Board of Governors of the Federal Reserve System

Supervisory Developments

This section provides an overview of how the Federal Reserve tailors its supervision of large financial institutions and regional and community banking organizations. The November 2018 Supervision and Regulation Report included information on supervisory ratings and outstanding supervisory findings. There have not been significant changes to this information since last November. As appropriate, updated charts will be shared in future reports.²

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 2017.³ 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.⁴

The Federal Reserve takes a risk-focused approach by scaling its supervisory work to the size and complexity of the institution.

In supervising financial institutions, a risk-focused approach to supervision is more efficient and results in more rigorous oversight of firms that pose increased risk to the financial system.

The supervision of the largest, most systemically important financial institutions is conducted by the LISCC program—a national program that uses both horizontal and firm-specific supervisory activities to assess the financial resiliency and risk-management practices of firms. By contrast, the supervision of institutions in the LFBO portfolio includes some horizontal elements, but firm-specific teams at the local Reserve Bank conduct most of the supervisory work, subject to oversight by the Board.

For RBOs and CBOs, the supervision model is more decentralized with greater decisionmaking flexibility provided to Reserve Banks; again, subject to oversight by Board staff.

As shown in figures 8 and 9, in 2018, the Federal Reserve, on average, spent the least amount of time supervising the holding companies of community banks whose primary federal regulator was either the OCC or FDIC (CBOs without SMBs). For firms with total assets of less than $3 billion, average supervisory time was approximately 40 hours per firm. For firms with total assets between $3 billion and $10 billion, the average supervisory time was 500 hours per firm. For community banks where the Federal Reserve is the primary federal regulator (CBOs with SMBs), Federal Reserve staff cannot leverage work done by other federal agencies. Therefore, more time is spent supervising these firms—on average between 1,000 and 3,500 hours per firm. For the larger and more complex firms in the RBO and LFBO portfolios, supervisors spent, on average, 17,000 and 30,000 hours per firm, respectively.

LISCC firms, which are considered systemically important, are subject to the most rigorous supervision with the most supervisory resources per firm—over 55,000 hours on average. For these institutions, Federal Reserve staff engage firm management on a more regular basis and conduct more examinations, including more horizontal examinations. Because of these firms' structures and activities, and the risks they could pose to the financial system, the supervisory program for larger institutions includes rigorous expectations for internal stress testing practices, quality of modeling, and other risk-management practices (figure 9).

Large Financial Institutions

This section discusses the supervisory program for LISCC and LFBO firms and tailoring by the Federal Reserve of its supervisory activities in the areas of capital, liquidity, governance and controls, and resolution planning.

The supervision framework for large financial institutions has two primary objectives: to enhance the resiliency of the firms while simultaneously reducing the impact to the economy in the event of failure.

In supervising large financial institutions, the Federal Reserve focuses on

• enhancing the resiliency of a firm to lower the probability of its failure through monitoring capital, liquidity, and governance and controls; and
• reducing the impact on the financial system and the broader economy in the event of a firm's failure or material weakness through resolution plan reviews.

The Federal Reserve accomplishes this through regular communication with the firms using targeted examinations, horizontal examinations, and continuous monitoring.

Enhancing Resiliency

Capital

Capital levels at large financial institutions are strong. These firms have experienced a more significant increase in capital ratios as compared with other portfolios. For example, the common equity tier 1 risk-based capital ratio has increased most significantly for LISCC firms and LBOs since the financial crisis (see figure 6).

To develop an understanding of firms' capital adequacy, the Federal Reserve evaluates

• a firm's planning processes used to determine the amount of capital necessary to cover risks and exposures and to support activities through a range of conditions and events; and
• capital position, which is the firm's ability to comply with applicable regulatory requirements and to support the firm's ability to continue to serve as a financial intermediary through a range of conditions.

Supervisory Stress Testing

The Federal Reserve conducts annual supervisory stress tests through two complementary, but distinct, programs: (1) the Dodd-Frank Act stress tests (DFAST); and (2) the quantitative assessment portion of CCAR. Together, DFAST's and CCAR's quantitative assessments help ensure that firms with total assets of $100 billion or more maintain sufficient capital to continue operations and lending to households and businesses during times of stress.

As noted in the prior section on Regulatory Developments, in February 2019, the Federal Reserve announced that it would provide relief to the less complex firms subject to the supervisory stress tests—generally those with total assets between $100 billion and $250 billion—by effectively moving them to an extended stress testing cycle for this year. As a result, those firms are not subject to supervisory stress tests during the 2019 cycle. These firms are still expected to maintain capital plans, which should include the results of a firm's internal stressed analysis. These firms' capital planning activities are assessed in the Horizontal Capital Review (HCR).

Capital Planning

The largest firms' capital planning processes are assessed annually through the Federal Reserve's CCAR exercise. In CCAR, the Federal Reserve conducts a quantitative assessment of firms' capital adequacy, as noted above, as well as an intensive qualitative assessment of the strength of each firm's internal capital planning processes through an in-depth analysis of its annual capital plan.

CCAR's qualitative assessment includes an evaluation of the extent to which the analysis underlying each firm's capital plan comprehensively captures and addresses potential risks stemming from companywide activities as well as the reasonableness and robustness of each capital plan. CCAR's qualitative assessment applies to LISCC firms and other large firms with total assets exceeding $250 billion. These firms are also subject to supervisory stress testing and other capital-related horizontal and firm-specific examinations conducted throughout the year.

In 2017, LFBO firms with total assets of $250 billion or less were removed from CCAR's qualitative assessment because they generally have a lower systemic risk profile compared to the largest and most complex firms. This change reduced supervisory burden for these LFBO firms. Instead, these firms are subject to the HCR. As compared to CCAR's assessment of capital planning practices, HCR is more limited in scope, includes targeted horizontal evaluations of specific areas of capital planning, and focuses on the more tailored standards set forth in supervisory guidance specific to these firms.

Because of the improvements in capital planning made by the largest firms, the Federal Reserve announced in March of this year that it is limiting the use of the "qualitative objection" in its CCAR exercise, effective for the 2019 cycle. These changes eliminate the qualitative objection for most firms.

The focus of CCAR in 2019 is on governance of capital planning, model sensitivity analysis, and use of model overlays. For firms with significant trading exposures, CCAR is focusing on the identification and capture of trading risks in the capital planning process. Outside of CCAR, the LISCC firms are subject to horizontal examinations that assess their capital policies, risk appetites, and limit setting; wholesale credit underwriting standards; and nonbank financial institution risk exposures. The focus of the HCR in 2019 is on loss estimation methodologies and governance for residential mortgage and commercial real estate portfolios, as well as governance of the capital planning process.

Liquidity

Similar to the supervision of firms' capital, supervisors hold large firms to the highest regulatory liquidity requirements (such as the liquidity coverage ratio (LCR) and liquidity stress testing requirements) and supervisory expectations. As a result, domestic LISCC firms and LBOs have greatly increased their liquidity positions since the financial crisis and currently hold substantial amounts of high-quality liquid assets (figure 10).

To develop an understanding of large firms' liquidity, the Federal Reserve evaluates

• liquidity risk management, which is a firm's governance and risk-management processes used to determine the amount of liquidity necessary to cover and limit risks and exposures and to support activities through a range of conditions; and
• liquidity position, which is the sufficiency of a firm's liquidity buffer and funding profile to comply with applicable regulatory requirements and to support the firm's ongoing obligations through a range of conditions.

The Federal Reserve conducts various horizontal reviews to evaluate the adequacy of liquidity positions and the effectiveness of liquidity risk-management practices and liquidity stress testing on the largest financial institutions. Additionally, the Federal Reserve conducts focused analysis on institutions' liquidity positions using data derived from regulatory reports to supplement the horizontal reviews. These reviews are tailored to account for differences in the size, complexity, and risk profile between firms in the LISCC and LFBO portfolios.

The LISCC liquidity program assesses the adequacy of LISCC firms' liquidity position and liquidity risk-management practices through both horizontal and firm-specific examinations, in-depth reviews, and analyses conducted throughout the year. The Comprehensive Liquidity Analysis and Review (CLAR) is the horizontal component of this program. CLAR and the firm-specific liquidity assessments are conducted on a forward-looking basis, analyzing the firms' liquidity risk-management practices and resiliency under normal and stressed conditions. Since CLAR only targets a select population of liquidity risk topics in a given year, firm-specific events help ensure that the Federal Reserve evaluates and considers the most critical inherent risk and risk-management areas in the assessment of a firm.

In the LFBO portfolio, an annual Horizontal Liquidity Review (HLR) is conducted for all firms with total assets in excess of $100 billion that are not in the LISCC portfolio. Similar to CLAR, assessments of liquidity risk management and liquidity positions for the LFBO portfolio are forward looking, analyzing a firm's liquidity under normal and stressed conditions. The scope of the HLR review is adjusted to factor in a firm's size and complexity, and expectations are tailored given the lower systemic risk posed by these institutions. Similar to CLAR, HLR targets a select number of liquidity risk topics in a given year.

In 2019, LISCC liquidity supervision is focusing on the adequacy of a firm's cash-flow forecasting capabilities, practices for establishing liquidity risk limits, and measurement of intraday liquidity risk. Topics for evaluation in the 2019 HLR included an assessment of an LFBO's liquidity buffer and contingency funding plans. In addition, a review of liquidity stress testing practices at branches of foreign banks in the LFBO portfolio was conducted to ensure consistency with supervisory expectations.

Governance and Controls (G&C)

To develop an understanding of governance and controls, the Federal Reserve evaluates the effectiveness of a firm's board of directors, and management of business lines and independent risk management and controls.

The LISCC G&C program uses horizontal and firm-specific examinations to assess the strength of firms' governance, risk management, and internal controls. This includes compliance risk management, operational risk management, operational and cyber resilience, model risk management, internal audit, and other nonfinancial areas. Financial risk management practices are examined under the capital and liquidity programs. There are also firm-specific exams depending on a firm's risk profile and outstanding supervisory issues.

In contrast to the LISCC G&C program, given the diverse nature of the LFBO firms, much of the G&C-related supervisory work in this portfolio is firm-specific, based on the size and complexity of the firm and firm-specific risks. Given the significance of the risk, the LFBO portfolio assesses cyber resilience on a horizontal basis. A limited number of coordinated reviews have been conducted including ones assessing Bank Secrecy Act and anti-money-laundering (BSA/AML) and Office of Foreign Asset Control (OFAC) compliance, model risk management, and vendor management.

In 2019, several horizontal examinations and firm-specific examinations are being conducted on LISCC firms to assess G&C. Topics include operational and cyber resiliency, management of business lines, compliance risk management, and board effectiveness. In the LFBO portfolio, in addition to firm-specific reviews and the cyber-resiliency horizontal, coordinated reviews are planned in the areas of compliance metrics, risk reporting, and the use of artificial intelligence for fraud and BSA/AML detection.

Reducing the Impact of a Firm's Failure: Recovery and Resolution Preparedness Planning

The Federal Reserve's recovery and resolution preparedness (RRP) program for LISCC firms is conducted through horizontal and firm-specific supervisory assessments of recovery and resolution preparedness and capabilities. This includes the Federal Reserve's annual horizontal supervisory program for evaluating recovery and resolution plans of LISCC firms. With regards to Title I Resolution Plan reviews,⁵ the program works closely with the FDIC and produces joint work products. The review culminates in determinations by the Board and the FDIC regarding LISCC firms' resolution plans. Additionally, the LISCC program reviews recovery plans, which culminates in assessments that are included as inputs into supervisory messages to the firms.

The LISCC RRP program consists of dedicated staff specializing in various areas. The 2019 LISCC RRP reviews target areas of high risk to recovery and resolution plan execution and other capabilities not previously reviewed. Review of the 2019 resolution plans includes areas such as resolution capital and liquidity; legal entity rationalization and separability; payments, clearing and settlement activities; derivatives and trading activities; and governance. In addition, the Federal Reserve is conducting a full review of firms' 2019 recovery plans.

For LFBO firms, the Federal Reserve and FDIC conduct joint point-in-time reviews of Title I resolution plan submissions, which are comprehensive but more tailored than the reviews of the LISCC firms' plans. There are no separate supervisory activities to assess resolution capabilities apart from the Title 1 plan reviews. In addition, LFBO firms are not required to submit recovery plans, and there is no distinct review of these firms' recovery strategy due to the firms' simpler, less complex structures and activities.

Regional and Community Banking Organizations

The Federal Reserve tailors its regional and community bank supervisory programs in a way that avoids imposing excessive burden.

While weaknesses at small banks are less likely to cause systemic problems, by their nature—and relative lack of geographic and portfolio diversification—many regional and community banking organizations are vulnerable to localized economic problems. Accordingly, the Federal Reserve supervises and regulates smaller banks with a tailored approach based on a variety of factors, including size, condition, risk profile, and organizational structure.

Supervision of CBO SMBs is carried out generally through a single, point-in-time examination and is supplemented by off-site surveillance using quarterly financial data that are submitted by banks via the Consolidated Report of Condition and Income (Call Report). The Federal Reserve's CBO SMB examinations are conducted in accordance with statutory mandates (generally one examination per every supervisory cycle—12 or 18 months). In 2018, the Federal Reserve conducted 259 examinations independently or jointly with another supervisor at CBO SMBs.

Supervision of regional banks consists of a limited number of targeted reviews and off-site monitoring conducted throughout an examination cycle, which is slightly more intensive than the singular point-in-time examination conducted at community banks. In contrast to the Federal Reserve's supervisory program for larger institutions, large-scale, centrally coordinated on-site horizontal reviews are rarely used for the supervision of RBOs. In 2019, one review with common work programs on credit-underwriting practices is scheduled for RBO SMBs. This review will be conducted off-site and is designed specifically to inform the RBO risk-assessment and scoping process for future credit examinations.

CBO and RBO examinations are executed by local Reserve Bank staff. Further, the Federal Reserve works very closely and coordinates with state banking departments for the supervision of SMBs. One example is the protocol that allows for alternating the lead between the Federal Reserve and the responsible state banking department on SMB examinations, generating efficiencies in the supervisory programs.

Within the CBO and RBO portfolios, supervision is tailored based on organizational structure. For example, the supervisory processes for SMBs and holding companies vary significantly. In its assessments of noncomplex holding companies where the depository institution is not a state member bank, the Federal Reserve relies on, and coordinates with, to the fullest extent possible, the insured depository institution's primary regulator's assessment of capital, liquidity, and management function at the depository subsidiary.⁶ The Federal Reserve will also conduct a limited review of the financial condition of a holding company and any nonbank subsidiaries that are not owned by the depository subsidiary. This review assesses the likelihood of a potential negative impact on the depository institution from the holding company or its nonbank activities, as well as the holding company's ability to act as a source of strength to the depository subsidiary.

In cases where the control functions are centrally managed at the holding company level, examiners conduct coordinated reviews with the primary federal regulators of these control functions. The Federal Reserve has developed and regularly updates programs to efficiently and accurately assess holding companies while minimizing burden on the institution. This has included the development and implementation of standardized examination programs, tools, and report templates for smaller, noncomplex holding companies. The Federal Reserve also implemented an abbreviated ratings framework for noncomplex holding companies with less than $3 billion in total consolidated assets.

The Federal Reserve continues to take steps to address concerns about regulatory burden on community banks.

As a result of recent legislative changes, the Federal Reserve has extended the examination cycle for eligible banks with between $1 billion and $3 billion in assets from every 12 months to every 18 months (placing these banks on the same cycle as banks below $1 billion). The Federal Reserve has also exempted noncomplex holding companies with between $1 billion and $3 billion in assets from holding company capital and reporting requirements (holding companies below $1 billion were already exempted from these requirements). These changes reduced exam frequency and reporting requirements for roughly 100 SMBs (12 percent of the SMB population), bringing the total number of SMBs supervised on the longer cycle and with lower reporting requirements to roughly 725 (91 percent of the SMB population). Similarly, these changes reduced examination frequency and reporting requirements for roughly 360 holding companies (8 percent of the holding company population), bringing the total number of holding companies exempted from holding company capital and reporting requirements to more than 3,700 holding companies (87 percent of the holding company population).

With respect to regulatory reporting, financial regulators finalized a new and streamlined Call Report for small financial institutions (FFIEC 051), which became effective for March 31, 2017, reporting. The streamlined Call Report has approximately 40 percent fewer data items. Additional changes effective June 30, 2018, further streamlined the report by combining data items, increasing reporting thresholds, or reducing the reporting frequency of data items affecting an additional 10 percent of the report.

Additionally, a notice of proposed rulemaking for the community bank leverage ratio was issued (discussed previously in the Regulatory Developments section), which would allow electing community banks to opt-in to a simpler regulatory capital framework.

To ease the burden associated with examinations, the Federal Reserve is conducting more supervisory activities off-site and simplifying pre-examination requests for documentation. The Federal Reserve recognizes there are differences in risk among community banks and has further tailored the supervision of these banks. The Federal Reserve continues to follow a risk-focused approach that aims to deploy examination resources to higher-risk banks. This risk-focused approach contributes to reduced regulatory burden, allowing banks more time and resources to serve the credit needs of their local community (figure 11).

The Federal Reserve uses the metrics-based Bank Exams Tailored to Risk (BETR) program in its implementation of a risk-focused supervisory program.⁷ The BETR program relies upon regulatory reporting (largely quarterly Call Report) data and examiner judgement to appropriately classify institutions into low, moderate, and high risk. This allows Reserve Bank staff to direct their resources effectively to areas of heightened risk and to minimize excessive burden on low- and moderate-risk institutions. The Federal Reserve has developed exam procedures that are tailored to the BETR risk classification. The median time estimated to review low-risk SMBs is roughly one-half to two-thirds of the estimated time required to review high-risk SMBs. The median resources devoted to reviewing instances of low credit risk is less than half the estimated time to review instances of high credit risk (figure 12).

In its efforts to minimize burden, the Federal Reserve relies upon standardized regulatory reports and the results from internal control functions within the supervised institutions in assessing their condition.

In its review of community and regional SMBs, the Federal Reserve relies heavily on data collected from standardized regulatory reporting and the results and materials produced by internal control functions (e.g., internal audit and loan review) in its assessment of the financial condition and management of the supervised institution. When assessing the adequacy of an institution's management and risk-management functions at community and regional SMBs, the Federal Reserve focuses on major control functions of the bank, allowing examiners the ability, when warranted, to reduce the intensity of their review and rely on an institution's internal independent testing.

For ongoing surveillance, the Federal Reserve relies almost exclusively on data reported in the Call Report to assess the financial condition at community SMBs. The Federal Reserve may request additional materials for institutions that are in less-than-satisfactory condition to ensure that the institution is addressing any areas of concern.

For regional SMBs, the Federal Reserve supplements its reliance on Call Report data with additional information gathered during its continuous monitoring processes. The Federal Reserve only requires supplemental regulatory reporting for higher-risk institutions or institutions that are engaged in certain activities, hold certain investments, or have operations in foreign countries.

Footnotes