Board of Governors of the Federal Reserve System

Supervisory Developments

Overview

This section provides an overview of key developments related to the Federal Reserve's prudential supervision of financial institutions, including large financial institutions (known as LISCC firms and LFBO firms) as well as community and regional banking organizations (known as CBOs and RBOs). Table 2 provides an overview of the organizations supervised by the Federal Reserve, by portfolio, including the number of institutions and total assets in each portfolio.

Table 2. Summary of organizations supervised by the Federal Reserve (as of 2020:Q2)

The Federal Reserve also has responsibility for certain laws and regulations relating to consumer protection and community reinvestment. The scope of the Federal Reserve's supervisory jurisdiction varies based on the particular law or regulation and on the asset size of the state member bank. 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.

More information about the Federal Reserve's consumer-focused supervisory program can be found in the Federal Reserve's 106th Annual Report 2019.⁷ 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

Federal Reserve supervision responded quickly to the current crisis.

The Federal Reserve promotes a safe, sound, and efficient banking system and a fair and transparent consumer financial services marketplace that supports the growth and financial stability of the U.S. economy. In response to the disruptions posed by the COVID event, Federal Reserve supervisors have focused on ensuring that financial institutions can meet the challenges faced by their customers and local communities.

In June 2020, the Federal Reserve, along with the FDIC, OCC, National Credit Union Administration, and Conference of State Bank Supervisors, issued guidance to promote consistency in the supervision and examination of financial institutions affected by the COVID event.⁹ The interagency guidance acknowledges that the stresses caused by the COVID event can affect a bank's financial condition and operational capabilities, even when the bank has appropriate governance and risk-management systems in place. The guidance instructs safety and soundness examiners to consider the unique, evolving, and potentially long-term nature of the issues confronting institutions and to exercise appropriate flexibility in their supervisory response. In assessing the safety and soundness of an institution, examiners will consider the institution's asset size, complexity, and risk profile, as well as the industry and business focus of its customers.

The Federal Reserve has resumed examinations following a pause.

Examination activities help the Federal Reserve understand the safety and soundness of each institution and assess its compliance with applicable laws and regulations, including those related to consumer protection.

At the start of the COVID event, the Federal Reserve temporarily adjusted its supervisory approach. From late-March to mid-June, examiners focused on monitoring and reduced examination activities, with the greatest reduction occurring at the smallest banks. The Federal Reserve's supervisory approach gave firms time to adapt to the COVID event and provide customers with needed assistance. Financial institutions implemented contingency operating plans and adapted operations to the new environment. In June, examination activities resumed for all firms. All examination activities, including full scope examinations, will be conducted off-site until local conditions improve to facilitate on-site examinations.

The Federal Reserve recognizes that the current situation significantly affects institutions and communities in different ways and will work with financial institutions to understand specific issues as it engages in supervisory activities. Financial institutions supervised by the Federal Reserve should work directly with their Reserve Bank and state banking agencies, as applicable, if they have questions on planned supervisory activities.

Supervised Institutions

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

Firms identified as posing elevated risk to U.S. financial stability are supervised by the Large Institution Supervision Coordinating Committee, or LISCC, program. The LISCC program is a national program that uses both cross-firm (horizontal) and firm-specific supervisory activities to assess the financial resiliency and risk-management practices of firms. The list of firms in the LISCC portfolio is updated from time to time in light of developments at firms and in the financial sector. During the period covered by this report, the LISCC portfolio included eight domestic firms and three foreign banking organizations.

The Large and Foreign Banking Organization, or LFBO, program supervises all other large financial institutions that are not included in the LISCC program. The LFBO program includes some cross-firm supervisory activities, but firm-specific teams at the local Reserve Bank conduct most of the supervisory work, subject to oversight by the Board.

Firms with assets less than $100 billion are supervised by the community banking organization, or CBO, and regional banking organization, or RBO, programs.¹⁰ For CBOs and RBOs, the supervision model is more decentralized than the LISCC and the LFBO programs, with greater decisionmaking flexibility provided to Reserve Banks; again, subject to oversight by Board staff.

Large Financial Institutions

This section of the report discusses the supervisory approach for large financial institutions, which are U.S. firms with assets of $100 billion or more and foreign banking organizations with combined U.S. assets of $100 billion or more. These firms are within either the LISCC portfolio or the LFBO portfolio. Large financial institutions are subject to regulatory requirements that are tailored to the risk profiles of these firms. Box 4 provides an overview of these regulatory requirements.

Large financial institutions remain well capitalized.

Federal Reserve supervision helps to ensure that large financial institutions remain financially resilient, so that they can meet their obligations to creditors and other counterparties and continue to lend through a range of conditions. Large financial institutions remain well capitalized and able to support lending, although the COVID event has introduced significant financial uncertainty for the banking industry. The aggregate CET1 capital ratio for large banks in the second quarter was 12.2 percent, a similar level to the end of 2019, despite rising provisions and a slowdown in economic activity.¹¹ As discussed earlier in box 2, preliminary earnings data show an increase in the CET1 ratio in the third quarter of 2020. The improvement in capital ratios has been supported by the rebound in earnings, and in part by the capital conservation measures discussed below.

Stress testing is a cornerstone of Federal Reserve oversight.

Since the 2008 financial crisis, the Federal Reserve has taken action to improve the quantity and quality of capital in the banking system. Stress testing is a critical tool to assess overall financial resilience of large banks. For firms with $100 billion or more in total assets, the Federal Reserve conducts a stress test to measure the resiliency of their capital under hypothetical stress scenarios and to verify that banks are prepared to deal with severe economic and financial conditions.¹² Starting this year, the results of the same stress test will also be used to set the stress capital buffer requirements for large banks.¹³

The unusual nature of the current crisis has made it particularly difficult to predict near-term trends. Given this ongoing uncertainty, the Board conducted a sensitivity analysis earlier this year, in addition to its normal stress test, to assess the resiliency of large banks under three hypothetical recessions, or downside scenarios, that could result from the COVID event.¹⁴ The scenarios included: a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped, double-dip recession.

In the three downside scenarios, the unemployment rate peaked at between 15.6 percent and 19.5 percent, significantly more adverse than any of the Board's pre-coronavirus stress test scenarios.

The annual stress test and sensitivity analysis generally showed that large banks are well capitalized and would remain so under a V-shaped downside scenario or an economic downturn similar in severity and duration to the last crisis. However, a delay in the economic recovery could have measurable negative effects on capital levels at many banks. Given the uncertainty surrounding recovery, the Federal Reserve took several preemptive actions for large banks to help ensure that these firms remain sufficiently capitalized.

For large banks, the Federal Reserve suspended share repurchases, capped the growth of dividends, and imposed a limit that dividends cannot exceed recent income. The distribution limitations were initially applied for the third quarter of 2020. At the end of the third quarter, given continued economic uncertainty from the COVID event, the Board extended the limitations through the end of the year.

These capital conservation measures have resulted in a preservation of capital at large banks, further allowing them to support the economic recovery.

The Federal Reserve is adapting its capital planning examinations.

In response to the current macroeconomic environment, the Federal Reserve modified its annual capital planning examinations—Comprehensive Capital Analysis and Review (CCAR) and the Horizontal Capital Review (HCR)—to focus on monitoring how firms' capital planning responded to the COVID event.¹⁵ In this year's CCAR and HCR, Federal Reserve examiners monitored how firms were managing their capital in the current environment, planning for contingencies, and positioning themselves to continue lending to creditworthy households and businesses.

The Federal Reserve's monitoring efforts have revealed certain differences in how firms adapted their capital planning to the COVID event. Firms used different forecasts of the COVID event on their capital positions. In some cases, firms relied exclusively on V-shaped scenarios rather than considering the potential for slower economic recovery. The severe macroeconomic conditions (such as the high unemployment rate arising from the crisis) and the effects of the economic stimulus and loan modification programs have been difficult for firms to incorporate into loss forecasting models. These challenges have prompted many firms to rely upon qualitative approaches, including the application of management judgment, to forecast losses and revenues. In addition, some firms have expedited their governance processes to respond to the rapidly changing situation.

Because of the economic uncertainty from the COVID event, the Federal Reserve is requiring large banks to update and resubmit their capital plans in the fourth quarter to reflect the current stresses, which will help firms reassess their capital needs and maintain strong capital positions. The resubmission will also allow the Board to conduct additional analysis to further assess the financial conditions and risks of these banks and to determine if further supervisory actions are necessary.

In addition, the Board is performing another round of stress tests in the fourth quarter because of the continued uncertainty from the COVID event. Large banks will be tested against two scenarios featuring severe recessions to assess their resiliency under a range of outcomes. The Board will release firm-specific results from banks' performance under both scenarios by the end of this year.

Supervisors are monitoring credit portfolios exposed to industries materially affected by the COVID event (such as transportation and hospitality) in recognition of heightened risks that may be material loss drivers under certain economic conditions.

Supervisors are also focused on assessing

• credit-risk-management practices and loss projections for the highest risk portfolios;
• the timeliness of credit loss recognition and whether loss projections properly account for uncertainty in the current environment; and
• whether risk identification, measurement, and mitigation measures are sufficient to maintain capital adequacy under a range of adverse scenarios.

The COVID event has led to unprecedented action to accommodate borrowers.

As discussed above, since the start of the COVID event, financial institutions—including large financial institutions—have accommodated borrowers in many ways, including payment deferrals, interest-only payment periods, fee waivers, forbearance, and temporary suspensions from credit reporting. The Federal Reserve and the other federal banking agencies have encouraged financial institutions to work in a prudent and safe and sound manner with borrowers who have been affected by the COVID event. Federal banking agencies view these accommodations as a positive response by institutions, which can help to manage or mitigate the adverse impact of the COVID event on their borrowers and communities.¹⁶

In response to the COVID event, large financial institutions have provided loan modifications on a sizable portion of their loan balances. Large financial institutions that reported on loan modification programs in their second-quarter public financial filings¹⁷ disclosed $330 billion of modified loans.¹⁸ This amount equates to approximately 6 percent of total loan balances for these firms as of the second quarter of 2020.

For consumer loans, there was an initial surge in loan modifications in March and April, followed by a significant decline, particularly for non-mortgage retail credit such as credit card loans and auto loans. The decline has been driven both by bank actions, such as tighter re-enrollment conditions, and actions by borrowers, many of whom have resumed payments on outstanding loans. Early in the COVID event, many borrowers enrolled in payment deferral programs as a precautionary measure but have exited those programs as economic conditions stabilized.

For commercial loans, loan modifications continued to increase in the third quarter. Industries more severely affected by the COVID event, such as hotels, hospitality, and retail, show the highest concentrations of modifications.

Large firms have shown operational resilience to the COVID event.

The Federal Reserve is conducting monitoring and examination activities to understand how large financial institutions have adapted their controls and operational risk management in light of the COVID event. As a whole, large firms have been resilient, leveraging their business continuity and business resumption strategies to enable remote work, with a few notable challenges. For example, firms were required to adjust practices that traditionally require an on-site presence, such as obtaining signatures or managing lockbox operations. Many firms and their third-party service providers rapidly modified processes and controls in light of these challenges, and the processes continue to evolve.

Firms are increasingly using remote endpoints, external networks, and collaboration tools to support remote work, heightening potential vulnerabilities related to cybersecurity attacks. Ransomware attacks, especially those targeting third-party service providers, are occurring with greater frequency and increasing effectiveness. The Federal Reserve's cybersecurity monitoring effort is designed to analyze the heightened risk environment, build supervisory knowledge of cyber risks, and take appropriate supervisory actions.

Supervisors have also engaged with large financial institutions to understand governance and control challenges. Among other topics, supervisors have been monitoring increased potential for internal and external fraud as a result of the work-from-home environment and assessing potential gaps in internal controls and internal audits created by the temporary movement of audit or control employees to assist with other activities.

Large financial institutions' supervisory priorities for 2020.

For the remainder of 2020, supervisors have tailored safety and soundness supervisory activities to those that are most relevant to understanding and assessing a firm's financial and operational resilience. Specifically, supervisory work is focused on three areas: (i) examinations to support the timely issuance of supervisory ratings, (ii) examinations and monitoring of areas of heightened risk for the firms, and (iii) monitoring emerging risks related to the COVID event. Examination processes have been streamlined and adjusted to reflect the remote working environment.

Community and Regional Banking Organizations

This section of the report discusses the supervisory approach for banking organizations with assets less than $100 billion, including CBOs, which have less than $10 billion in total assets, and RBOs, which have total assets between $10 billion and $100 billion.

Most CBOs and RBOs were in satisfactory condition prior to the COVID event.

Most CBOs and RBOs entered 2020 in sound financial condition with improved risk management, including management of credit concentrations. At the end of 2019, over 95 percent of CBOs and RBOs had a supervisory rating of satisfactory or higher. More than 99 percent of CBO and RBO insured depository institutions were considered well capitalized, and more than 96 percent of CBOs and all RBOs were profitable in 2019.¹⁹

The majority of CBOs and RBOs remain in satisfactory condition, though the COVID event has impacted financial performance.

Community and regional banking organizations remain in generally satisfactory financial condition, though the COVID event has introduced significant financial uncertainty for the banking industry. The aggregate tier 1 leverage ratio remains relatively robust, at 10.2 percent for CBOs and nearly 9.1 percent for RBOs as of the second quarter of 2020 (figure 10), although capital ratios for these categories of banks have declined since the beginning of the COVID event. The decrease in the tier 1 leverage ratio is largely the result of strong PPP lending, which increased the assets used in the denominator of the leverage ratio. Adjusting for PPP loans, the aggregate tier 1 leverage ratio would be 10.9 percent for CBOs and 9.5 percent for RBOs as of June 30. Less than 1 percent of organizations in these two portfolios report capital levels that do not meet the "well-capitalized" designation.

In an effort to build capital resiliency, most CBOs and RBOs took steps to reduce capital distributions or build capital in the first and second quarters of 2020. CBO-insured depository institutions reduced their dividends in the second quarter to $2.7 billion from $4.5 billion in the fourth quarter of 2019. RBOs reduced their dividends over the same period to $2.0 billion from $2.1 billion in the fourth quarter of 2019. To further preserve capital, most RBOs have suspended their share repurchase programs.

Profitability measures for CBOs and RBOs fell in the first half of 2020, after lockdowns and other measures were taken to control the spread of COVID-19 and as the COVID event began affecting businesses. Despite additional income from PPP loans, close to 4.6 percent of CBOs and 13.6 percent of RBOs were not profitable for the first half of 2020, as net interest income declined and provisions increased. A spike in first-quarter goodwill impairment losses also weighed on RBOs' profitability.

CBOs and RBOs made extraordinary efforts to work with their borrowers affected by the COVID event.

CBOs and RBOs have made substantial efforts to support their borrowers with loan modifications. CBO- and RBO- insured depository institutions reported $367 billion, or roughly 10.5 percent of outstanding loans and leases, as modifications under section 4013 of the CARES Act. Loan modifications can include payment deferrals, interest-only payment periods, fee waivers, forbearance, and temporary suspensions from credit reporting.

Federal Reserve supervisors have found that while both CBOs and RBOs had expected to receive additional requests for loan modifications after those provided at the beginning of the COVID event (i.e., initial or first-wave modifications), new or additional requests for modifications (i.e., the second wave) have been fewer than the first wave. CBO modifications in the second wave have generally been limited to short-term targeted changes, typically an interest-only loan for a set period, and primarily provided to commercial borrowers in the hospitality and retail sectors.

While many RBOs saw a temporary increase in the second wave of loan modifications in July, the level of modification requests was still lower than the first wave. While institutions continue to work with their borrowers, they have formalized their underwriting process for those borrowers requesting additional modifications or are requiring a borrower to demonstrate a financial need and the ability to perform under the terms of the new modification request.

Several actions taken by the Federal Reserve addressed the unique challenges and operating conditions faced by CBOs and RBOs.

To balance the responsibility to promote safety and soundness against institutions' operating challenges, the Federal Reserve has taken a number of actions:

• Extension of the filing deadline for the March financial regulatory reports: The federal banking agencies provided institutions with relief on the filing deadline for their March 31, 2020, Call Reports, as long as an institution submitted the report within 30 days of the official filing date. Roughly 20 percent of Call Report filers took advantage of this additional time, with all respondents reporting within the additional time allowed. The Federal Reserve provided similar relief to holding companies with $5 billion or less in total assets for submitting the March 30, 2020, financial regulator reports (i.e., FR Y-9C and FR Y-11). Roughly 21 percent of eligible holding companies took advantage of this additional time.
• Temporary relief on the community bank leverage ratio (CBLR): The Federal Reserve and the other federal banking agencies adopted interim final rules to lower the CBLR from 9 percent to 8 percent beginning in the second quarter of 2020 and for the remainder of calendar year 2020. The ratio moves to 8.5 percent for calendar year 2021, and 9 percent thereafter. Roughly 40 percent of eligible banks have adopted the CBLR as of June 30, 2020, and 9.4 percent of CBLR adopters benefited from this relief, as their CBLR fell between 8 percent and 9 percent as of June 30, 2020.
• Deferral of certain appraisal regulatory requirements: From April 17, 2020, through December 31, 2020, the federal banking agencies are deferring certain appraisals and evaluations for up to 120 days after closing of residential or commercial real estate loan transactions.

The supervisory approach has been adapted in response to the COVID event.

As a result of the COVID event, the Federal Reserve has shifted the focus of CBO and RBO supervisory activities to assessing the overall safety and soundness of an institution as well as the effectiveness of an institution's risk management and responsiveness to changing economic and market conditions. Stresses caused by the COVID event can adversely affect an institution's financial condition and operational capabilities, even when institution management has appropriate governance and risk-management systems in place to identify, monitor, and control risk. Therefore, in assessing safety and soundness, examiners will consider the unique, evolving, and potentially long-term nature of the challenges confronting institutions and exercise appropriate flexibility in their supervisory response.²⁰

In mid-June, as operational conditions began to stabilize, the Federal Reserve resumed CBO and RBO examination activities and anticipates that examination activities, including full-scope examinations, will be conducted off-site until conditions improve to facilitate on-site examinations.²¹ In scheduling CBO and RBO examinations, the Federal Reserve is considering unique safety and soundness concerns of each banking organization and their operational capacity for an examination.

One of the primary goals of the Federal Reserve's supervisory approach is to ensure the resilience of financial institutions while not impeding the flow of credit that is vital for economic recovery. Therefore, where possible, the Federal Reserve will streamline the supervisory review of lower risk, well-managed institutions in sound financial condition while focusing its supervisory attention on high-risk institutions as warranted by facts and circumstances.

Examiners will continue to assess CBOs and RBOs in accordance with existing policies and procedures and may provide feedback, or possibly downgrade an institution's supervisory rating, if conditions at the institution deteriorate. For the remainder of the year, the Federal Reserve's focus for CBO and RBO supervisory activities will be on evaluating a supervised institution's capital resiliency, liquidity resiliency, and effectiveness of an institution's risk management and responsiveness to changing economic and market conditions.

The Federal Reserve will continue its off-site monitoring activities of CBOs and RBOs and will maintain contact with bank management and other regulators. Such efforts provide the Federal Reserve with information on emerging risks and market trends along with the identification of industry trends and the concerns of bankers.

Footnotes