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The Federal Reserve's supervisory processes
Before the Subcommittee on Financial Institutions and Consumer Credit of the
Committee on Banking and Financial Services, U.S. House of Representatives
October 8, 1997
Madam Chairwoman and members of the subcommittee, I am pleased to be here today to
discuss the Federal Reserve's efforts in recent years to strengthen its supervisory processes
and also to share with you the Board's views about what challenges lie ahead, both for the
banking system and the supervisory process. As you know, the U.S. economy and its banking
system have enjoyed half a decade of improving strength in which U.S. banks have become
better capitalized and more profitable than they have been in generations. Moreover, in the
past 13 months not a single insured bank has failed, and the Bank Insurance Fund is now
capitalized at a level requiring most banks to pay only nominal fees for their insurance.
While we can take comfort and, to some degree, satisfaction in these events, experience has
demonstrated that at times like these -- if we are not vigilant -- risks can occur that set the
stage for future problems.
As I begin my remarks, I would like to point out that no system of supervision or regulation
can provide total assurance that banking problems will not occur or that banks will not fail.
Nor should it. Our goal as regulators is to identify weak banking practices early so that small
or emerging problems can be addressed before they become large and costly -- either to the
insurance fund or the financial system as a whole. We believe that progress made in recent
years to focus our examinations on the areas of highest risk at banking organizations places
us in a better position to identify problems early, control systemic risk, and maintain
financial stability. That goal and the need to adapt the supervisory process to the potentially
rapidly changing conditions in banking and financial markets underlies our decision to
pursue a more risk-focused supervisory approach.
We are well under way in implementing this new supervisory framework, and initial
indications about that process from both the Federal Reserve's supervisory staff and the
banking industry, itself, have been favorable. The risk-focused approach reflects our
supervisory response to the effects that technology and financial innovation have had on the
pace of change in banking organizations, the nature of U.S. and world financial markets, and
the techniques employed for managing and controlling risk. As banking practices and
markets continue to evolve, our emphasis on risk-focused supervision will be even more
necessary in the years to come.
The Federal Reserve's Oversight Role
As the primary federal supervisor of U.S. bank holding companies, state member banks, and
most U.S. offices of foreign banks, the Federal Reserve has sought to apply effective
supervision and contain excessive risks to the federal safety net, while also ensuring that
banks adequately serve their communities and accommodate economic growth. As the
nation's central bank, the Federal Reserve brings a different, important perspective to the
supervisory process through its attention to the broad and long-term consequences of

supervisory actions on the financial system and the economy. Significantly, the practical,
hands-on involvement which the Federal Reserve gains through its supervisory function
supports and complements our other central bank responsibilities including fostering a safe
and efficient payment system and ensuring the stability of the financial system.
Past studies of bank failures have cited a number of contributing factors including, but
certainly not limited to, inadequate supervisory staffing and antiquated examination
procedures. Over the years, as it has supervised and regulated banking organizations, the
Federal Reserve has emphasized periodic, on-site examinations that entail substantive loan
portfolio reviews and significant transaction testing to identify emerging problems. In that
connection, the Federal Reserve has sought to maintain a sufficient number and quality of
supervisory personnel to conduct examinations with appropriate frequency and depth. That
approach appears to have provided us with some consistent success.
As conditions within the industry have substantially improved, the Board has been mindful
of the cost of conducting its supervisory activities and has worked to contain those costs in
the face of increased responsibilities. Throughout this period we have recognized the need to
maintain stability in our work force, and have sought to avoid excessive build-ups or periods
of disruptive retrenchment. That approach has enabled us to maintain what we believe has
been an adequate and consistent level of oversight of banking organizations under our
supervision during both good times and bad.
Developments Driving Change
During the past decade, the U.S. banking system has experienced a great deal of turmoil,
stress, and change. Ten years ago, many of the country's largest banks announced huge loan
loss provisions, beginning the process of reducing the industry's overhang of doubtful
developing country loans. At the same time, many of these institutions and smaller regional
banks were struggling with oil and agriculture sector difficulties or accumulating commercial
real estate problems. These and other difficulties took a heavy toll. By the end of the 1980s,
more than 200 banks were failing annually, and there were more than 1,000 other problem
banks.
This experience provided important lessons and forced supervisors and bankers, alike, to
reconsider the way they approached their jobs. For their part, bankers recognized the need
to build their capital and reserves, strengthen their internal controls, and improve practices
for identifying, underwriting and managing risk. Supervisors were also reminded of the need
to remain vigilant and of the high costs that bank failures can bring, not only to the insurance
fund but to local communities as well. The FDIC Improvement Act of 1991 emphasized that
point, requiring frequent examinations and prompt regulatory actions when serious problems
emerge.
Beyond these largely domestic, institutional events, banks and businesses throughout the
world were dealing in the 1980s and 1990s with new technologies that were leading to a
multitude of new and increasingly complex financial products that changed the nature of
banking and financial markets. These technologies have brought many benefits that facilitate
more efficient markets and, in turn, greater international trade and economic growth.
They may also, however, have raised macro-stability concerns by concentrating the growing
volume and complexity of certain activities within a small number of truly global institutions.
It is essential that these largest firms adequately manage the related risks of these activities
and that they remain adequately supervised. For it is these institutions that have the potential
to disrupt worldwide payment systems and contribute most to systemic risk. In addition to

the formal supervisory oversight exerted by regulators, concerns may be eased somewhat by
the strong counterparty discipline being brought to bear worldwide on banks and other
financial institutions dealing in these new products. The scrutiny among counterparties in the
global market place has contributed to improvements in capital positions and in overall risk
management practices.
In many ways, U.S. banks have been in the vanguard in applying technological advances to
their products, distribution systems, and management processes, with such applications and
innovations as ATMs, home banking, securitizations, and credit derivatives. Such efforts,
combined with greater attention to pricing their services and measuring their risks, have had
material effects on the increased strength and profitability that our banks have seen.
Within the United States, our banking system has also experienced a dramatic consolidation
in the number of banking institutions, with the number of independent commercial banking
organizations declining from 12,400 in 1980 to 7,400 in June of this year.1 That structural
change has also contributed to industry earnings by providing banks with greater
opportunities to reduce costs.
The challenge going forward for many of these institutions may be in managing the growth
and the continuing process of industry consolidation. This challenge may be greatest as
banking organizations expand, particularly through acquisitions, into more diverse or
nontraditional banking activities. That growth into a wider array of activities is especially
important if banks are to meet the wide-ranging needs of their business and household
customers while competing effectively with other regulated and unregulated firms. However,
the managerial implications of rapid growth and growth into new activities should not be
overlooked, either by the institutions or their supervisors.
Supervisory Challenges Ahead
There is also no shortage of tasks facing the Federal Reserve as a bank supervisor, despite
the virtually unprecedented strong condition of the U.S. banking system today. We, too, must
deal with the evolving financial markets and advances in technology. At the same time, we
must ensure that our own supervisory practices, tools, and standards take advantage of
technological improvements and financial techniques so that our oversight is not only
effective, but also as unobtrusive and appropriate as possible. These tasks are wide-ranging,
extending from our own re-engineering of the supervisory process to the way supervisors
approach issues such as measuring capital adequacy and how we seek convergence on bank
supervisory standards worldwide.
Risk-focused examinations
Constructing a sound supervisory process while minimizing regulatory burden has been a
long-standing and ongoing effort at the Federal Reserve and an objective we have sought to
advance with our emphasis on risk-focused examinations. Particularly in the past decade, we
have found that the increased range of products and the greater depth and liquidity of
financial markets permit banking organizations to change their risk profiles more rapidly
than ever before. That possibility requires that we strike an appropriate balance between
evaluating the condition of an institution at a point in time and evaluating the soundness of
the bank's processes for managing risk. Recognition of the need for that balance is at the
heart of the risk-focused examination approach.
The risk-focused approach, by definition, entails a more formal risk assessment planning
phase that identifies those areas and activities that warrant the most extensive review. This

preplanning process is supported by technology, for example, to download certain
information about a bank's loan portfolio to our own computer systems and target areas of
the portfolio for review.
Once on-site, examiners analyze the bank's loans and other assets to ascertain the
organization's current condition, and also to evaluate its internal control process and its own
ability to identify and resolve problems. As a result, the Federal Reserve is placing greater
reliance than before on a bank's internal auditors and on the accuracy and adequacy of its
information systems. The review of the information flow extends from top to bottom, and
with the expectation that bank senior management and boards of directors are actively
involved in monitoring the bank's activities and providing sufficient guidance regarding risk
assumption.
As in the past, performance of substantive checks on the reliability of a bank's controls
remains today a cornerstone of the examination process, albeit in a more automated and
advanced form. For example, automated loan sampling is performed for the purpose of
generating statistically valid conclusions about the accuracy of a bank's internal loan review
process. To the extent we can validate the integrity of a bank's internal controls more
efficiently, we can place more confidence in them at an earlier stage and can also take
greater comfort that management is getting an accurate indication of the bank's condition.
Toward that end, Board staff is working to refine loan sampling procedures that should
further boost examiner productivity and accomplish other supervisory goals. Moreover, as
examiners are able to complete loan reviews more quickly, they will have more time to
review other high priority aspects of the institution's operations.
A significant benefit of the risk-focused approach is its emphasis on ensuring that the bank's
internal oversight processes are sound and that communication between the bank and senior
examiners is ongoing between examinations. That approach is generally supported by
institutions we supervise and provides a more comprehensive oversight process that
complements our annual or 18-month examinations. Such an approach strengthens our
ability to respond promptly if conditions deteriorate.
Another benefit of the risk-focused approach has been a greater amount of planning,
analysis, and information gathering at Reserve Banks prior to the on-site portion of the
examination. Far from reducing our hands-on knowledge of the institution, this approach has
ensured that when we are on-site, we are reviewing and analyzing the right areas, talking to
the right people, and making better use of our time and that of the bank's management and
employees. In addition to improving productivity, it has also reduced our travel costs and
improved employee morale.
Examination staff at the Reserve Banks indicate that this process may be reducing on-site
examination time by 15-30 percent in many cases and overall examination time of Federal
Reserve personnel by perhaps 10 percent. While those results are tentative, partial, and
unscientific, they are certainly encouraging in terms of resource implications.
Complementing the risk-focused approach to supervision are enhancements to the tools we
use to grade a bank's condition and management. Since 1995, we have asked Federal
Reserve examiners to provide a specific supervisory rating for a bank's risk management
process. More recently, the CAMEL rating system, too, has been revised by the banking
agencies to place more emphasis on the adequacy of a bank's risk management practices and
was expanded to include a specific "S" rating for an institution's sensitivity to market risk. As

you may know, the Federal Reserve has also, for some time, used a rating scheme that
focuses heavily on managerial procedures and controls in its oversight of U.S. branches and
agencies of foreign banks.
How effective is the risk-focused process? Since economic and industry conditions have
been generally favorable for the past several years, there has not been a sufficiently stressful
economic downturn to test fully bank risk-management systems or supervisory practices.
The market volatility beginning in 1994 did, however, provide some tests for the risk
management systems of the larger banks with active trading desks. Nevertheless, there are
many indications that bank and supervisory practices are materially better than they were in
the 1980s and early 1990s.
For example, the risk-focused approach is helping to identify certain deficiencies before they
show up in a bank's financial condition. These are evidenced by instances where ratings for
the quality of bank management are lower than those for capital, asset quality, or earnings.
Because managerial weaknesses eventually show up in a bank's financial condition, it is
important to identify and resolve those weaknesses early. In that regard, the risk-focused
approach endeavors to prevent problems from developing to the point that they cause
unnecessary losses that impair the institution's capital and require resolution under the
Prompt Corrective Action mandate.
One example of how the risk-focused approach is helping to identify and address
deficiencies is our supervisory experience with the U.S. branches of foreign banks.
Subsequent to the enactment of the Foreign Bank Supervision Enhancement Act of 1991,
which gave the Federal Reserve greater supervisory authority over foreign branches, our
examinations uncovered a number of entities with internal control and audit weaknesses.
This result was not completely unexpected, as these foreign banking organizations were not
previously subject to the same level of oversight as our domestic organizations.
Recognizing the seriousness of these weaknesses and their potential for causing problems in
the future, the Federal Reserve has taken a number of steps to ensure that practices are
materially upgraded at foreign branches and that any weaknesses continue to be uncovered.
In addition to identifying and addressing internal control and audit weaknesses through
examinations and supervisory follow-up, these efforts include ensuring that the foreign bank
provides the necessary managerial support to its U.S. branches, including adequate systems
of controls and audit. To place even more emphasis on internal controls and audit systems,
the foreign branch rating system was revised in 1994. Furthermore, in 1996 additional steps
were taken to ensure that internal control weaknesses are corrected and will not cause
financial harm by adopting requirements for audit procedures in situations where significant
control weaknesses are detected.
These efforts to detect problems at their early stages and resolve them appear to be having
positive effects. After peaking in 1993, there has been a steady decline in the number of U.S.
branches and agencies with an overall examination rating of fair or lower and a rating of fair
or lower in an examination component substantively affected by internal control and audit
weaknesses. We believe that our continued efforts in this area will lead to further
improvements in the internal control and audit practices of foreign banking organizations
Implementing the risk-focused approach has not been an easy task. It has required a
significant revision of our broad and specialized training programs, including expansion of
capital markets, information technology, and global trading activities as well as courses

devoted exclusively to internal controls. These education programs will, of course, need to
be continually updated as industry activities and conditions evolve.
With the greater discretion provided to examiners to focus on areas of highest risk, ensuring
the consistency and quality of examinations has increased in importance. Fortunately, new
training courses and improved examination platforms, tools, and programs that guide
examiners through the appropriate selection of examination procedures will help. In
addition, our ability to evaluate more thoroughly the quality of an examination has improve
with the greater depth of analysis provided in supporting examination materials such as the
written risk assessments and analysis of exam findings. Those materials are allowing us to
perform comparative reviews of examinations across institutions of similar size, risk profile,
and complexity to ensure quality and consistency.
So far we have been able to evaluate the effectiveness of our examination programs by
identifying whether problems are identified early and resolved in a timely fashion, by
evaluating whether examination reports and findings provide clear feedback to management
and identify areas of highest risk, and by monitoring the extent to which our examinations
are complying with statutory mandates for the frequency of examinations. Based on those
criteria, I believe our examination program has been generally successful.
Application of technology to supervisory process
The Federal Reserve has also done much to increase its own use of technology in an effort
to improve examiner productivity, enhance analyses, and reduce burden on banks. Much of
this effort has been conducted on an interagency basis, particularly in cooperation with the
FDIC and state banking departments with whom we share supervision of state-chartered
banks. Specific results include the development of a personal computer, laptop workstation
that provides examiners with a decision tree framework to assist them through the necessary
procedures. The workstation also helps them document their work and prepare exam reports
more efficiently. In addition, a software program has also been developed for receiving and
analyzing loan portfolio data transmitted electronically from financial institutions. This
process not only saves time but also improves the examiner's understanding of the risks
presented by individual portfolios.
The Federal Reserve is also developing an electronic examination tool for large domestic
and foreign banking organizations that enhances our ability to share examination analysis
and findings and other pertinent supervisory information among our Reserve Banks and with
other supervisory authorities. This platform should substantively improve our ability to
provide comprehensive oversight to those firms that are most prominent in the payment
system and global financial markets.
In addition to examination tools, the Federal Reserve has for many years maintained a
comprehensive source of banking structure, financial, and examination data in its National
Information Center. By year-end, we will have completed significant enhancements to the
tools that provide examiners and analysts at the federal and state banking agencies access to
those data.
The Year 2000
One of the clearest reminders that managing technology is a challenge of its own is the need
for banks to resolve the "Year 2000" problem. U.S. banks appear to be taking this matter
seriously and are generally well under-way toward identifying their individual needs and
developing action plans. The Federal Reserve and the other federal bank supervisors are

reviewing the relevant efforts of every insured depository institution in order to determine
whether adequate progress on this issue is being made. This process should be complete by
the middle of next year so that any detected deficiencies may be addressed in time. Meeting
the demands of this review and ensuring proper remedies both before and after the year
2000 will be a significant and costly task to both the industry and the banking agencies.
However, even within the context of banking, the scope of the Year 2000 problem extends
far beyond U.S. banks to foreign banks, bank borrowers, depositors, vendors, and other
counterparties. Through the Bank for International Settlements and other international
forums, the Federal Reserve and other U.S. banking agencies have emphasized the need for
all institutions to recognize this issue and to address it actively. Importantly, century date
compliance is gaining more attention internationally, and the Basle Supervisors Committee is
taking steps to address this matter.
Banks and others need to address year 2000 system alterations, not only because of the
potential effects on overall markets, but also as a threat to individual firm viability. At a
minimum, banks should be concerned about their ability to provide uninterrupted service to
their customers into the next millennium. If nothing else, it is simply good business.
Efforts to accommodate industry growth and innovation
Another goal of the Federal Reserve's supervisory approach is to remove unnecessary
barriers that might hinder the industry's ability to grow, innovate, and remain competitive.
Recently, the Board refined its application process to ensure that well-run, well capitalized
banking organizations may apply to acquire banks and nonbanks in a more streamlined
fashion and commence certain types of new activities without prior approval. The Board
also significantly revised various rules for section 20 companies and scaled back or removed
many redundant firewalls. While these refinements require some changes to the supervisory
process, we firmly believe that removing barriers to these lower risk activities is essential to
maintaining the industry's health and competitiveness and its ability to serve its customers
and the community.
Supervising nationwide and international institutions
The consolidation and transformation of the U.S. banking system resulting from evolving
market, statutory, and regulatory changes are also requiring the Federal Reserve to adapt to
new conditions. As previously noted, we are working closely with the FDIC and state
banking agencies to deal with the challenges presented by interstate banking and branching
to ensure that the dual banking system remains viable in future years.
To address that goal, the FDIC, the Federal Reserve, and the state banking departments
began on October 1 a common risk-focused process for the examination of state-chartered
community banks. Another initiative has been the State/Federal Supervisory Protocol, which
commits the various banking agencies to work toward a "seamless" and minimally
burdensome oversight process. In short, it sets forth a process in which state banking
supervisors will accept the supervisory reports of other agencies for banks operating in their
states through branches, but headquartered elsewhere. The fact that the plan has been
accepted by all involved parties is encouraging. We now need to ensure that it is
implemented as intended, as banks make use of their broader branching powers.
Similar coordination efforts are necessary and under-way in an international context.
Through the Bank for International Settlements, for example, the Federal Reserve and the
other U.S. banking agencies participate with supervisors from other G-10 countries to

develop not only prudential capital and other regulatory standards, but also to promote
sound practices over a broad range of banking issues.
In this regard, the Basle Committee on Banking Supervision, with the approval of the central
bank Governors of the G-10 countries, recently issued three documents: one dealing with the
management of interest rate risk by banks, one dealing with the Year 2000 problems, and
another identifying 25 "core principles" of effective supervision that is directed at bank
supervisors worldwide. The Basle Committee is also working to improve international risk
disclosure practices of banks, and has created the new market risk capital standard that is
based on banks' internal value-at-risk models. That standard goes into effect in January of
next year.
Beyond the work of the Basle Committee and the banking agencies, we are also meeting
with the SEC and international securities and insurance regulators to identify common issues
and to bring about greater convergence in our respective regulatory frameworks. That effort
also has links to the committee's efforts and should prove helpful in strengthening the
oversight and regulation of financial institutions throughout the world that provide a broad
range of financial products. Successful groundwork from this effort could also have
implications for moving forward domestically in an era of financial reform.
Guidance as well as supervisory and regulatory standards such as these -- whether
developed in a domestic or international context -- are soon incorporated into examination
procedures and help examiners in their reviews of many of the more complex activities of
global banking organizations. These global institutions are perhaps the most challenging to
supervise. Since it is not feasible for supervisors to review all locations of a global banking
organization, emphasis is placed on the integrity of risk management and internal control
systems, coordination with international supervisors, strong capital standards, and improved
disclosures.
Staffing the supervisory process
A final supervisory challenge relates to the Federal Reserve's need to continue attracting,
training, and retaining expert staff. Retaining sufficient numbers of individuals with the
expertise to evaluate fully the risks in a rapidly changing banking industry is a major priority
for the Federal Reserve and figures prominently in the bank supervision function's strategic
plan. Particularly challenging is attracting and retaining specialists in the areas of capital
markets and information technology where we have experienced increased turnover. We will
continue efforts to attract and retain both specialists and generalists that are qualified to
address issues as the industry evolves.
As I have outlined in my testimony, the Federal Reserve's supervisory strategy is to maintain
staff that can adequately evaluate the general soundness of banking activities by placing
strong emphasis on the bank's management processes, systems, and controls. I believe such
an approach will serve us well as the industry continues to evolve either by expanding the
scope of its activities or through broader structural changes from financial modernization
legislation. Nevertheless, developing the supervisory techniques, and attracting and training
the personnel to do the job will pose a continuing challenge in the years ahead.
Conclusion
The history of banking and of bank supervision shows a long and rather close relationship
between the health of the banking system and the economy, a connection reflecting the role
of banks in the credit intermediation process. We can expect that relationship to continue
and for bank earnings and asset quality to fluctuate as economic conditions change. As

supervisors, we must prepare for such developments.
In many ways, however, the banking and financial system have changed dramatically in the
past decade both in terms of structure and diversity of activities. Risk-management practices
have also advanced, helped by technological and financial innovations. I believe that both
bank supervisors and the banking industry have learned important lessons from the
experience of the past ten years specifically about the need to actively monitor, manage, and
control risks.
Nevertheless, conditions can always change, and the risk-focused approach will be
continually challenged to anticipate and avoid new kinds of problems. We must recognize
that a risk-focused approach to supervision is a developing process and however successful
it may be, there will again be bank failures. Indeed, having no bank failures may suggest
inadequate risk-taking by banks and less economic growth. Through our supervisory process,
the Federal Reserve seeks to maintain the proper balance--permitting banks maximum
freedom, while still protecting the safety net and maintaining financial stability. Devoting
adequate attention to banking practices and conditions and responding promptly as events
unfold is the key. We intend to do that now and in the years ahead.
Footnotes
1 "Independent commercial banking organizations" is defined as the sum of all bank holding
companies and independent banks. Multi-bank holding companies are, therefore, considered
as a single organization.
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