the recommendations GAO
              has made. In its recent report on foreign banking organizations operating
              in the United States, GAO noted that regulators have begun to put greater
              emphasis on risk management processes and operational controls in



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Summary
Bank and Thrift Examinations: Adoption of
Risk-Focused Examination Strategies




examinations of these organizations. However, GAO has not fully assessed
the effectiveness of the changes for bank and thrift examination and notes
that they have been instituted during favorable economic conditions that
have contributed to strong bank and thrift profits. Also, several critical
tasks remain for the regulatory agencies: ensuring consistency in the
supervision and examination policies of multiple regulatory agencies,
ensuring staff expertise, and examining increasingly complex banking
organizations.




Page 2                                                     GAO/T-GGD-98-13
Statement

Bank and Thrift Examinations: Adoption of
Risk-Focused Examination Strategies

              Ms. Chairwoman and Members of the Committee:

              We are pleased to be here today to discuss bank and thrift supervision and
              examination.

              Supervisory and examination procedures today show evidence of lessons
              learned from the bank and thrift crises of the 1980s and early 1990s. These
              procedures are the primary basis used by the federal regulatory agencies
              to assess the risks that banks and thrifts assume and to take actions that
              are needed to maintain a safe and sound banking system and protect the
              deposit insurance funds.

              A combination of regulatory and legislative changes, along with market
              forces, has expanded the number and scope of activities undertaken by
              insured depository institutions, particularly the largest ones, and thus the
              risks that they assume. These expanded activities include offering and/or
              dealing in a range of nontraditional bank products, such as mutual funds,
              securities, derivatives, and other off-balance sheet products.1 The resulting
              complex institutions represent a major supervisory and regulatory
              challenge. In keeping with the changes in the banking environment,
              federal bank and thrift regulators have recently announced that bank
              examinations will explicitly include an assessment of how effectively
              banks manage risk and a rating on their sensitivity to risks posed by a
              variety of market factors.

              Although we have not yet fully assessed the implementation of most of the
              recent changes to supervisory and examination policy, they appear to
              address some of our concerns about examinations in the aftermath of
              bank failures in the 1980s and early 1990s. Perhaps the most
              important—yet unanswered—question to ask in assessing changes in bank
              and thrift supervision is to what extent improvements in the detection of
              problems can help ensure that regulators take timely and forceful
              corrective action to prevent or minimize losses to the deposit insurance
              funds.

              In my testimony today, I would like to review some of our prior reports
              and more recent work that



              1
               Off-balance sheet products represent wholesale activities and fall into two broad categories:
              (1) derivative products and (2) contingent liabilities. Derivative products—such as futures, forwards,
              options, and swaps—are financial instruments whose value depends on the value of another
              underlying financial product. Contingent liabilities represent agreements by a banking institution to
              provide funds when certain conditions are met.



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                                 Statement
                                 Bank and Thrift Examinations: Adoption of
                                 Risk-Focused Examination Strategies




                             •   describe the history of the bank and thrift crises of the late 1980s and early
                                 1990s and the legislative response to these crises,
                             •   highlight supervisory and examination weaknesses we have noted in the
                                 past and improvement efforts that have been made or are under way, and
                             •   identify continuing issues.


                                 From 1980 to 1994, record losses were absorbed by the federal deposit
Bank and Thrift Crises           insurance funds. In this period, nearly 1,300 thrifts failed, and 1,617
Highlighted                      federally insured banks were closed or received FDIC financial assistance.
Shortcomings in                  Losses to deposit insurance funds have been estimated at about
                                 $125 billion.
Supervision and
Resolution
Excessive Regulatory             Banks and thrifts failed during the 1980s for several reasons. A mismatch
Forbearance Contributed          between the income from fixed rate mortgages and the costs of borrowing
to Problems of Thrifts and       funds at market rates in competition with nondepository institutions were
                                 among the reasons for large losses that led to the failure of thrifts. Banks
Banks and Insurance Fund         suffered losses from defaults on loans concentrated in several industries
Losses                           that suffered economic downturns over the decade, including agriculture,
                                 real estate, and developing nation loans.

                                 One factor we and others cited as contributing to the problems of both
                                 thrifts and banks during this period was excessive forbearance by federal
                                 regulators. Regulators had wide discretion in choosing the severity and
                                 timing of enforcement actions to correct unsafe and unsound practices.
                                 They also had a common philosophy of trying to work informally and
                                 cooperatively with troubled institutions. In a 1991 report, we concluded
                                 that these conditions had resulted in enforcement actions that were
                                 neither timely nor forceful enough to (1) correct unsafe and unsound
                                 banking practices or (2) prevent or minimize losses to the insurance funds.
                                 The regulators themselves have recognized that their supervisory practices
                                 failed to adequately control risky practices that led to numerous thrift and
                                 bank failures. We made specific recommendations for changes to the
                                 supervisory process that would help ensure that institutions failing to
                                 operate in a safe and sound manner would be subject to timely and
                                 forceful supervisory response, including, if necessary, prompt closure.

Legislation Was Enacted to       Congress passed two major laws to address the thrift and bank crisis of
Address Problems                 the 1980s. The first, the Financial Institutions Reform, Recovery, and
                                 Enforcement Act of 1989 (FIRREA), primarily responded to the bankruptcy



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                                Bank and Thrift Examinations: Adoption of
                                Risk-Focused Examination Strategies




                                of the Federal Savings and Loan Insurance Corporation (FSLIC) and
                                troubles in the thrift industry. In addition to creating the Savings
                                Association Insurance Fund to replace FSLIC, FIRREA created a new thrift
                                industry regulator with increased enforcement authority—the Office of
                                Thrift Supervision. It also authorized FDIC to terminate a bank’s or thrift’s
                                deposit insurance for unsafe and unsound conditions.

                                The second law, the Federal Deposit Insurance Corporation Improvement
                                Act of 1991 (FDICIA), was enacted, in part, because of concerns that the
                                exercise of regulatory discretion during the 1980s did not adequately
                                protect the safety and soundness of the banking system or minimize
                                insurance fund losses. FDICIA contains several safety and soundness
                                provisions based on a simple principle: if a depository institution fails to
                                operate in a safe and sound manner, it should be subject to timely and
                                forceful supervisory response, including, if necessary, prompt closure.
                                Also, FDICIA requires a number of corporate governance and accounting
                                reforms to (1) strengthen corporate governance, (2) improve financial
                                reporting, and (3) aid early identification of safety and soundness
                                problems. Among the corporate governance and accounting reforms,
                                FDICIA establishes generally accepted accounting principles as the standard
                                for all reports to regulators; requires that management and auditors
                                annually report on the financial condition and management of the largest
                                depository institutions, including effectiveness of and compliance with
                                internal controls; and requires that institutions have independent audit
                                committees composed of outside directors.

                                In addition, FDICIA contains provisions for improving regulatory
                                supervision. FDICIA mandates annual on-site examinations of insured banks
                                and thrifts.2 Also, consistent with specific recommendations we made, it
                                requires implementation of a “trip wire” approach to limit regulatory
                                discretion in key areas, including capital, by mandating specific regulatory
                                responses to safety and soundness problems. These changes, incorporated
                                in sections 38 and 39 of the Federal Deposit Insurance Act, were intended
                                to increase the likelihood of prompt regulatory action to prevent or
                                minimize loss to the insurance funds.

The Effectiveness of New Laws   In November 1996, we reported that inherent limitations of section 38
in Safeguarding Deposit         requirements and the regulatory implementation of section 39 raise
Insurance Funds Could           questions about their potential for effectively ensuring that regulators act
Potentially Be Limited          early and forcefully enough to prevent or minimize losses to the insurance
                                funds. Section 38 requires regulators to take specific, increasingly severe

                                2
                                 An 18-month cycle is allowed for qualified smaller institutions with assets of less than $250 million.



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                                   regulatory action as an institution’s capital drops to lower levels. Although
                                   this requirement should strengthen oversight in several ways,3 it is
                                   inherently limited as a tool for early intervention to correct problems and
                                   thus safeguard the insurance funds. This is because impaired capital levels
                                   often do not appear until after a bank has experienced problems in other
                                   areas, such as asset quality and management.

                                   Section 39 allows regulatory action before capital is impaired. However,
                                   section 39, as implemented, appears to do little to reduce regulatory
                                   discretion. The implementing guidelines and regulations did not
                                   (1) establish clear and specific definitions of unsound conditions and
                                   practices or (2) link such conditions or practices to specific mandatory
                                   regulatory actions. As we noted in our 1996 report, the subjective nature of
                                   the implementation continued the wide discretion that regulators had in
                                   the 1980s over the timing and forcefulness of enforcement actions.


Other Weaknesses Were              Of course, before regulators can initiate an enforcement action, they must
Noted That Could Limit             first identify problems within an institution. The primary tool regulators
Effectiveness or Reliability       use for this is the full-scope safety and soundness examination.
                                   Traditionally, such examinations have relied significantly on transaction
of Examinations                    testing.4 Transaction testing is used to evaluate the adequacy of the credit
                                   administration process, assess the quality of loans, and ensure the
                                   adequacy of the allowance for loan and lease losses. In past reviews of
                                   bank and thrift examinations, we found limitations that could undermine
                                   the reliability and effectiveness of examinations. These included the
                                   following:

                               •   A lack of comprehensive internal control assessments: In past work, we
                                   found that weak internal controls were a common characteristic of failed
                                   banks and thrifts.5 Assessing the adequacy of internal controls is
                                   important, because timely detection of inadequate controls can provide an
                                   early warning of problems before they seriously erode asset quality and
                                   capital. Our past reports on the examination process found that examiners

                                   3
                                    Section 38 should help prevent certain practices that rapidly eroded the capital of troubled
                                   institutions and contributed to deposit insurance fund losses. Section 38 imposes growth restrictions
                                   to prevent “undercapitalized” and “significantly undercapitalized” institutions from trying to “grow”
                                   their way out of financial difficulty.
                                   4
                                    Regulatory guidance describes transaction testing as a reliable and essential examination technique
                                   for use in the assessment of an institution’s condition and the verification of its adherence to internal
                                   policies, procedures, and controls.
                                   5
                                    A financial institution’s system of internal control provides the framework for achieving management
                                   objectives, protecting assets from loss, reporting financial information accurately, and complying with
                                   pertinent laws and regulations.



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    Statement
    Bank and Thrift Examinations: Adoption of
    Risk-Focused Examination Strategies




    did not systematically test critical internal controls such as compliance
    with loan underwriting policies. We recommended that a comprehensive
    review of internal controls be a part of bank and thrift examinations and
    that the condition of a bank’s or thrift’s system of internal controls receive
    explicit consideration in a determination of an institution’s examination
    rating.
•   Insufficient review of loan quality and loan loss reserves: Effective loan
    quality assessment is important, because loans generally make up the
    majority of bank and thrift assets and involve the greatest risk.
    Determining the adequacy of loan loss reserves is critical because without
    such a determination, in combination with a proper assessment of loan
    quality, examiners have no reliable basis to understand an institution’s
    true financial condition. We recommended that examination policies
    require a representative sampling of loans and better documentation of
    loan quality and the development of a methodology to determine the
    adequacy of loan loss reserves.
•   Weaknesses in detecting and ensuring corrective actions related to insider
    lending: Loans to insiders—such as bank directors, officers, or
    principals—should pose no greater risk than transactions with other bank
    customers. Abusive insider activities can be among the most insidious of
    reasons for the deterioration of the health of a bank. In 1994, we reported
    that examiners faced numerous impediments to determining the full
    extent of insider problems at banks and that such problems were not
    always corrected as a result of examinations. We recommended that bank
    regulators review insider activities in their next examination of each bank,
    partly by comparing data provided during the examination with
    information from other sources. We also recommended that federal bank
    regulators ensure that all directors understand their responsibility for
    seeing that effective corrective action is taken.
•   Insufficient assessment of actual and potential risks of bank holding
    company activities to insured bank subsidiaries: In our reports, we have
    found that transactions between a bank holding company and its insured
    bank subsidiary were not always thoroughly reviewed. Such transactions
    include loans from the bank to other, nonbank subsidiaries; fees charged
    by the bank holding company to the bank subsidiary; and asset transfers
    from nonbank subsidiaries to the bank subsidiary. We recommended that
    the supervisors develop and require mandatory procedures for assessing
    the actual and potential risks to insured bank subsidiaries of bank holding
    company activities.

    We also found in past reviews the need for improvements in important
    elements of examination quality control. We regard these quality controls



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                              Risk-Focused Examination Strategies




                              as essential, because examiners have broad discretion and must exercise
                              considerable judgment in planning and conducting examinations and in
                              drawing conclusions about bank safety and soundness. Our findings led us
                              to recommend that regulators establish policies to ensure

                          •   sufficient documentation of the analysis that underlies the examination
                              report, and
                          •   thorough supervisory review of all examination and inspection procedures

                              Finally, we have noted in past reports that improved coordination among
                              federal and state banking supervisors could result in more efficient and
                              effective use of examination resources. Coordination is also critical for the
                              supervision of large banking institutions in that it could foster consistency
                              in examinations and reduce regulatory burden.


                              Regulators have made a number of changes in an effort to improve their
Regulators Have Made          examinations since the bank and thrift crises of the late 1980s, and I would
Significant Efforts to        like to highlight some that seem most significant. In general, these changes
Improve                       appear appropriate and consistent with recommendations we have made.
                              However, we have not fully assessed the effectiveness of their
Examinations                  implementation. When evaluating these changes, it is also important to
                              note that they have occurred during favorable economic conditions that
                              have contributed to strong bank and thrift profits. The most important test
                              for the changes will be whether the information they provide in
                              examination reports would lessen the severity of problems for banks and
                              thrifts during any future economic downturn.


A Changing Banking            One of the most significant efforts at improvement involves changes in
Environment Has               examinations to account for a dynamic banking environment in which
Prompted Greater              institutions can rapidly reposition their portfolio risk exposures.
                              Regulators have recognized that in such an environment, periodic
Emphasis on Risk              assessments of the condition of financial institutions based on transaction
Management and Internal       testing alone are not sufficient for ensuring the continued safe and sound
Controls                      operation of financial institutions. To ensure that institutions have the
                              internal controls and processes in place necessary to identify, measure,
                              monitor, and control risk exposures that can change rapidly, the approach
                              regulators are taking to the examination process is evolving to emphasize
                              evaluations of the appropriateness of such internal controls and processes
                              instead of relying heavily on transaction testing.




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                               Bank and Thrift Examinations: Adoption of
                               Risk-Focused Examination Strategies




Assessment of Risk             Regulators have changed the system they use to rate the safety and
Management and Internal        soundness of banks and thrifts to reflect an increasing emphasis on risk
Controls Is Reflected in New   management and internal controls. Until January 1997, examiners used the
Rating System                  rating system known as CAMEL (capital adequacy, asset quality,
                               management and administration, earnings, and liquidity). Examiners were
                               instructed in 1996 to give greater emphasis to the adequacy of an
                               institution’s risk management processes, including its internal controls
                               when evaluating management under the CAMEL system.

                               On December 9, 1996, the Federal Financial Institution Examination
                               Council added an “S” to create a new CAMELS rating, with the S
                               representing an institution’s sensitivity to market risk. The S rating
                               component is to represent the result of a combined assessment of both the
                               institution’s level of market risk and its ability to manage market risk.6
                               Regulators expect the sophistication of an institution’s risk management
                               system to be commensurate with the complexity of its holdings and
                               activities and appropriate to its specific needs and circumstances.

                               I should mention that in regulators’ examinations of U.S. branches of
                               foreign banks, an emphasis on risk management and internal controls
                               began in 1994 with implementation of a rating system known as ROCA (risk
                               management, operational controls, compliance, and asset quality.)

                               As I noted earlier, we have recommended that the condition of a bank or
                               thrift’s system of internal controls receive explicit consideration in a
                               determination of the institution’s examination rating. We have also
                               recommended that the regulators develop and require minimum
                               mandatory procedures to assess the actual and potential risks of bank
                               holding company activities to insured bank subsidiaries. Increased
                               attention to internal controls and risk management, if effectively
                               implemented, should help enhance the regulators’ ability to keep pace
                               with a changing banking environment. The supervisors’ effective
                               implementation of these initiatives is essential to the success of their
                               examination programs. Regulators also told us that they believe that these
                               initiatives complement the prompt corrective action policies mandated by
                               FDICIA.




                               6
                                Market risk—the potential for losses due to changes in interest rates, foreign exchange rates,
                               commodity prices, or equity prices—can adversely affect a bank or thrift’s earnings or economic
                               capital. For many banks, market risk is largely the interest rate risk associated with their loan
                               portfolios.



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                                Risk-Focused Examination Strategies




Regulators Have Made            Other improvement efforts I’d like to highlight that we regard as consistent
Other Improvement Efforts       with our earlier recommendations include the following:

                            •   Improvements in examination guidelines to detect insider lending
                                problems: The recommendations we made in this area have been adopted
                                by the Federal Reserve Board, FDIC, and the OCC. Specifically, examination
                                guidance now explicitly calls for reviewing insider activities and ensuring
                                that directors understand their responsibility for effective corrective
                                action.
                            •   Improvements under way in examination documentation and supervisory
                                review of examination findings: Federal banking regulators have described
                                relevant improvement efforts. For example, according to the Federal
                                Reserve’s Framework for Risk-Focused Supervision of Large Complex
                                Institutions, the Federal Reserve has been working to refine its standards
                                for workpapers, especially for examinations of state member banks. Also,
                                the Federal Reserve and FDIC have recently implemented an automated
                                examination process to standardize documentation. Federal Reserve
                                officials said that about 25 U.S. states, to date, have also indicated they
                                will begin using this standardized work process. In addition, OCC issued a
                                new policy in February 1997 describing workpaper requirements for all of
                                its supervisory activities.
                            •   Agreements to coordinate examinations by federal and state banking
                                regulators: The Federal Reserve Board, FDIC, and state banking
                                departments completed a single Nationwide State/Federal Supervisory
                                Agreement in November 1996 covering state-chartered banks that open
                                branches in other states. This agreement modifies an April 1996
                                State/Federal Protocol and Model Agreement by including the Federal
                                Reserve Board as a signatory. Together, these agreements set out, among
                                other things, the goals of supervision, division of responsibilities among
                                the various regulators, and common examination and application
                                processes. Federal Reserve and FDIC officials told us that implementation
                                to date has been successful. These officials also said the examination
                                process has been improved by assigning each institution a single case
                                manager who is responsible for coordinating all examinations of that
                                institution.


                                Changes in examination procedures and in the banking industry will lead
Continuing Issues               to new challenges for the supervisory agencies. A key task will be ensuring
                                consistency in the supervisory and examination policies and practices of
                                the agencies. Further, the agencies face the tasks of ensuring staff
                                expertise and examining increasingly complex banking organizations.



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Supervisory Coordination   Nontraditional lines of business and interstate branching will bring
and Consistency            increasing numbers of depository institutions under the jurisdiction of
                           several regulatory agencies. One result of this will be a more complex task
                           of ensuring that the regulations and enforcement actions of multiple
                           agencies are consistent and that their examinations provide a complete
                           picture of the banks’ and thrifts’ operations.

                           The division of responsibilities among the bank and thrift regulatory
                           agencies is not generally based on specific areas of expertise, functions, or
                           activities of either the regulatory agency or the banks for which they are
                           responsible. Rather, responsibilities are divided according to the type of
                           charter—thrift or bank, national or state—and whether banks are
                           members of the Federal Reserve System. Some analysts, bank industry
                           representatives, and agency officials credit the current structure with
                           encouraging financial innovations and providing checks and balances to
                           guard against arbitrary oversight decisions or actions. We and others,
                           however, have identified concerns that arise from having four agencies
                           with similar responsibilities. These concerns include possible inconsistent
                           treatment of institutions in examination policies and practices,
                           enforcement actions, and regulatory standards and decisionmaking. In the
                           case of bank holding companies, with the Federal Reserve responsible for
                           the bank holding company and other federal regulators responsible for the
                           banking subsidiaries, divided supervisory responsibility may hinder
                           regulators from obtaining a complete picture of an entire banking
                           organization.

                           Although we recognize that only Congress can make the policy judgments
                           in deciding whether and how to restructure the bank oversight system, we
                           have recommended that Congress reduce the number of agencies with
                           primary responsibilities for bank oversight. If the current structure, with
                           multiple agencies, continues, coordinating their activities and ensuring
                           consistency in their regulations and enforcement actions will remain
                           difficult issues. The regulatory agencies have several initiatives under way
                           that are intended to better coordinate their activities and ensure
                           consistency, such as the automated examination process developed by the
                           Federal Reserve and FDIC. Ultimately, these initiatives should be judged by
                           their results, particularly including the quality of the examinations.


Supervisory Expertise      As banking activities have become more complex, bank examinations
                           have required increasingly broader expertise. As a result, another issue




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                          that the regulators will continue to face is the need to build and maintain
                          the expertise needed for supervising these more complex organizations.

                          Federal regulators have hired specialists, such as economists with
                          technical expertise in the quantitative methods and economic models
                          underlying banks’ risk management systems and specialists in electronic
                          banking, bank information systems, and risk management. Further, the
                          agencies have a number of initiatives to improve the scope and quality of
                          information that is provided to field examiners to help them understand
                          banking activities and the risks that banks undertake.

                          In addition, the supervisory agencies have recently completed training on
                          the risk-focused examination process and the new CAMELS rating system.
                          Previously, the Federal Reserve took steps to enhance examiner training
                          on internal controls by developing an Internal Controls School in 1995 that
                          was designed initially for examiners of U.S. branches and agencies of
                          foreign banks and expanded to meet the needs of examiners of U.S.
                          domestic banks. Federal Reserve officials told us that they also developed
                          a training seminar in 1996 for examiners and in-house international
                          supervisory staff that emphasizes ensuring the appropriate supervisory
                          strategy for the U.S. operations of foreign banks.


Examinations of Complex   With the passage of interstate banking and the increased reliance of banks
Financial Institutions    on lines of business other than traditional lending, we anticipate that the
                          task of bank management will become more difficult. The bank regulatory
                          agencies will face a similar challenge—ensuring that their examinations
                          and enforcement strategies lead to sound management practices as banks
                          increasingly rely on nontraditional lines of business. Since large, complex
                          bank organizations are likely to come under the regulatory jurisdiction of
                          several agencies, the problem of coordination that I mentioned earlier will
                          be relevant for these organizations. Several of our recent reports point to
                          other types of issues that are likely to become increasingly common as
                          banks move into more complex lines of business.

                          In our report on the operations of securities activities in banks and bank
                          holding companies, for instance, we noted that most banks provided
                          securities services in affiliates that are regulated primarily by securities
                          regulators. Some securities activities are overseen by the bank regulators,
                          however, so the potential for inconsistent oversight exists. Because
                          securities oversight would be enhanced by increased cooperation,
                          coordination, and sharing of regulatory expertise among bank and



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securities regulators, we recommended that the bank regulators work with
the Securities and Exchange Commission and the National Association of
Securities Dealers to develop consistent standards for investor protection
and to ensure the safety and soundness of banks that are engaged in some
form of securities business.

In our report on the operations of foreign bank organizations in the United
States, we noted deficiencies in the internal controls of these
organizations. Although federal bank regulators are aware of these
deficiencies and have initiatives under way that they believe will address
these problems, we noted that the regulators do not have plans to evaluate
the results of these initiatives. We recommended that the Federal Reserve
Board develop a strategy for evaluating the outcomes of the efforts to
improve the internal controls of foreign bank organizations.

It will be important for the regulatory officials to develop a strategy,
including objective measures, for assessing the progress they are making
through their efforts to improve the examination process and to ensure
that the procedures and systems necessary to collect the data relevant to
those measures are in place and operating. Such objective evaluations
should be useful in determining whether the examinations are achieving
their intended results or whether additional initiatives may be needed.

At the same time, we are encouraged by some of the changes that the bank
regulatory agencies have made in their examination procedures, since they
appear to address a number of the shortcomings that we had addressed in
our earlier reports. As one official noted, the small number of banks in
difficulty has provided the regulatory agencies with an opportunity to
improve their operations. However, the business of banking has been
changing at the same time, and banks are taking on new risks. Also,
because of the differences in the responsibilities and the examination and
enforcement approaches among regulators, such as those for the security
activities of depository institutions, a key question is whether
improvement will be uniformly adopted by all regulators and consistently
implemented. Whether current examination strategies provide an adequate
basis for the regulatory agencies to anticipate problems and take
appropriate and prompt corrective actions to address those problems,
especially during any future economic downturn, is unknown.


Ms. Chairwoman, this concludes my statement. My colleagues and I would
be pleased to respond to any questions you may have.



Page 13                                                     GAO/T-GGD-98-13
Page 14   GAO/T-GGD-98-13
Page 15   GAO/T-GGD-98-13
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              Foreign Banks: Internal Control and Audit Weaknesses in U.S. Branches
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              Financial Regulation: Bank Modernization Legislation (GAO/T-OCE/GGD-97-103,
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              Bank and Thrift Regulation: Implementation of FDICIA’s Prompt Regulatory
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              Bank Oversight: Fundamental Principles for Modernizing the U.S.
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              Bank and Thrift Regulation: FDICIA Safety and Soundness Reforms Need to
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              Page 16                                                     GAO/T-GGD-98-13
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(233535)   Page 17                                                 GAO/T-GGD-98-13
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