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BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 00-13 (SUP)
August 15, 2000
TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE
SUPERVISORY STAFF AT EACH FEDERAL RESERVE BANK
AND TO FINANCIAL HOLDING COMPANIES
SUBJECT:
Framework for Financial Holding Company
Supervision
Introduction
The Gramm-Leach-Bliley Act ("GLB Act") repeals those provisions of
the Glass-Steagall Act and the Bank Holding Company Act that restrict the ability of
bank holding companies ("BHCs") to affiliate with securities firms and insurance
companies. The GLB Act authorizes qualifying BHCs to operate as financial holding
companies ("FHCs") and to engage in a diversified range of financial activities. In
addition to controlling depository institutions, permissible activities for FHCs include
conducting securities underwriting and dealing, serving as an insurance agent and
insurance underwriter, acting as a futures commission merchant, and engaging in
merchant banking. Permissible activities also include those that the Board and the
Secretary of the Treasury jointly determine to be financial in nature or incidental to
financial activities, or that the Board determines is complementary to a financial
activity and does not pose a substantial risk to the safety and soundness of depository
institutions or the financial system generally.
Under the GLB Act, the Federal Reserve has supervisory oversight
authority and responsibility for BHCs, including BHCs that operate as FHCs. The
statute includes provisions that streamline various aspects of the Federal Reserve's
supervision for all BHCs and sets forth parameters for the relationship between the
Federal Reserve and other regulators. The statute differentiates between the Federal
Reserve's relations with regulators of depository institutions and functional regulators,
which include insurance, securities and commodities regulators. There should be
minimal, if any, noticeable change in the well-established relationships between the
Federal Reserve as BHC (including FHC) supervisor and bank and thrift supervisors
(federal and state). The Federal Reserve's relationships with functional regulators
will, in practice, depend upon the extent to which an FHC is engaged in functionally
regulated activities and also will be influenced by already established working
arrangements.
This SR letter provides guidance concerning the purpose and scope of
the Federal Reserve's supervision of FHCs, with particular focus on the legislation's
requirements for working with functional regulators. The framework should be used
by Federal Reserve staff in supervising FHCs and coordinating activities with the
appropriate primary supervisors of an FHC's banking, insurance, and securities
subsidiaries.
The Federal Reserve's supervisory oversight role is that of an umbrella
supervisor concentrating on a consolidated or group-wide analysis of an organization.
Umbrella supervision is not viewed as an extension of more traditional bank-like
supervision throughout an FHC. The FHC framework set forth in this letter is
consistent with and incorporates principles that are well established for BHCs.
Because the GLB Act does not require significant changes in supervisory practice for
non-FHC BHCs, this document focuses on addressing supervisory practice for, and
relationships with, FHCs, particularly those that are engaged in securities or insurance
activities.
Roles of Supervisors
The Federal Reserve is responsible for the consolidated supervision of
FHCs. In this regard, the Federal Reserve will assess the holding company on a
consolidated or group-wide basis with the objective of ensuring that the holding
company does not threaten the viability of its depository institution subsidiaries. The
manner in which the Federal Reserve fulfills this role will likely evolve along with the
activities and structure of FHCs and may differ depending on the mix of banking,
securities, and insurance activities of an FHC.
Depository institution subsidiaries of FHCs are supervised by their
appropriate primary bank or thrift supervisor (federal and state). The GLB Act did
not alter the role of the Federal Reserve, as holding company supervisor, vis-a-vis the
primary supervisors of FHC-associated bank and thrift subsidiaries because the
Federal Reserve has traditionally relied to the fullest extent possible on those
supervisors.
Nonbank (or nonthrift) subsidiaries engaged in securities, commodities
or insurance activities are supervised by their appropriate functional regulators. Such
functionally regulated subsidiaries include a broker, dealer, investment adviser, and
investment company registered with and regulated by the SEC (or, in the case of an
investment adviser, registered with any state); an insurance company or insurance
agent subject to supervision by a state insurance regulator; and a nonbank subsidiary
engaged in CFTC-regulated activities.
Objectives of Financial Holding Company Supervision
The Federal Reserve, as umbrella supervisor, will seek to determine that
FHCs are operated in a safe and sound manner so that their financial condition does
not threaten the viability of affiliated depository institutions. Oversight of FHCs
(particularly those engaged in a broad range of financial activities) at the consolidated
level is important because the risks associated with those activities can cut across
legal entities and business lines. The purpose of FHC supervision is to identify and
evaluate, on a consolidated or group-wide basis, the significant risks that exist in a
diversified holding company in order to assess how these risks might affect the safety
and soundness of depository institution subsidiaries.
Accordingly, the Federal Reserve will focus on the financial strength and
stability of FHCs, their consolidated risk-management processes, and overall capital
adequacy. The Federal Reserve will review and assess the internal policies, reports,
and procedures and effectiveness of the FHC consolidated risk management process.
The appropriate bank, thrift, or functional regulator will continue to have primary
responsibility for evaluating risks, hedging, and risk management at the legal-entity
level for the entity or entities that it supervises.
As noted above, financial holding company supervision is not intended
to impose bank-like supervision on FHCs, nor is it intended to duplicate or replace
supervision by the primary bank, thrift, or functional regulators of FHC subsidiaries.
Rather, it seeks, on the one hand, to balance the objective of protecting the depository
institution subsidiaries of increasingly complex organizations with significant interrelated activities and risks, against, on the other, the objective of not imposing an
unduly duplicative or onerous burden on the subsidiaries of the organization.
Effective financial holding company supervision requires:
• Strong, cooperative relationships between the Federal Reserve and
primary bank, thrift, and functional regulators and foreign
supervisors. These relationships respect the individual statutory
authorities and responsibilities of the respective supervisors, but at
the same time, allow for enhanced information flows and
coordination so that individual responsibilities can be carried out
effectively without creating duplication or excessive burden;
• Substantial reliance by the Federal Reserve on reports filed with, or
prepared by, bank, thrift, and functional regulators, as well as on
publicly available information for both regulated and non-regulated
subsidiaries; and
• Continued reliance on the risk-focused supervision and
examination process and on market discipline.
Financial Holding Company Supervision in Practice
The supervisory activities of the Federal Reserve fall into three broad
categories: information gathering, assessments and supervisory cooperation; ongoing
supervision; and promotion of sound practices and improved disclosure.
Information gathering, assessments, and supervisory cooperation
To fulfill its responsibilities, the Federal Reserve needs to interact closely
and exchange information with the primary bank, thrift, and functional regulators. It is
also important that the Federal Reserve develop strong relationships with senior
management and boards of directors of FHCs, and have access to timely information
from FHCs. In order to understand how risk management and internal control policies
and procedures established at the consolidated level are being implemented and
assessed, these relationships will need to include heads of significant business lines
and key internal audit, control, and risk management officials.
To achieve these objectives, Federal Reserve supervisory staff will:
• Regularly assess an FHC's centralized risk management and control
processes. Such assessments are necessary to understand an
organization's overall risk profile, to identify material contributions
to core risks, and to determine how such risks are being managed
and controlled on a consolidated basis.
• Perform limited targeted transaction testing, where appropriate, to
verify that risk management systems of the FHC are adequately and
appropriately measuring and managing areas of risk for the
organization, and to confirm that laws and regulations applicable to
the FHC and within the jurisdiction of the Federal Reserve are
being followed.
• Have periodic discussions with FHC senior management and
boards of directors. Such discussions will enable the Federal
Reserve to build relationships with key personnel and to understand
changing activities and the evolving risk profile of the consolidated
organization. Periodic discussions also will provide a forum for
supervisory staff to present any findings or concerns related to the
activities of the group as a whole or to business lines that cut across
legal entities.
• Have periodic discussions with key personnel responsible for
corporate management and control functions, such as heads of
business lines, risk management, internal audit and internal control.
In performing the tasks described above, Federal Reserve supervisory
staff, to the extent possible, should coordinate their actions with those of the primary
bank, thrift, and functional regulators of the FHC's subsidiaries. For example, in order
to understand the risks and risk-management systems of an FHC at the consolidated
level, the Federal Reserve will need information concerning assets or liabilities
booked in significant bank, thrift, and functionally regulated subsidiaries within the
FHC group. The primary bank, thrift, and functional regulators of such subsidiaries
also may have a need for information from the FHC, consistent with their respective
statutory mandates. To assist in sharing needed information, Federal Reserve
supervisory staff should:
• Have periodic meetings with the primary bank, thrift and functional
regulators of an FHC's subsidiaries to develop an understanding of
the risk profiles of the individual regulated legal entities and their
relation to the FHC's overall risk profile. These meetings also
should be used, where appropriate, to share information regarding
supervisory plans and coordinate supervisory activities and followup, as needed.
• Review the examination findings of primary bank, thrift and
functional regulators (and their self-regulatory organizations)
together with other relevant information in order to develop a
consolidated picture of the FHC's financial condition and risk
profile, the effectiveness of risk management and internal control
policies, and the implications for the affiliated depository
institutions.
• Make available to primary bank, thrift and functional regulators, to
the extent permissible, pertinent information regarding the financial
condition, risk management policies, and operations of an FHC that
may have a material impact on individual regulated subsidiaries, as
well as information concerning transactions or relationships
between the regulated subsidiaries and other subsidiaries within the
FHC group. This process will assist supervisors in performing
their statutory and supervisory responsibilities over regulated
subsidiaries.
• Participate in the sharing of information among international
supervisors, consistent with applicable law, to ensure that an FHC's
global activities are supervised on a consolidated basis and to
minimize material gaps in supervision.
• Review internal audit and management reports and publicly
available information (including market information on equity and
debt prices of the consolidated organization), as well as reports and
statistics collected by other regulators, including those of
depository institution subsidiaries. To limit regulatory burden, this
information should be obtained, to the fullest extent possible, from
the parent organization, from primary bank, thrift, and functional
regulators of the FHC's regulated subsidiaries, and from publicly
available sources, such as externally audited financial statements.
Ongoing supervision
FHC structure, management, and the applications process
The Federal Reserve is responsible for understanding the consolidated
organization's legal, organizational, and risk management structure, major business
activities, and risk exposures and risk management systems. The Federal Reserve
needs to understand the nature and degree of involvement of the board of directors at
the consolidated group level in overseeing the risk management and control process of
the organization. The Federal Reserve, when considering any formal application,
declaration, certification, or notification process at the FHC level, will coordinate, as
appropriate, with primary bank, thrift, and functional regulators.
Reporting and examination
The Federal Reserve will rely, to the fullest extent possible, on reports
that an FHC or its subsidiaries are required to file with, or are prepared by, federal or
state authorities (or self-regulatory organizations). The Federal Reserve will rely on
routinely prepared management reports, publicly reported information, and externally
audited financial statements. The Federal Reserve also will rely to the fullest extent
possible on the examination of an FHC's bank and nonbank subsidiaries by their
appropriate primary bank, thrift, and functional regulators (and their self-regulatory
organizations).
If supervisory staff requires a specialized report from a functionally
regulated subsidiary of an FHC, staff first will request it from the subsidiary's
appropriate functional regulator. In the event that the report is not made available to
the Federal Reserve, supervisory staff may obtain the report directly from the
functionally regulated subsidiary if it is necessary to assess (i) a material risk to the
FHC or any of its depository institution subsidiaries, (ii) compliance with any federal
law that the Federal Reserve has specific jurisdiction to enforce against the FHC or a
subsidiary, or (iii) the FHC's systems for monitoring and controlling financial and
operational risks that may pose a safety and soundness threat to a depository
institution subsidiary.
The Federal Reserve may examine a functionally regulated subsidiary
when it has reasonable cause to believe (or reasonably determines) that (i) the
subsidiary is engaged in an activity that poses a material risk to an affiliated
depository institution, (ii) the examination is necessary to be adequately informed
about the FHC's systems for monitoring and controlling the financial and operational
risks that may pose a safety and soundness risk to a depository institution subsidiary,
or (iii) the subsidiary is not in compliance with any federal law that the Board has
specific jurisdiction to enforce (and the Board cannot determine compliance by
examining the FHC or its affiliated depository institutions). Before examining a
functionally regulated subsidiary, supervisory staff should first seek to obtain the
necessary information from the appropriate functional regulator. If an examination is
determined to be necessary, the Federal Reserve should coordinate its actions with the
appropriate functional regulator.
Consistent with current practice, the Federal Reserve will continue to
rely to the fullest extent possible on the work performed by bank, thrift, and functional
regulators to validate that material risks are measured and managed adequately at the
regulated subsidiary level. Where necessary and appropriate, and consistent with (i)
through (iii) above, the Federal Reserve may conduct or participate in reviews at
banks, thrifts, or functionally regulated subsidiaries to validate that risk management
and internal control policies established at the consolidated level are being
implemented effectively.
For a subsidiary of an FHC that is not supervised by a bank, thrift, or
functional regulator, the Federal Reserve will obtain information from the subsidiary,
as appropriate and necessary, to assess the financial condition of the FHC as a whole.
In addition, the Federal Reserve will conduct examinations of such subsidiaries, if
necessary, to be informed as to the nature of the subsidiary's operations and financial
condition, as well as the subsidiary's financial and operational risks that may pose a
threat to the safety and soundness of any depository institution subsidiary of the FHC
and the systems for monitoring and controlling such risks. Under the GLB Act, the
Federal Reserve may not examine any subsidiary of an FHC that is an investment
company registered with the SEC and that is not itself a BHC.
Capital adequacy
The Federal Reserve is responsible for assessing consolidated capital
adequacy for FHCs with the ultimate objective of protecting the insured depository
subsidiaries from the effects of disruptions in the nonbank portions of the
organization. Capital adequacy will be assessed in relation to the risk profile of the
consolidated organization. The Federal Reserve will review the FHC's internal risk
assessment and related capital analysis process for determining the adequacy of its
overall capital position. Such a review will include consideration of present and
future economic conditions, future business development plans, possible stress
scenarios, and internal risk control and audit procedures. As BHCs, FHCs are subject
to the Federal Reserve's holding company capital guidelines, which set forth
minimum capital ratios that serve as tripwires for additional supervisory scrutiny and
corrective action. The Federal Reserve will review these requirements as they apply
to FHCs and may, if warranted, adapt the manner in which they apply to FHCs that
engage in a broad range of financial activities.
Although the Federal Reserve is responsible for assessing the
consolidated capital adequacy of FHCs, the primary bank, thrift, or functional
regulators of FHC subsidiaries will continue to set and enforce applicable capital
requirements for the regulated entities within their jurisdiction. Under the GLB Act,
the Federal Reserve may not establish separate capital adequacy requirements for an
FHC subsidiary that is in compliance with the capital requirements of its functional
regulator.
Consistent with current practice, the Federal Reserve will continue to
place significant reliance on the primary bank, thrift, or functional regulator's analysis
of the capital adequacy of a regulated subsidiary and use that analysis as significant
input in assessing an FHC's consolidated capital adequacy. This is especially true
where a securities broker-dealer or insurance company comprises a predominant part
of an FHC.
When assessing consolidated capital adequacy for FHCs with
functionally regulated subsidiaries, several issues take on particular prominence.
Capital adequacy requirements that have been established for banking, securities, and
insurance entities by their respective regulators reflect varying definitions of the
elements of capital and varying approaches to asset and liability valuations.
Techniques for assessing capital adequacy must be sufficiently robust to identify
situations such as double or multiple leverage or double gearing, because in such
cases the actual capital protection may be overstated.
Intra-group exposures and concentrations
Intra-group exposures, including servicing arrangements and risk
concentrations, have the potential to threaten the condition of regulated entities. Intragroup exposures may be significant at large, complex FHCs, especially those that
operate their businesses on global lines that cut across legal entities within the firm.
The focus of the Federal Reserve in this area is on the potential impact of intra-group
exposures and concentrations on insured depository institution subsidiaries of an
FHC.
Risk concentrations can take many forms, including exposures to one or
more counterparties or related entities, industry sectors, and geographic regions. For
risk concentrations, the holding company supervisor is uniquely positioned to
understand the combinations of exposures within an organization across all legal
entities. This understanding is critical at the group level -- risk concentrations that are
prudent on a legal entity basis may aggregate to an unsafe level for the consolidated
organization.
The Federal Reserve will monitor intra-group exposures and risk
concentrations as follows:
• The appropriate primary bank and thrift regulators will continue to
monitor and enforce section 23A and 23B restrictions at the bank
or thrift level. The Federal Reserve will focus on assessing whether
the FHC monitors and ensures compliance with these statutory
requirements. The Federal Reserve plans to begin collecting data
from each depository institution subsidiary of BHCs, including
FHCs, on their covered transactions with affiliates that are subject
to sections 23A and 23B and will share that data with primary bank
and thrift regulators.
• Functional regulators will continue to monitor and enforce any
intra-group exposure restrictions that may apply to the regulated
entities under their jurisdictions.
• The Federal Reserve will focus on understanding and monitoring
related-party exposures at the group level, including areas such as
servicing agreements, derivatives exposures, and payments system
exposures, with an important focus on the extent to which a
depository institution subsidiary's risk management is dependant on
transactions with affiliates.
• The Federal Reserve also will focus on management's effectiveness
in monitoring and controlling intra-group exposures and risk
concentrations. The Federal Reserve will consider how an
organization's risk management processes measure and manage
group-wide risk concentrations.
Enforcement powers
The Federal Reserve generally is authorized to take enforcement action
against FHCs and their nonbank subsidiaries. The primary bank and thrift supervisors
have the authority to take enforcement action against the banks and thrifts under their
jurisdictions. Under the GLB Act, the Federal Reserve may take enforcement action
against a functionally regulated subsidiary of an FHC, but only when such action is
necessary to prevent or redress an unsafe or unsound practice or breach of fiduciary
duty that poses a material risk either to the financial safety, soundness or stability of
an affiliated depository institution, or to the domestic or international payments
system. In such circumstances, the Federal Reserve may only take the action if it is
not reasonably possible to protect effectively against the material risk through an
action directed at or against an affiliated depository institution.
Under any circumstances, the Board may take enforcement action
against a functionally regulated subsidiary to enforce compliance with any federal law
that the Federal Reserve has specific jurisdiction to enforce against the subsidiary. In
the event the Federal Reserve believes that an enforcement action by the Federal
Reserve against a functionally regulated entity is necessary, the Federal Reserve will
notify the entity's appropriate functional regulator and will coordinate such an action
with any taken by the functional regulator wherever practical. It is expected that the
Federal Reserve will not take an enforcement action against a functionally regulated
subsidiary (or a person associated with the subsidiary) if the problem involves factors
and statutes that are the primary responsibility of the functional regulator.
Under the existing bank holding company framework, the Federal
Reserve coordinates enforcement actions with the primary bank and thrift regulators,
possibly with some adaptation of the action for the holding company context (such as
limitations on parent company debt or dividends). The Federal Reserve will continue
to coordinate enforcement actions with those regulators. In a similar fashion, the
Federal Reserve will coordinate with functional regulators when formulating and
issuing enforcement actions that involve or may have an impact on functionally
regulated subsidiaries.
Promotion of sound practices and improved disclosure
The Federal Reserve can promote sound practices in a number of ways,
such as by monitoring trends in risk exposures and risk management practices across
the FHC population through a combination of efforts. These include regular
discussions, centered on specific issues and emerging risks, with FHC management;
regular meetings with primary bank, thrift, and functional regulators to explore and
discuss issues of mutual interest and/or concern; interagency working groups or
specialty teams to gain early insight into risks that cut across the various entities of a
conglomerate or groups of conglomerates; and industry conferences on relevant topics
of interest.
These initiatives will contribute to the development of sound practices
that the Federal Reserve and other primary bank, thrift, and functional regulators can
communicate to the senior management and board of directors of the FHCs, as well as
to the senior management of their bank and nonbank subsidiaries.
Improved transparency and public disclosure can meaningfully
supplement the efforts of supervisors to monitor the increasingly complex and global
activities of diversified banking organizations. The Federal Reserve will, consistent
with sound accounting principles and practices, and with considerations of depository
institution safety and soundness, participate in efforts to enhance disclosures that
illuminate group-wide activities, risk exposures, risk management, controls, and intragroup exposures.
Ongoing challenges
Most of the concepts discussed in this framework are already being
applied by the Federal Reserve in the context of the consolidated supervision of
BHCs.1 Examples include greater reliance on risk-focused supervision; strengthening
relationships with senior management; improving coordination with other federal,
state and international regulatory and supervisory authorities; greater reliance on
specialty teams, sound practices papers and public disclosures; and simplification of
the applications process.
Still, supervision of more diversified FHCs presents new challenges. To
address these challenges, the Federal Reserve will continue its efforts to strengthen (i)
cooperative arrangements with bank and thrift regulators, the SEC, CFTC, state
insurance and securities regulators, and foreign supervisors; (ii) relationships with
FHC management and personnel responsible for significant risk management
functions and, where necessary, the management of the organization's nonbank
subsidiaries; (iii) information flows that provide supervisors with relevant, up-to-date
information without imposing unwarranted burden on financial organizations; (iv)
techniques for evaluating capital adequacy for FHCs engaged in an expanded range of
nonbank financial activities; (v) public disclosures and market discipline; (vi)
techniques for assessing the overall risk profile of FHCs and the implications for
affiliated depository institutions; and (vii) incentives for FHCs to continually review
and improve their risk management processes, internal controls, and audit practices.
The Federal Reserve is committed to continuing to work in a
constructive and cooperative fashion with all regulators involved in overseeing the
activities of FHCs and their bank and nonbank subsidiaries.
Reserve Banks are asked to distribute this SR letter to FHCs as well as to
the state banking agencies and functional regulators in their districts. Questions
pertaining to this framework should be directed to Roger Cole, Associate Director, at
(202) 452-2618, Michael Martinson, Deputy Associate Director, at (202) 452-3640, or
Barbara Bouchard, Manager, Policy Development, at (202) 452-3072.
Richard Spillenkothen
Director
Cross Reference: SR 99-15
Notes:
1. The Federal Reserve�s framework for supervising large complex banking
organizations (LCBOs) is described in SR letter 99-15. Return to text
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