Supervisory Developments
This section provides an overview of key developments related to the supervision of institutions by the Federal Reserve, including trends and details for all large financial institutions (LISCC firms and large and foreign banking organizations) as well as trends and details regarding regional and community banking organizations.
This report focuses on the Federal Reserve's prudential supervisory responsibilities. The Federal Reserve is also responsible for timely and effective supervision of consumer protection and community reinvestment laws and regulations. This consumer-focused supervisory work is designed to promote a fair and transparent financial services marketplace and to ensure that the financial institutions under the Federal Reserve's jurisdiction comply with applicable federal consumer protection laws and regulations. The scope of the Federal Reserve's supervisory jurisdiction varies based on the particular law or regulation, and on the size of the state member bank.
More information about the Federal Reserve's consumer-focused supervisory program can be found in the Federal Reserve's 104th Annual Report 2017.7 The Federal Reserve also publishes the Consumer Compliance Supervision Bulletin, which shares information about examiners' supervisory observations and other noteworthy developments related to consumer protection.8
Large Financial Institutions
This section of the report discusses issues and priorities related to the supervision of firms in the LISCC and large and foreign banking organization portfolios.
The safety and soundness of large financial institutions continues to improve…
Large financial institutions are in sound financial condition. Capital levels are strong and much higher than before the financial crisis (figure 10). Recent stress test results show that the capital levels of large firms after a hypothetical severe global recession would remain above regulatory minimums (figure 11).9 These hypothetical post-stress ratios are higher than the actual capital levels of large banks in the years leading up to the most recent recession as shown from 2006-09 in figure 10. Large financial institutions have substantially increased the percentage of high-quality liquid assets on their balance sheets, which indicates an improved ability to address any emerging liquidity needs (figure 12).
Figure 10. Large financial institution common equity tier 1 ratio
Note: Common equity tier 1 is the ratio of tier 1 common equity to risk-weighted assets.
Source: Call Report and FR Y-9C.
Figure 11. CCAR post-stress capital ratios
Note: Results of annual supervisory stress test (2012-18). Federal Reserve estimates of capital ratios in the severely adverse scenario. Regulatory minimum tier 1 capital ratio is 6.0 percent. Regulatory minimum tier 1 leverage ratio is 4.0 percent.
Source: Internal Federal Reserve supervisory databases.
Figure 12. Large financial institution high-quality liquid assets
Note: High-quality liquidity assets (HQLA) are estimated by adding excess reserves to an estimate of securities that qualify for HQLA.
Source: FR Y-9C, FR 2900, Federal Reserve accounting system.
Since the crisis, large financial institutions have addressed and closed out a significant number of supervisory findings (matters requiring attention (MRAs) or matters requiring immediate attention (MRIAs)).10 (See Box 3, "What Are RFI Ratings and MRAs" for more information on MRAs and MRIAs.) As a result, the number of outstanding supervisory findings have generally decreased (figure 13). However, MRAs and MRIAs have actually increased for large foreign banking operations (FBOs), reflecting changes in regulation that required substantive changes to their U.S. structures.
Figure 13. Outstanding supervisory findings, large firms and FBOs
Note: Values prior to 2018 are as of year-end. The 2018 value is as of the end of 2018:Q2.
Source: Internal Federal Reserve supervisory databases.
Box 3. What Are RFI Ratings and MRAs?
Examiners summarize inspection results in written reports to the senior management and board of directors of supervised holding companies. These reports describe conclusions on all factors addressed during the inspection process, including the adequacy of risk management and governance over the banking organization's activities, the consolidated financial condition of the company, and the potential adverse impact of parent and nonbanking activities on the organization.
Within these reports, examiners assign supervisory ratings using the Federal Reserve's RFI rating system, which is named for the individual components of the rating system: risk management (R), financial condition (F), and impact of parent and nonbanking activities (I).1 Examiners assign ratings both overall in a composite form and to specific aspects of a company's performance on a five-point scale, with ratings of 1 and 2, for example, signifying "strong" or "satisfactory" assessments. A composite rating of 3 reflects "fair" status and indicates the company is vulnerable and requires more than normal supervisory attention and financial surveillance, but there is only a remote threat to its continued viability. Composite ratings of 4 and 5 reflect "marginal" or "unsatisfactory" conditions and are assigned to companies when the organization's future viability could be impaired unless prompt action is taken or the BHC's continued viability is in serious doubt. Ratings of 3, 4, or 5 are considered less-than-satisfactory. Examiners assign component and subcomponent ratings following similar rating conventions.2 Individual company ratings are confidential supervisory information and cannot be disclosed publicly.
In many cases, holding company inspection reports will include recommendations for follow-up action on the part of the organization's management. Examiners refer to these recommendations as "matters requiring attention," or MRAs. MRAs call for action to address weaknesses in processes or controls that could lead to deterioration in a banking organization's soundness; may result in harm to consumers; or that have caused, or could lead to, noncompliance with laws and regulations. When weaknesses are acute or protracted, Federal Reserve examiners may recommend that management take action more quickly by issuing a "matter requiring immediate attention," or MRIA.
A high volume of MRAs may prompt an examiner to assign a less-than-satisfactory RFI composite rating to a holding company, but the existence of MRAs is not in and of itself an indication that a banking organization is troubled. MRAs may be issued regardless of a company's RFI rating and are not uncommon for companies deemed strong or satisfactory overall.
In the event that holding companies do not address MRAs in a timely or complete manner, examiners may determine that the related weaknesses represent a significant threat to the safety and soundness of the company or its ability to operate in compliance with law and may recommend further action. For example, the Federal Reserve could issue a formal enforcement action with a company. Formal enforcement actions derive from, and carry the full weight and enforceability of, law.
1. See SR letter 04-18, "Bank Holding Company Rating System," at https://fedweb.frb.gov/fedweb/bsr/srltrs/SR0418.htm. There is separate rating system for banks that is discussed in Box 9, "State Member Bank and Consolidated Supervision." Return to text
2. On November 2, 2018, the Federal Reserve Board adopted a new rating system for large financial institutions (LFIs) that will replace the RFI rating system for those firms. See www.federalreserve.gov/newsevents/pressreleases/files/bcreg20181102a1.pdf. The Federal Reserve will assign initial LFI ratings to firms in the LISCC portfolio in early 2019 and to other large firms in early 2020. The Federal Reserve will continue to utilize the RFI rating system in assessing U.S. bank holding companies with less than $100 billion in consolidated assets. In addition, the Federal Reserve adopted a final rule to begin applying the RFI rating system to non-insurance, non-commercial savings and loan holding companies beginning in 2019. Return to text
Return to text… but material risk-management weaknesses persist at a number of firms.
While most firms have improved in key areas of supervisory focus, such as capital planning and liquidity management, some firms continue to work to meet supervisory expectations in certain risk-management areas, which is reflected in aggregate bank holding company supervisory ratings for large financial institutions (figure 14).
Firms with less-than-satisfactory ratings generally exhibit weaknesses in one or more areas such as compliance, internal controls, model risk management, operational risk management, and/or data and information technology (IT) infrastructure. Some firms continue to exhibit weaknesses in Bank Secrecy Act (BSA) and anti-money-laundering (AML) programs. These risk-management areas sometimes have longer remediation timelines.
Figure 14. Holding company ratings for firms > $50 billion
Source: Internal Federal Reserve supervisory databases.
For larger firms, supervisors will continue to conduct horizontal examinations across multiple firms.
To improve consistency and efficiency, supervisors have increased, and will continue to increase, focus on horizontal supervisory examinations within portfolios. In addition, across all programs, supervisors will also spend time reviewing emerging risks, as well as actions firms have taken to address safety-and-soundness weaknesses previously identified.
Box 4. Consolidated Supervision of Large Financial Institutions
Following the financial crisis, the Federal Reserve in 2012 introduced a new framework for the consolidated supervision of large financial institutions.1 The framework applies to LISCC firms, large banking organizations, and large FBOs and consists of two primary objectives:
- Enhance the resiliency of a firm to lower the probability of its failure or inability to continue to be able to lend to households and businesses.
- Reduce the impact on the financial system and the broader economy in the event of a firm's failure or material weakness.
To achieve these objectives, the supervisory efforts are organized to focus on four specific components:
Capital: Assess the strength of firms' capital, or ability to absorb losses, under stressed conditions and how firms measure and use that capital on a forward-looking basis; evaluate how firms manage and control financial risks that could lead to capital reduction through losses.
Liquidity: Assess the adequacy of firms' funding and liquid assets and evaluate how firms manage risks associated with their funding and liquid assets, including under stress scenarios.
Governance and controls: Determine the adequacy of firms' practices through assessments of the effectiveness of the boards of directors' oversight of operations and risk management, the strength of risk-management practices in business lines, and the adequacy of the independent risk-management and the internal audit functions. Also, evaluate how well controls enable appropriate risk-management practices at a firm.
Recovery and resolution planning (recovery planning generally applies to certain covered firms only): Promote the resiliency of covered firms by advancing their recovery preparedness and planning and minimize the impact that distress or failure of a systemically important firm may impose on the broader financial system by furthering firms' resolvability.
1. See SR letter 12-17, "Consolidated Supervision Framework for Large Financial Institutions," at www.federalreserve.gov/supervisionreg/srletters/sr1217.htm. Return to text
Supervision of LISCC Firms
In general, LISCC firms are improving in key areas of supervisory focus.
The overall safety and soundness of LISCC firms has improved in recent years. LISCC
firms meet regulatory capital requirements and have materially enhanced capital planning practices.11 LISCC firms also generally have adequate liquid assets and funding structures. In addition, liquidity risk-management practices, including internal liquidity stress testing, have improved as has the quality of liquidity data.
LISCC firms also have improved governance practices and have strengthened aspects of how they manage compliance with internal and regulatory requirements and other operational risks. U.S. LISCC firms improved their ability to mitigate the adverse effects of a potential failure and unwinding of their operations. They have modified internal corporate structures, reviewed and positioned resources that would be needed to facilitate an orderly resolution, and improved internal shared services arrangements to support operational continuity in the event of resolution. In addition, LISCC firms have developed recovery plans and options to better prepare for severe stress.
The number of supervisory findings issued to LISCC firms, as well as the number of outstanding issues, has declined over the past five years.
The number of supervisory findings issued per year has steadily declined,12 with about 45 percent fewer supervisory findings issued in 2017 as compared with 2013.13 The average number of supervisory findings issued per firm per year declined from about 42 per firm in 2013 to about 23 in 2017. Since 2013, as firms implemented and sustained improvements in governance, risk management, and controls, more supervisory findings were closed than were issued, resulting in an overall 22 percent reduction in outstanding issues.
However, some weaknesses persist, particularly related to governance and controls.
Over half of the supervisory findings issued in the past five years were related to governance and risk-management control issues, while about 28 percent were for capital-related issues and about 10 percent related to liquidity. Moreover, of the supervisory findings currently outstanding, nearly 60 percent relate to issues in governance and controls, including weaknesses in BSA/AML programs, internal audit functions, IT risk management (including cybersecurity), and model risk management (figure 15). There are also a number of outstanding supervisory findings related to how firms gather, validate, and report data for regulatory purposes.
Figure 15. Outstanding supervisory findings by category, LISCC firms
Note: As of 2018:Q2, there were 825 total outstanding supervisory findings for LISCC firms.
Source: Internal Federal Reserve supervisory databases.
Over the past several years, supervisory work has revealed continued weaknesses in LISCC firms' management of compliance and employee conduct risks as well as certain operational activities, including IT and the production and management of data. Some of these issues are reflected in public enforcement actions currently outstanding against LISCC firms.14
Outside of governance and controls, additional areas still require improvement. With regard to capital, outstanding supervisory issues relate to methods for developing assumptions used in internal stress tests and internal governance of capital models, as well as some areas of credit risk management. Some firms have also been asked to make additional improvements in liquidity risk management to fully meet supervisory expectations. With regard to resolution planning, certain weaknesses were highlighted by the Federal Reserve in 2017, including the feasibility of selling off business units under stress, complexity in derivatives portfolios, and issues around legal entity structures.15
In 2018 and 2019, supervisors will continue to focus on horizontal supervisory examinations within the LISCC portfolio, including in some of the areas listed in box 5. In addition, supervisors will also review emerging risks as well as actions firms have taken to address safety-and-soundness weaknesses previously identified (including those related to existing supervisory findings and outstanding public enforcement actions).
Box 5. Upcoming LISCC Supervisory Priorities
Capital
- Capital planning
- Regulatory reporting
- Counterparty risk
- Collateral management
- Wholesale credit underwriting
Liquidity
- Internal liquidity stress test assumptions
- Liquidity position
- Governance over liquidity data, contingency funding plans, and currency risk management
- Compliance with liquidity regulation
Governance and controls
- Information technology and cyber-related risks
- Internal audit
- Compliance and business conduct
- Vendor risk management
- Risk committee practices
Recovery and resolution planning
- Recovery planning
- LISCC foreign bank intermediate holding company resolution plans
Box 6. Supervisory Issues at Wells Fargo
On February 2, 2018, the Federal Reserve entered into a consent order with Wells Fargo & Company that restricts the firm's growth until it implements a remediation plan that sufficiently addresses weaknesses in governance and certain areas of its risk management and internal controls. This penalty is in response to weaknesses in compliance risk management that led to widespread consumer abuses and other compliance breakdowns by the firm. The consent order requires the firm to engage a third party to review implementation of the remediation plan. The growth restriction will stay in place until both the implementation and third-party review are carried out to the satisfaction of the Federal Reserve. The Federal Reserve Board will vote on any decision to terminate the asset growth restriction on the firm.
Box 7. What Are Governance and Controls?
Governance and controls are essential elements of ensuring a firm operates in a safe and sound manner. The term includes several broad activities, such as
- oversight by the board of directors,
- execution by senior management of the board's strategy,
- maintenance of effective and independent risk-management and control functions (including internal audit and policies and procedures),
- compliance with laws and regulations, and
- planning for the ongoing resiliency of the firm.
Some specific examples of governance and controls include IT and data infrastructure, cybersecurity, and BSA/AML protections. For large firms, sound governance and controls are especially important, given the increased size, complexity, and scope of operations, as well as challenges that arise from managing such large entities consistently across their various business areas.
Supervision of Large and Foreign Banking Organizations
The safety and soundness of large and foreign banking organizations is stable.
Large and foreign banking organizations generally meet supervisory expectations for capital and liquidity. Most firms continue to strengthen their capital planning processes and have mature revenue and loss estimation approaches that result in credible loss estimates. In particular, most firms have integrated their stress-testing programs with their ongoing decisionmaking processes, improved their data and modeling capabilities, and established robust governance practices. However, improvements are still needed at some firms as weaknesses have been identified in capturing higher-risk loans in loss projections and gaps have been identified in firms' own internal reviews of their capital planning processes.
On balance, most firms in the large and foreign banking operations (LFBOs) portfolio have established liquidity risk limit frameworks that reflect firms' risk profiles and appropriate governance processes. While firms have an independent review function in place, the role of the function continues to develop across firms. Deficiencies noted include weaknesses in some firms' liquidity risk identification processes and a lack of robust internal risk functions.
Nonfinancial risks are the most significant risks in the LFBO portfolio.
Almost 70 percent of the supervisory findings for LFBO firms are related to governance and controls (figure 16). Areas of concern include compliance control deficiencies evidenced by long-standing BSA/AML issues as well as some associated with IT risk management (including cybersecurity). The majority of public enforcement actions currently open for LFBO firms are related to BSA/AML and the Office of Foreign Assets Control (OFAC) compliance.
Figure 16. Outstanding supervisory findings by category, LBO and non-LISCC FBO firms
Note: As of 2018:Q2, total supervisory findings, by portfolio, were: LBO-361; FBO > $50B-602; FBO < $50B-723. Chart key shows bars in order from bottom to top.
Source: Internal Federal Reserve supervisory databases.
For FBOs, challenges remain regarding compliance with enhanced prudential standards requirements.
In 2014, the Federal Reserve finalized a rule requiring each FBO with U.S. subsidiary assets greater than $50 billion to form an intermediate holding company (IHC) to hold subsidiary assets beginning in 2016. IHCs provide the Federal Reserve a framework to apply enhanced prudential standards such as capital and liquidity requirements and to improve FBO supervision. The IHC requirement also provided a mechanism for FBOs to more effectively manage their U.S. operations. The IHC structural requirement is a material change for the supervision and regulation of foreign banks, and while FBOs continue to face challenges in implementing this requirement, the firms have made progress in the approximately two years since the requirement took effect.
FBOs continue to strengthen risk-management and reporting systems of their respective IHCs to meet supervisory expectations. Some FBOs have established multiyear projects to address known deficiencies in their IHCs' risk-management and reporting systems.16
Supervisory findings for FBO branches and agencies are concentrated in compliance risk management and controls.
FBO branches and agencies often engage in BSA/AML compliance-sensitive businesses such as dollar clearing, foreign correspondent banking, and trade finance. Examiners have noted that some firms lack sufficiently strong BSA/AML compliance systems. These deficiencies have resulted in public enforcement actions and substantial penalties from bank supervisory and law enforcement agencies.
Upcoming supervisory priorities in 2018 and 2019 will include review and validation of actions by firms to address outstanding supervisory findings. For the LFBO portfolio as a whole, focus will remain on the areas listed in box 8.
Box 8. Upcoming LFBO Supervisory Priorities
Capital
- Loss estimation methodologies
- Capital policies and scenario design
Liquidity
- Independent review function and liquidity limits risk management
- Security dealer internal stress testing assumptions
Governance and controls
- Cyber-related risks
- Internal audit
- Compliance and business conduct
- BSA/AML and OFAC compliance program control
Recovery and resolution planning
- Resolution plans, including IHC resolution plans
Regional and Community Banking Organizations
The majority of the firms in the regional and community bank portfolios are in satisfactory condition.
The financial condition of regional and community banking organizations (RBOs and CBOs, respectively) is generally satisfactory. These institutions have maintained high common equity tier 1 capital levels over the past decade (figure 17). More than 99 percent of banking organizations in this portfolio report capital levels consistent with the "well-capitalized" designation under regulatory capital standards. Although highly liquid assets have been trending down over the past five years for these firms as lending activity has picked up, reliance on wholesale funding remains relatively low.
Figure 17. Common equity tier 1 ratio for RBO and CBO firms
Note: Common equity tier 1 is the ratio of tier 1 common equity to risk-weighted assets.
Source: Call Report and FR Y-9C.
Supervisory recommendations issued during the financial crisis have largely been addressed and closed (figure 18).
Supervision and regulation of these institutions is aimed at tailoring requirements to match the size, risk, and complexity of each institution. As firms in these portfolios grow, merge, or enter into new markets or activities, supervisors pay close attention to ensuring that risk-management processes keep pace with their complexity and risk. The Federal Reserve completes full-scope examination or inspection activities for all CBOs, RBOs, and savings and loan holding companies (SLHCs) within each supervisory cycle. However, the scope of individual supervisory events is tailored to the size, complexity, and unique risk characteristics of each institution. To improve supervisory efficiency, Federal Reserve examiners are reducing the amount of time spent onsite at examinations, increasing the risk focus of examinations, and leveraging, where appropriate, supervisory findings from other regulators.
Figure 18. Outstanding supervisory findings for smaller institutions
Note: Values prior to 2018 are as of year-end. The 2018 value is as of the end of 2018:Q2.
Source: Internal Federal Reserve supervisory databases.
There are few RBOs or CBOs in less-than-satisfactory condition.
Supervisory ratings in these portfolios reflect the generally stable condition of the portfolio, with the vast majority of institutions rated satisfactory.17 Less than 6 percent of all RBO and CBO holding companies are rated less than satisfactory, reflecting the generally strong condition of their banking subsidiaries (figure 19). The percentage of RBO and CBO companies rated satisfactory has been trending upward since the low in 2010.
Figure 19. Holding company ratings for firms < $50 billion
Source: Internal Federal Reserve supervisory databases.
Box 9. State Member Bank and Consolidated Supervision
The Federal Reserve is responsible for the supervision and regulation of state-chartered banks that are members of the Federal Reserve System (known as state member banks or SMBs). By statute, the Federal Reserve, or chartering state banking department, must perform an onsite, full-scope examination of each SMB at least once every 12 or 18 months.
Results from the onsite examination are reported to the board of directors and management of the bank in a report of examination, which includes an assessment and ratings of the bank's capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk under the Uniform Interagency Financial Institution Rating System, also known as the CAMELS ratings system.1
Consolidated Supervision of Community and Regional Holding Companies
Consolidated supervision of the holding company includes an assessment of the organization's structure and condition, including nonbank subsidiaries, activities, and governance. Assessments of the holding company are conveyed through ratings of risk management, financial condition, and the impact of the holding company on the insured depository, under the RFI rating system.
The Federal Reserve's supervision of holding companies is tailored within portfolios based on the size, complexity, and risk profile of each institution. In addition, there is a significant distinction between the Federal Reserve's supervisory programs for those holding companies with SMB subsidiaries versus holding companies with non-SMB depository subsidiaries; for the latter, the Federal Reserve relies extensively on findings of the primary federal and/or state bank regulator.
Reliance on the Primary Regulators
A long-standing tenet of the Federal Reserve's CBO and RBO holding company supervisory approach is to rely on--and coordinate extensively with--the insured depository primary regulator in order to reduce burden and duplicative efforts. In the CBO portfolio, small, noncomplex holding company supervision is generally completed offsite and draws significantly on the primary regulator's assessment of the subsidiary bank or savings and loan.
Considerable efforts have been taken by the Federal Reserve in recent years to align our supervisory planning schedule with those of the OCC and FDIC to optimize coordination, resulting in a significant decline in the number of examination events led by the Federal Reserve at these companies. The Federal Reserve's Office of Inspector General (OIG) issued a report in June 2018, which concluded that "In accordance with applicable guidance related to consolidated supervision, we determined that the Federal Reserve Banks relied on the primary federal regulator (PFR) of regional banking organizations' (RBOs) insured depository institutions to supervise the RBOs we sampled." 2
The Federal Reserve relies to the fullest extent possible on the work of primary functional state Department of Insurance (DOI) regulators as part of the overall supervisory assessment of insurance SLHCs (ISLHCs). The Federal Reserve has worked closely with the DOIs and the National Association of Insurance Commissioners to develop strategies to tailor the supervisory program for ISLHCs and address the complexities associated with insurers, maximize supervisory efficiencies, and avoid duplication.
1. See SR letter 96-38, "Uniform Financial Institutions Rating System" at www.federalreserve.gov/boarddocs/srletters/1996/sr9638.htm. Return to text
2. See Evaluation Report 2018-SR-B-010, June 20, 2018, on the OIG website at https://oig.federalreserve.gov/reports/board-consolidated-supervision-jun2018.htm. Return to text
Supervision of Regional Banking Organizations
The condition of the RBO portfolio has steadily improved and stabilized post-crisis.
In line with the broader industry, the quality and quantity of capital at RBO firms remain high. Currently, common equity tier 1 ratios for this portfolio are around 12 percent, and all institutions report capital ratios consistent with the "well capitalized" designation under interagency capital guidelines.
Although liquidity risk in this portfolio is considered low or moderate, examiners have observed some deterioration in RBO liquidity positions. As a result of loan growth outstripping growth in core deposits, some banking organizations have increased their reliance on riskier noncore funding sources, such as brokered and listing service deposits.
Risk management and controls at RBOs remain an area of supervisory focus.
Current risks in the portfolio are primarily the result of the consolidation of smaller firms into larger regional banks. The total number of holding companies supervised in the regional banking portfolio increased by 40 percent over the past five years, and the number of those companies that have state member lead banks has doubled. There are now 78 institutions supervised in the RBO program, with combined assets of approximately $1.6 trillion.
Despite the growing number of RBOs, the total number of supervisory findings cited for RBO firms has declined over the past five years. Internal audit, BSA/AML, and risk-management weaknesses have been among the leading supervisory findings for RBOs for several years, reflecting the need for these capabilities to evolve commensurate with the increased size, scope, and complexity of these firms.
Figure 20 depicts the current breakdown of outstanding supervisory findings by category for RBO firms. Because of substantial recent growth at several firms, the RBO supervisory program has focused on assessing centralized control functions, including internal controls and audit, loan review, corporate compliance programs, IT infrastructure, and other areas impacted by merger integrations.
Figure 20. Outstanding supervisory findings by category, RBO firms
Note: As of 2018:Q2, there were 294 total outstanding supervisory findings for RBO firms.
Source: Internal Federal Reserve supervisory databases.
RBO reviews identify opportunities for risk-management improvement but not widespread safety-and-soundness concerns.
Reserve Banks recently conducted coordinated reviews of sales practices/incentive compensation and commercial credit underwriting at certain RBO state member banks (SMBs). The sales practices/incentive compensation review evaluated the range of practices for the design and implementation of incentive compensation programs; controls to prevent, detect, and report unauthorized account openings; risk-assessment processes; internal audit reviews; complaints processing; and employee terminations and separations.
Overall, the reviews identified acceptable practices and, when noted, findings were determined to be correctable in the normal course of business. Reserve Banks continue to regularly review consumer complaints for potential issues and discuss supervisory expectations with respect to maintaining a measured and balanced incentive compensation program.
In the underwriting review, examiners reviewed a sample of recently underwritten commercial loans and concluded that the majority included acceptable structures, terms, and adequate credit analysis. Examiners provided feedback to firms so they could address weakness in some areas as needed, including policy exceptions, financial covenants, financial analysis, guarantor support, and liberal credit structures.
Supervisory priorities for each RBO are established during a supervisory planning process. Supervisory plans are coordinated with the subsidiary depository's primary regulator, as appropriate, and are tailored to idiosyncratic risk characteristics of each institution. Risks are also monitored across the portfolio. Some common risk focus areas that have emerged for the RBO portfolio for the current supervisory cycle are included in box 10.
Box 10. Upcoming RBO Supervisory Priorities
Credit Risk
- Concentrations of credit
- Commercial real estate and construction & land development
- Underwriting practices
Operational Risk
- Merger and acquisition risks
- Information technology and cybersecurity
Other
- Sales practices and incentive compensation
- Bank Secrecy Act/anti-money-laundering
Box 11. Bank Exams Tailored to Risk (BETR) Program: Minimizing Regulatory Burden and Optimizing Supervision Resources
In an effort to design an examination program that is more forward-looking and risk focused, the Federal Reserve developed risk metrics via the Bank Exams Tailored to Risk (BETR) program to assist with the scoping of examinations along different categories of risk.
For each risk category, BETR classifies each bank into one of three risk tiers: low, moderate, or high. In turn, these risk tiers provide examiners with a starting point for determining the scope of work to be performed during examinations. Examiners may also apply qualitative factors and their own judgment to confirm or adjust these model-driven risk tiers. For banks tiered as low risk, examiners perform limited transaction testing. In contrast, for high-risk banks, examiners apply the full extent of examination procedures.
BETR helps minimize regulatory burden and optimize the allocation of supervisory resources by directing examiners away from low-risk banks to higher-risk banks, and from low-risk areas to areas presenting heightened risk within a bank.
The BETR program has been deployed for six financial risks: credit, liquidity, interest rate, earnings, capital, and securities. These financial risk categories accounted for about half of community bank examination time in 2017. Credit risk is a key driver of community bank examinations and accounts for over one-third of all examination hours. The Federal Reserve is currently working to develop metrics for nonfinancial risks.
According to these BETR risk metrics, the share of banks tiered high risk is at, or near, historical lows for all six financial risks. As shown in figure A, continuing improvement in earnings risk is especially noticeable.
In contrast, liquidity risk is displaying some deterioration. While the share of banks tiered high risk for liquidity has not increased, the moderate-risk tier is growing. In aggregate measures, loan growth has been robust, while core deposit growth has not always kept pace. To bridge that gap, some banks have increased their reliance on noncore funding sources, such as brokered and listing service deposits.
Figure A. Risk tiering trends for community and regional banks based on BETR
Supervision of Community Banking Organizations
Community banks are currently in robust financial condition.
Capital levels at CBO firms have remained high over the past decade, following a slight drop during the financial crisis. Common equity tier 1 ratios for CBO firms average above 13 percent. More than 99 percent of the companies in this portfolio report capital ratios consistent with the "well capitalized" designation under interagency capital guidelines. Similar to the RBO portfolio, there has been a slight uptick in liquidity risks associated with this portfolio, although the majority of CBO firms are still considered to have low-to-moderate liquidity risk.
The trend of consolidation among community banks has continued. The net impact of charter conversions, mergers, and a single bank failure was a 2 percent decline in the total number of SMBs in 2017. This decline is roughly in line with trends from recent years.
CBO supervisory findings have been declining.
During 2017, the Federal Reserve led examinations at 332 CBO SMBs and conducted 2,256 holding company inspections.18 For CBO SMBs, the vast majority exhibit a moderate-risk profile, with only 27 considered high risk. Based on recent examination findings, the direction of risk at CBO SMBs is stable. The volume of supervisory findings at CBOs has steadily declined over the past five years (figure 18), as has the number of firms under enforcement actions. Figure 21 depicts the current outstanding supervisory findings by category for CBO firms.
Figure 21. Outstanding supervisory findings by category, CBO firms
Note: As of 2018:Q2, there were 2,460 total outstanding supervisory findings for CBO firms.
Source: Internal Federal Reserve supervisory databases.
The decline in supervisory findings over recent years is consistent with the improved ratings of the portfolios and economic conditions. In part, the decline may be attributed to changes in bank underwriting practices. Specifically, post-crisis, community banks have reduced concentrations in certain asset classes--such as construction and land development lending.
Supervisory focus remains on management of concentrations of credit, interest rate risk, and liquidity risk.
Areas of emerging risk that have received supervisory attention over the recent period include the management of concentrations of credit (specifically, commercial real estate, agriculture, and oil and gas), the impact of rising interest rates, and increased liquidity risk.
CBO supervision priorities include efforts to modernize, increase efficiencies, and reduce burden associated with the examination process.
The Federal Reserve continues to reduce unnecessary burden for community banks, including for supervisory examinations, as shown by the Bank Exams Tailored to Risk (BETR) program (see box 11). As of the first quarter of 2018, changes in loan review procedures associated with the BETR program allowed examiners the discretion to reduce the number of loan files reviewed at community banks exhibiting low credit risk. Conversely, banks with higher credit risk may see higher levels of testing or more focus on evaluating credit administration policies and practices.
Furthering efforts to reduce burden associated with examinations, examiners are now conducting the majority of community bank examinations offsite (i.e., not at a supervised bank's physical location) (figure 22).
Finally, the Federal Reserve is actively participating with Federal Financial Institutions Examination Council (FFIEC) member agencies to review the technology platforms used to communicate with other regulators and supervised institutions and together are pursuing opportunities to further leverage technology platforms to reduce regulatory burden.
Figure 22. Percent of time spent offsite
Note: Data prior to 2018 are yearly; 2018 data are as of 2018:Q2.
Source: Internal Federal Reserve supervisory databases.
Community SMB supervision is driven by statutory mandates, and the Federal Reserve conducts a full-scope examination each supervisory cycle. Some of the emerging or higher-risk areas for CBOs for this supervisory cycle are included in box 12.
Box 12. Upcoming CBO Supervisory Priorities
Credit Risk
- Concentrations of credit
- Commercial real estate and construction & land development
- Agriculture
Operational Risk
- Information technology and cybersecurity
Other
- Bank Secrecy Act/anti-money-laundering
- Liquidity risk
References
7. See 104th Annual Report 2017, section 5, "Consumer and Community Affairs," at www.federalreserve.gov/publications/annual-report.htm. Return to text
8. See The Consumer Compliance Supervision Bulletin at www.federalreserve.gov/publications/consumer-compliance-supervision-bulletin.htm. Return to text
9. As referenced here, the required minimum post-stress ratios for the tier 1 capital and tier 1 leverage ratio are 6.0 percent and 4.0 percent, respectively. See also the Federal Reserve's Comprehensive Capital Analysis and Review 2018: Assessment Framework and Results report at www.federalreserve.gov/publications/files/2018-ccar-assessment-framework-results-20180628.pdf. Return to text
10. For more information about MRAs and MRIAs, see SR letter 13-13, "Supervisory Considerations for the Communication of Supervisory Findings," at www.federalreserve.gov/supervisionreg/srletters/sr1313a1.pdf. Return to text
11. In the 2018 Comprehensive Capital Analysis and Review (CCAR) exercise, the Federal Reserve did not object to any firm's capital plan based on quantitative grounds. However, the Board of Governors did object to the capital plan of DB USA Corporation based upon qualitative grounds. The Federal Reserve also issued a conditional non-objection to the capital plans of State Street Corporation, The Goldman Sachs Group, Inc., and Morgan Stanley based on quantitative grounds. See the Federal Reserve 2018 CCAR press release at www.federalreserve.gov/newsevents/pressreleases/bcreg20180628a.htm. Return to text
12. Note that supervisory findings related to resolution plans are not classified as MRAs or MRIAs. Shortcomings and deficiencies found in firm specific resolution plans can be located at www.federalreserve.gov/supervisionreg/resolution-plans.htm. Return to text
13. It should be noted that supervisory findings issued over multiple years will vary in approach and granularity as supervisory practices and policy evolve, which has an effect on the number of recommendations issued. However, the general trend in the issuance of supervisory findings indicates improved risk management at LISCC firms. Return to text
14. Some of the outstanding enforcement actions were issued around the same time to multiple firms because of significant issues that emerged across firms, such as seven enforcement actions related to foreign exchange market abuses and related conduct issues, and several enforcement actions to address BSA/AML weaknesses.
Formal enforcement actions against entities supervised by the Federal Reserve are available on the Federal Reserve Board's website at www.federalreserve.gov/apps/enforcementactions/search.aspx. Return to text
15. For more information about resolution plans, see the Federal Reserve Board's website at www.federalreserve.gov/supervisionreg/resolution-plans.htm. Return to text
16. These statements generally also apply to LISCC FBOs. Return to text
17. Ratings in this context refers to the composite rating of the top-tier holding company, which generally mirrors the composite rating of the subsidiary banking organization(s). See Box 3, "What Are RFI Ratings and MRAs?" See also SR letter 04-18, "Bank Holding Company Rating System," at www.federalreserve.gov/boarddocs/srletters/2004/sr0418.htm, and SR letter 13-21, "Inspection Frequency and Scope Requirements for Bank Holding Companies and Savings and Loan Holding Companies with Total Consolidated Assets of $10 Billion or Less," at www.federalreserve.gov/supervisionreg/srletters/sr1321.htm. Return to text
18. For noncomplex holding companies with less than $1 billion in assets (referred to as "small shell holding companies") the Federal Reserve uses an offsite inspection program that relies substantially on the work performed by the insured depository institution regulator. Return to text