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February 10, 1948. Chairman Fccles: At Governor Vardaman's request, I am attaching for your information copies of two memoranda which I have prepared for him — one relating to the Board's legal responsibilities in connection with examinations of State member banks and the other relating to the Board's legal responsibilities in connection with audits of Federal Reserve Banks. LEGAL RESPONSIBILITIES OF THE BOARD OF GOVERNORS AS TO EXAMINATIONS OF STATE MEMBER BANKS This memorandum considers the legal responsibilities and authority of the Board of Governors as to procedures in examinations of State member banks, with particular reference to the question whether the Board1s existing practices adequately meet its legal obligations in this field. Conclusion It is my conclusion that the procedures which are now being followed by the Board with respect to examinations of State member banks fully meet the requirements of the law and carry out the Board's responsibilities as a legal matterj but the Board has the legal authority, if it deems it necessary or desirable, to change the present procedures and to make such examinations itself using its own examiners for the purpose• Existing Practices with Respect to Examination of State Member Banks State member banks are now examined by the Federal Reserve Banks with examiners approved by the Board. The Bank Examination Department of each Reserve Bank is under the supervision of a Vice President designated by the Bank after consultation with the Board. His salary is subject to the approval of the Board. State member banks are examined at least once each year, with additional examinations if considered desirable. The Federal Reserve Banks use a standard form of examination report prescribed by the Board after consultation with Reserve Bank representatives. In order to avoid duplication and to minimize inconvenience to the banks examined wherever practicable, joint examinations are made in cooperation with the State Banking Authorities or alternate examinations are made by agreement with State authorities. The reports of examination are reviewed t?y the Vice President of the Reserve Bank or his assistants, and letters are written by the Vice President to the member banks making such criticisms and recommendations as appear to be called for by the report. Copies of reports of examination are furnished to State member banks and to the Board. The Board's Division of Examinations reviews and follows the examination and supervisory activities of the Federal Reserve Banks with a view to furthering coordination of policies and practices under the general policies of the Board. Upon receipt of a report of examination in the Board1 s Division of Examinations, a Review Examiner reviews the report and initiates action regarding matters requiring further attention. Ordinarily, such matters are followed by correspondence, but matters of pressing importance are covered by telegraph or telephone. -2Periodically, Conferences of Examiners are held in Washington to consider matters pertaining to policy, practice, and procedure in the examination and supervision of member banks. Members of the Board's Division of Examinations plan, arrange, and participate in the conferences and assist in the formulation of views and recommendations. From time to time, the officers in charge of examinations at the Reserve Banks spend a few days in the Board's offices for the purpose of discussing matters of mutual interest. Statutory Provisions It may be helpful to make a brief chronological review of the various provisions of the Federal Reserve Act which Congress has enacted from time to time with respect to the examinations of State member banks of the Federal Reserve System. One of the purposes of the original Federal Reserve Act, passed in 1913, as stated in the preamble, was "to establish a more effective supervision of banking in the United States11, and to carry out this objective the law provided for an increased number of examinations of national banks and also provided for Federal examinations of State banks coming into the System. Section 21 of the original Act required the Controller of the Currency to examine every member bank, national and State, at least twice in each calendar year and oftener if considered necessary. It soon developed, however, that State banks were reluctant to come into the System because of this authority for examinations by the Coiaptroller of the Currency, and accordingly this authority, in so far as it applied to State banks, was eliminated by a provision added to section 9 in 1917. There were, however, two other provisions in the original Federal Reserve Act relating to this subject which remain in the law at present virtually unchanged. One of these is the provision in section 11(a) authorizing the Board "to examine at its discretion the accounts, books and affairs of each Federal reserve bank and of each member bank and to require such statements and reports as it may deem necessaiy." The other provision is found in section 21 and reads as follows: "In addition to the examinations made and conducted by the Comptroller of the Currency, every Federal reserve bank may, with the approval of the Federal reserve agent or the Board of Governors of the Federal Reserve System, provide for special examination of member banks within its district. * * * Such examinations shall be so conducted as to inform the Federal reserve bank of the condition of its member banks and of the lines of credit which are being extended by them. Every Federal reserve bank shall at all times furnish to the Board of Governors of the Federal Reserve System such information as may be demanded concerning the condition of any member bank within the district of the said Federal reserve bank." -3Briefly stated, therefore, under the original Federal Reserve Act examinations of State member banks were authorized to be made by the Comptroller of the Currency and the Federal Reserve Board, and special examinations were authorized by the Federal Reserve Banks. The authority of the Comptroller has been repealed. The revision of the law in 1917 added the following two sentences to section 9 relating to examinations of State member banks by the Board or lay the Federal Reserve Banks and these are still a part of the law: "As a condition of membership such banks shall likewise be subject to examinations made by direction of the Board of Governors of the Federal Reserve System or of the Federal reserve bank by examiners selected or approved by the Board of Governors of the Federal Reserve System. "Whenever the directors of the Federal reserve bank shall approve the examinations made by the State authorities, such examinations and the reports thereof may be accepted in lieu of examinations made by examiners selected or approved by the Board of Governors of the Federal Reserve System: Provided» however* That when it deems it necessary the board may order special examinations by examiners of its own selection and shall in all cases approve the form of the report." One other provision may be mentioned in this connection. In 1933 a provision was put in section A of the Act requiring each Federal Reserve Bank to keep itself informed as to loans and investments of member banks in order to ascertain whether bank credit is being used for speculation, and the chairman of each bank is required to report to the Board any undue use of bank credit by a member bank. In summary, therefore, currently effective provisions of the law provide for examinations of State member banks to be made by the Board, to be made by direction of the Board ty examiners selected by it, or to be made by direction of the Federal Reserve Bank with examiners approved by the Board. The law also authorizes the directors of a Reserve Bank to approve examinations made by the State authorities which may be accepted in lieu of Federal Reserve examinations, and it authorizes special examinations by Federal Reserve Banks with the approval of the Board or Federal Reserve Agent. The Federal Reserve Bank must keep itself informed as to member bank loans and investments and must furnish to the Board any information concerning any member bank within its district. Adequacy of Present Procedures In Relation to Legal Responsibilities It is clear from the provisions of the statute that the Board of Governors has a definite responsibility with respect to examinations of State member banks, although the law also gives the Federal Reserve Banks a certain amount of responsibility with respect to such examinations. -4It is the Board1s responsibility to see that proper examinations are made either by itself or by the Reserve Banks, bat the language of the various provisions of the law on the subject indicates that it was expected that ordinarily the Eeserve Banks would also have an important role in the examination procedure. A reading of the entire provisions on the subject, however, shows in ay opinion that the chief or basic responsibility is that of the Board. This responsibility, under the specific language of section 9, can be discharged by following either of two alternative methods of examination of State member banks provided for in section 9s Such examinations may be made by the Board or by the direction of the Board by examiners selected or approved by it, or they may be made by direction of the Federal Reserve Bank by examiners selected or approved by the Board. It is obvious, therefore, that the requirements of the law are met either l^y a procedure under which the Board makes or directs the examinations of State member banks with examiners of its own selection or a procedure under which the Federal Reserve Bank directs such examinations with examiners approved by the Board. The latter is the procedure which is now being followed and in ay opinion this procedure complies with the intent and language of the statute. A procedure under which the Board would make or direct the examinations of State member banks, however, would also comply with the intent and language of the statute. Accordingly, the Board has full legal authority, if it desires to do so, to change the present examination procedure and to make its own examinations of State member banks. The objectives of examinations of banks are, broadly speaking, to obtain full information as to their condition and operations, to ascertain whether they are complying with applicable laws and regulations, and to form the basis for any needed corrective measures as far as practicable. If in the Board1s judgment these objectives are not being adequately met by the present procedure with respect to State member banks or if it feels the procedure is for any reason not producing satisfactory results, the Board has the authority, and indeed the responsibility, to consider whether a change in the procedure would be desirable. In such event the Board might decide to adopt any one of several alternatives. It might decide to give closer and more detailed supervision to the examination of State member banks as conducted by the Federal Reserve Banks j it might decide to conduct occasional examinations itself of such banks, leaving most of the examinations, however, with the Federal Reserve Banksj it might decide to conduct all such examinations itself with its own examiners j or it might decide to conduct them through the instrumentality of the Federal Reserve Agents (as was the case prior to 1936^ Other possibilities or combinations of these possibilities might be considered. Any one of the alternatives mentioned would be permissible under the broad authority given to the Board by the law. 2/9/48 LEGAL RESPONSIBILITIES OF THE BOARD OF GO?EMORS AS TO AUDITS OF FEDERAL RESERVE BAHKS This memorandum considers the legal responsibilities and authority of the Board of Governors as to the auditing of Federal Reserve Banks, with particular reference to the question whether the Board has legal authority to station resident auditors at the Federal Reserve Banks, Conclusions It is my conclusion that the practices which are now being followed by the Board with respect to audits of the Federal Reserve Banks fully meet the requirements of the law and carry out the Boardfs responsibilities as a legal matter. The Board has the authority, however, to adopt additional measures in this field if it should deem it advisable. It is also my conclusion that, although the question is open to considerable doubt, the legal authority of the Board to station resident examiners or auditors at the Federal Reserve Banks can be sustained. The question whether this is desirable depends, of course, upon considerations of policy and practice. Statutory Provisions There is no provision of law which refers specifically and in terms to audits of Federal Reserve Banks, but under the provisions of the Federal Reserve Act, the Board has a number of authorities which relate directly or indirectly to this general subject. Without quoting at length the various statutory provisions which may have a bearing upon the questions here under consideration, the following powerf, based upon provisions of the Federal Reserve Act, may be mentioned: The Board's authority *to examine at its discretion the accounts, books and affairs of each Federal Reserve Bank and of each member bank and to require such statements and reports as it may deem necessary1* j the power to exercise "general supervision" over the Federal Reserve Banks; the power to approve the appointment of the President and First Vice President of Federal Reserve Banksj the power to suspend or remove officers or directors of Federal Reserve Banks; the duty to order the examination of each Federal Reserve Bank at least once a year and to order a special examination of a Federal Reserve Bank upon application of ten member banksj and the power to make all rules and regulations necessary to enable the Board effectively to perform the duties, functions or services specified in the Federal Reserve Act. The Federal Reserve Agent is to maintain a local office of the Board on the premises of the Federal Reserve Bank and to act as the Board's official representative for the performance of its functions. Authority to Examine Includes Authority to Make Audits There is no clearly defined legal distinction between an examination and an audit of a bank. Dictionary and other authoritative definitions of these terms, as they are applied to banks, tend to be overlapping and confusing. However,generically, Bexamination0 is the broader term. -2In practice, the basic functions of an auditor are the verification of accounts and the review of accounting methods, systems, and controls. On the other hand, an examiner is primarily concerned with an appraisal of a bankfs assets and its management and policies and ordinarily does not purport to make an audit. However, an examination customarily includes verification of accounts and consideration of accounting practices and an examiner is generally regarded as having great latitude to extend this portion of his work beyond its usual scope as circumstances indicate that this is desirable. In practice the examinations of the Reserve Banks by the Board1s examiners involve audit procedure to a much greater extent than is customary in the case of examinations of commercial banks. In aiy event, the extremely broad provision authorizing the Board to examine the Federal Reserve Banks, taken in connection with the Board's power of general supervision and its other powers, seems fully ample to authorize the Board to make audits of the Federal Reserve Banks if/ in its discretion, it deems it necessary or advisable to do so. Existing Practices with Respect to Auditing Function at the Federal Reserve Banks Under the practice now in effect, each Federal Reserve Bank has an Audit Department under the supervision of an Auditor, appointed by and responsible to the board of directors of the Federal Reserve Bank. The Auditor is charged with the duty of auditing the books, records, and financial transactions of the Reserve Banks. In carrying out this responsibility, the Auditor plans and conducts an audit program designed to assure him that transactions are properly recorded, that the assets of the Bank are on hand or accounted for, that all liabilities, direct or contingent, are appropriately reflected, and that income and expenses are in order* The Auditor reports to the board of directors, through an Audit Review Committee, as to his findings and makes recommendations as to changes which should be effectuated. He is given opportunity to discuss matters with the Chairman and the Committee. An Auditor is, of course, appointed by the Federal Reserve Bank, although his salary is subject to the approval of the Board of Governors, as in the case of other Reserve Bank officers. Frequently proposed appointments of Auditors are discussed informally with representatives of the Division of Examinations. Copies of reports of audits made, except routine verifications where-no comments or criticisms are submitted, are forwarded to the Board of Governors. These reports are reviewed in the Division of Examinations in Washington, and matters of serious importance requiring attention are followed (l) currently Ty correspondence or informal inquiiy or (2) in •oregular course by reference to the field examining staff for review at the next examination. (In addition, the Division of Bank Operations reviews all such reports, primarily for matters of interest concerning Reserve Bank expenses and operations*) The Board examines the Federal Reserve Banks annually through its own examiners, and in connection with these examinations a review is made of the organization, operation, and personnel of the Audit Departments of the Reserve Banks. This involves a review of each report of audit made during the interval since the preceding examination and the manner in which the Department is maintaining its audit schedule, and may include consideration of the procedure and practices followed. The examiner discusses with the Auditor his relations with the board of directors and operating officers of the Bank, as well as the adequacy of the audit program and the appropriateness of the controls in force. The results of this inquiry are transmitted in confidence to the Director of the Board1s Division of Examinations, which also receives a comparable memorandum with respect to the Examination Department of the Bank. Periodically, Conferences of Auditors of the Federal Reserve Banks are held for the discussion of mutual problems. Representatives of the Board's Division of Examinations are active participants in these conferences, and assist in formulating objective standards of audit performance for the System. Adequacy of Present Procedures in Relation to Legal Responsibilities The Board has the specific duty to make examinations of Federal Reserve Banks, but its responsibilities as to audits of the Banks are only those which are implicit in its examining authority and general supervisory powers. It is clear from the above stateraent of the existing practices with respect to this subject that the Board performs the duty which the law imposes upon it to make annual examinations of the Federal Reserve Banks and, although there is nothing in the law specifically referring to audits, the Board*s examiners review the Reserve Bank auditing departments and audit reports made in those departments. It is my understanding that the existing practices and procedures followed by the Board as above outlined with respect to examinations of Federal Reserve Banks, together with the various contacts maintained with the banks are sufficient to keep the Board well informed as to important developments and policies at the Reserve Banks and that the examinations of the banks and the reviews of the audit departments are adequate to insure the proper verification and disclosure of the financial status of the banks. Accordingly, in my opinion these practices and procedures comply with the requirements of the law and carry out the Boardfs responsibilities in this field as a legal matter. -4The broad range of authority granted to the Board by the law, however, is sufficient to permit it to go further than it is now doing and to adopt different or additional measures with respect to audits of Reserve Banks, if considered necessary or advisable. Possibility of Resident Auditors or Examiners at Federal Reserve Banks The authority of the Board to station one or more of its own employees on the premises of each Federal Reserve Bank on a full-time basis to engage continuously in the auditing or examination of the Reserve Bank is open to question. Under established custom, examinations of banks by Government authorities always have been made periodically rather than on a continuous basis. Congress doubtless was familiar with this practice when it authorized the Board to examine the Reserve Banks, and the provision directing the Board to make at least one examination each year and special examinations at the request of member banks is some indication that Congress was thinking in terms of periodic examinations. The Board has the same authority to examine member banks as it has to examine the Reserve Banks, and whatever may have been the intent of Congress with respect to the examination of the Reserve Banks, it is hardly possible that it contemplated that the Board might station resident auditors or examiners at member banks to examine such banks continuously. However, the statute vests in the Board, in broad terms, authority to examine the Reserve Banks "at its discretion*, and it contains no prohibition against continuous examinations or other limitations upon the Board's authority. In the final analysis, the Board's authority to audit or examine the Federal Reserve Banks continuously probably depends upon whether the Board would be abusing its discretion in talcing such action. The contention that the Board was abusing its discretion and that continuous examinations were unwarranted might find some support in the fact that periodic examinations of banks is the extablished practice and that for over thirty years the Board has not deemed it necessary to audit or examine the Reserve Banks on a continuous basis. In view, however, of the peculiarly close relationships between the Board and the Reserve Banks, the nature of the responsibilities which the law places upon the Board for the supervision of the entire Federal Reserve System, and the narrow limitations of judicial review of discretionary action by Governmental agencies, it seems very doubtful whether anyone could successfully maintain that the Board was abusing its discretion if it should determine that continuous examinations or audits of the Federal Reserve Banks are necessary or advisable in the discharge of its responsibilities under the law. -5Doubts regarding the legality of the proposal could be Somewhat lessened by stationing Board examiners or auditors in the office of each Federal Reserve Agent (which by law is a local office of the Board at the Reserve Bank) with the duty of making audits of the Reserve Bank on a continuous basis* As an alternative, the Board might direct the Federal Reserve Agent or an Assistant Agent to make such continuous audits of the Reserve Bank and to report to and be solely responsible to the Board in the performance of these duties. While the question is debatable and the Board might be going further than Congress actually had in mind, it is my opinion that, as a technical legal matter, the Board has the authority to station resident examiners or auditors at each Federal Reserve Bank to engage continuously in examining or auditing the bank. The desirability of such action, as distinguished from its legality, would depend, however, upon important considerations of policy and practice. Practice of Farm Credit Administration In this connection it is interesting to note that the Farm Credit Administration utilizes what may be called a "Resident Examiner" in each Federal Land Bank District, who performs functions roughly similar to those which would be perf ormed by an audit unit or section at the Land Banks and Intermediate Credit Banks. This examiner usually has one or two assistants. His function apparently is to prepare material in advance of the annual audit by the traveling examination section aaii to help the examination force when it arrives to make the examination. This system was instituted during the war because of the small volume of business, which was back to about 1924 levels, and also because of the manpower shortage. Mr. Fox, Chief Examiner of the Farm Credit Administration, expressed the personal opinion that be did not think that this type of organization was especially desirable, particularly for a banking organization. 2/9/4S
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