Board of Governors of the Federal Reserve System

Supervisory Developments

This section provides an overview of recent supervisory efforts to assess institutions' safety and soundness and compliance with laws and regulations. There are separate subsections for large financial institutions with assets of $100 billion or more and community and regional banking organizations. Supervisory approaches and priorities differ by a financial institution's size and complexity.

The Federal Reserve is responsible for overseeing the implementation of certain laws and regulations relating to consumer protection and community reinvestment. The scope of the Federal Reserve's supervisory jurisdiction varies based on the consumer 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 marketplace for financial services and to ensure supervised institutions 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 109th Annual Report 2022.¹⁴

Federal Reserve Supervision

Supervisors conduct examinations to evaluate a banking organization's activities, risk management, and financial condition.¹⁵ Examinations include assessments of capital adequacy, asset quality, earnings strength and quality, liquidity position and funding sources, sensitivity to interest rate risks, and the quality of board and management oversight. Supervisors may also decide whether to further focus examinations on a firm's known and potential risks. For example, examiners may undertake additional credit quality and credit risk management testing at a bank with a rapidly growing concentration in CRE loans.

If supervisors find risk management or financial condition to be deficient, they provide direction and require the bank to correct its weaknesses. This direction takes the form of confidential supervisory findings: matters requiring attention (MRAs) and, for more significant issues that must be corrected on a priority basis, matters requiring immediate attention (MRIAs). These are communicated to a banking organization's management and board of directors in a written exam or inspection report. If a bank does not address these supervisory findings or the findings are significant enough to pose an immediate threat to a bank's safety and soundness, supervisors may also lower the bank's supervisory rating or pursue an enforcement action against the bank.

Supervisory ratings, which are confidential, provide an assessment of a firm's risk management and financial condition, based on examination results, supervisory findings, and other information collected from banking organizations and monitored throughout the year. These ratings reflect examiners' overall judgment of the firm's safety and soundness. Supervisory ratings are generally issued once a year for larger banking organizations and every 18 months for smaller firms but may also be issued in the interim if circumstances warrant.

Supervised Institutions

The Federal Reserve supervises bank holding companies, savings and loan holding companies, state member banks, and foreign banking organizations operating in the United States of varying size and complexity. The Federal Reserve follows a risk-focused approach by scaling supervisory work to the asset size and complexity of an institution.

• The Large Institution Supervision Coordinating Committee (LISCC) program supervises firms that pose elevated risk to U.S. financial stability.
• The Large and Foreign Banking Organization (LFBO) program supervises U.S. firms with total assets of $100 billion or more and all foreign banking organizations operating in the United States regardless of asset size.
• The Regional Banking Organization (RBO) program supervises U.S. firms with total assets between $10 billion and $100 billion.
• The Community Banking Organization (CBO) program supervises U.S. firms with less than $10 billion in total assets.

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 2023:Q2

Current Supervisory Priorities

During 2023, the Federal Reserve intensified examination efforts on assessing banks' preparedness for managing liquidity, interest rate, and credit risks. In addition, supervisors initiated continuous monitoring for a small number of firms with a risk profile that could result in funding pressures for the firm.

In August, the Federal Reserve established a Novel Activities Supervision Program to enhance the supervision of novel activities conducted by banking organizations supervised by the Federal Reserve. The program helps ensure that the risks associated with innovative activities are appropriately supervised and reviewed by examiners with expertise and experience in overseeing such activities.¹⁶ The program focuses on novel activities related to crypto-assets, distributed ledger technology, and complex, technology-driven partnerships with nonbanks to deliver financial services to customers. The program is risk-focused and will work in partnership with existing Federal Reserve supervisory teams to strengthen the oversight of novel activities.

Large Financial Institutions

This section of the report discusses the supervisory approach for large financial institutions—namely, U.S. firms with total assets of $100 billion or more, and foreign banking organizations with combined U.S. assets of $100 billion or more. These firms are either within the LISCC portfolio or the LFBO portfolio. Large financial institutions are subject to regulatory requirements that are tiered to the risk profiles of these firms. Appendix A provides an overview of key regulatory requirements. Supervisory efforts for large financial institutions focus on four components:

1. capital planning and positions,
2. liquidity risk management and positions,
3. governance and controls, and
4. recovery and resolution planning.

The Financial Condition of Large Financial Institutions

Large financial institutions' capital positions remain above minimum regulatory ratios, although unrealized losses on securities and other assets have weighed on their tangible capital. As of June 30, 2023, their aggregate CET1 capital ratio was 12.3 percent. Supervisors continue to closely monitor capital levels and, in June, completed the annual stress test for 23 large financial institutions. This year, the supervisory severely adverse scenario included a severe global recession accompanied by a period of heightened stress in commercial and residential real estate, as well as corporate debt markets. The stress test results show that the 23 large banks subject to the test this year have sufficient capital to absorb more than $540 billion in losses and continue to lend to households and businesses under stressful conditions.¹⁷

The Board also conducted an exploratory market shock on the trading books of the largest banks, testing them against greater inflationary pressures and rising interest rates. While not contributing to banks' capital requirements, the exploratory stress test was used to further understand the risks of bank trading activities and to assess the potential for testing banks against multiple scenarios in the future.

Large financial institutions' profitability, as measured by return on average assets and return on equity, remained at solid levels, with both measures staying above their 10-year average during the first half of 2023. However, net interest margins declined slightly because of slower lending activity, increases in deposit costs, and greater reliance on higher cost wholesale funding. Large financial institutions also increased credit loss provisions. Loan delinquencies remain low, but there have been recent increases in past due balances of CRE and consumer loans.

Liquidity positions remain substantially above regulatory minimums. However, liquidity positions have declined overall, and some large financial institutions have experienced deposit declines in an increasingly competitive deposit market.

Trends in Supervisory Ratings and Findings

Federal Reserve supervisors summarize their assessments of large financial institutions using the LFI rating system.¹⁸ The LFI rating system evaluates whether a firm possesses sufficient financial and operational strength and resilience to maintain safe-and-sound operations and comply with laws and regulations, including those related to consumer protection, through a range of conditions.¹⁹ It includes three components: (1) capital planning and positions; (2) liquidity risk management and positions; and (3) governance and controls. Each component is rated based on a four-point non-numeric scale: Broadly Meets Expectations, Conditionally Meets Expectations, Deficient-1, and Deficient-2. A firm is considered to be in satisfactory condition if all of its component ratings are "Broadly Meets Expectations" or "Conditionally Meets Expectations."

As of June 30, 2023, most large financial institutions were meeting supervisory expectations with respect to capital planning and positions and liquidity risk management and positions. However, some firms continue to face challenges meeting supervisory expectations related to governance and controls, mainly because of deficiencies in the management of risks related to operational resilience, cybersecurity, and BSA/AML compliance. As a result, only about half of the large financial institutions had satisfactory ratings across all three LFI rating components (figure 11).

Outstanding supervisory findings at large financial institutions have increased over the last year (figure 12). Governance and controls findings represent approximately two-thirds of outstanding issues (figure 13). More recently, matters requiring attention related to liquidity and interest rate risk management have increased. This stems from the effects of higher interest rates on the market value of banking organizations' asset holdings, particularly investment securities. Because unrealized losses diminish the ability of banks to sell securities to meet liquidity needs without incurring losses, these unrealized losses can increase liquidity risks and require closer management of contingency funding arrangements. Higher rates for deposit and wholesale funding also increase firms' interest costs and reduce earnings.

Supervisory Focus

During 2023, the Federal Reserve completed examinations to assess liquidity and heightened monitoring of liquidity risk management and liquidity positions at the largest banking organizations. This included reviewing contingency funding plans, access to secured funding, liquidity stress test projections, and intraday liquidity risk management practices. Supervisors also directed additional attention to evaluating firms' interest rate risk positions and management.

Large financial institution supervisors initiated horizontal reviews to assess interest rate risk management practices across the large firms. Horizontal reviews include a series of examinations focused on a single supervisory issue at several firms. This allows examiners to compare risk management practices at different firms, identify gaps in practices at specific firms, and promote sound practices across the industry. These reviews assess the adequacy of firms' risk management processes to identify, measure, monitor, and, as needed, mitigate interest rate and related liquidity risks. To the extent gaps are identified, supervisors issue MRAs or MRIAs to direct banks to address these issues.

Although loan delinquencies remain low, large financial institutions have recently increased provisions for credit losses. Some firms have indicated in public earnings releases that they expect increased loan losses, particularly within the office segment of CRE.²⁰ Supervisors, therefore, continue to closely monitor underwriting and loan quality. Recent efforts include a horizontal review to address exposures to potential deterioration in CRE markets. Supervisors are centering the review on evaluating credit risk monitoring and measurement, internal loan risk rating accuracy, steps taken to mitigate the risk of losses on CRE loans, and CRE risk reporting to firms' boards of directors and senior management.

Supervisors also continue to focus on monitoring credit risk associated with consumer loans as delinquency and charge-off rates return to pre-pandemic levels. They are also conducting work to assess the level and quality of loans to nonbank financial institutions, given a substantial increase in lending to this segment in recent years.

See below for additional detail on large financial institutions' supervisory priorities for the coming months.

Large Financial Institution Supervisory Priorities

Capital

• financial risks in the current economic environment, including

  • interest rate risk
  • market and counterparty credit risk
  • consumer and commercial credit risk
• risk-management practices in credit, market, and interest rate risk
• implementation of regulatory requirements (e.g., capital for counterparty credit exposure rules)

Liquidity

• internal liquidity stress tests
• contingency funding plans and intraday liquidity risk management
• changes in deposit behaviors and resulting effects on liquidity positions and risk-management practices
• asset/liability management and stress testing
• liquidity risk management at foreign banking organization branches

Governance and Controls

• operational resilience, including cybersecurity, novel banking, and information technology risks
• third-party vendor risk management
• compliance, internal loan review, and audit
• firm remediation efforts on previous supervisory findings

Recovery and Resolution Planning

• recovery and resolution planning, including biannual resolution plan review for the G-SIBs
• remediation of and follow-up on resolution plan shortcomings and exam findings, as necessary
• international coordination among global supervisors

Community and Regional Banking Organizations

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

The Financial Condition of CBOs and RBOs

CBOs and RBOs generally remain in sound financial condition, though increased funding costs are narrowing net interest margins.

Nearly all CBOs and RBOs remain well-capitalized. However, as interest rates have risen, some banks have experienced sizeable declines in the fair value of their securities investments and, as a result, have also seen their tangible equity levels decline. Federal Reserve examiners are closely monitoring tangible equity levels and their impact on banks' cost of funding.

Asset quality remains sound, and the level of problem loans remains low.²¹ CBOs and RBOs, however, hold a high proportion of the banking sector's CRE loans. Some CRE market segments have recently been under stress, particularly office. As a result, Federal Reserve examiners are closely monitoring conditions and engaging with bank management to assess the degree to which banks with high levels of CRE loans are prepared for potential changes in market conditions.

Liquidity remains satisfactory for most CBOs and RBOs, but liquidity at several RBOs was adversely affected by the banking stresses in the first half of 2023. For some RBOs, deposit declines were material and required these banks to seek new wholesale funding. These wholesale funding sources tend to be more costly and have put pressure on net interest margins for some RBOs, as well as some CBOs.

Federal Reserve examiners are closely monitoring liquidity risk management practices and contingency funding plans, and examiners are assessing banks' preparedness to manage unexpected deposit outflows. They are also encouraging CBOs and RBOs to maintain actionable and diversified funding sources to help them manage the competitive deposit and funding environment. Examiners are emphasizing that funding sources should be highly reliable and that banks should have sufficient collateral pledged so they can quickly access funding when needed.

Trends in Supervisory Ratings and Findings

The Federal Reserve and the other federal and state banking agencies utilize the Uniform Financial Institution Rating system (referred to as "CAMELS") to present the examiner's conclusions regarding the overall condition of the bank. The CAMELS composite rating represents an overall appraisal of six key assessment components covered under the CAMELS rating system: Capital Adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.

For the inspection of a holding company with less than $100 billion in total consolidated assets, the Federal Reserve utilizes the RFI rating system to present the examiner's conclusions regarding the overall condition of these holding companies. The RFI composite rating represents an overall appraisal of three components covered under the RFI rating system: Risk management, Financial Condition, and Impact of the non-depository entities on the subsidiary depository institutions.

The CAMELS and RFI rating systems are assigned based on a "1 to 5" numeric scale. A "1" numeric rating indicates the highest rating, strongest performance and practices, and least degree of supervisory concern. A "5" numeric rating indicates the lowest rating, weakest performance, and highest degree of supervisory concern. Banks and holding companies that are rated "1" or "2" are generally in satisfactory condition, while banks that are rated "3", "4", or "5" are in less-than-satisfactory condition.

Based on supervisory ratings as of June 2023, the vast majority of CBOs and RBOs remain in satisfactory condition with effective risk management practices (figure 14). However, the financial trends described above have resulted in an increase in the number of supervisory ratings downgrades.

The number of supervisory findings outstanding at CBOs and RBOs increased in the first half of 2023 (figure 15). The number of findings per examination also increased in 2023 relative to 2022. For the first half of 2023, information technology weaknesses and operational risk were the most cited supervisory issues for CBOs and RBOs (figures 16 and 17). Credit risk issues remained elevated, and issues with market risk, liquidity risk, and BSA/AML compliance were an increasing share of issues compared with prior years.

Supervisory Focus

During 2023, the Federal Reserve intensified monitoring of CBOs and RBOs that appeared most vulnerable to funding pressures. In many cases, Federal Reserve examiners issued findings requiring bank management to improve access to contingent funding, increase liquid asset buffers, and revalidate the deposit outflow assumptions in a bank's contingency funding plans. Examiners have also increased their focus on ensuring that banks understand the nature of their deposit concentrations and accurately assess the stability of each deposit segment.

Federal Reserve examiners are also closely monitoring real estate markets and banks with large CRE concentrations. While credit quality conditions currently remain stable, examiners are closely monitoring banks' asset quality metrics for emerging deterioration. Banks with larger CRE credit concentrations are expected to have robust risk management practices including, but not limited to, the ability to quantify the impact of changing economic conditions on their earnings, asset quality, and capital.

Finally, Federal Reserve examiners are focused on the impact of rising interest rates on banks' capital and earnings. In general, examiners expect banks to preserve capital when they are experiencing financial difficulties or when the macroeconomic outlook for their primary sources of earnings have deteriorated.

See below for additional detail on CBO and RBO supervisory priorities for the coming months.

CBO and RBO Supervisory Priorities

Credit Risk

• high-risk loan portfolios and debt service coverage capacity in a changing interest rate environment
• credit concentrations, particularly in CRE loan portfolios
• impact of rising capitalization rates and real estate valuation uncertainty
• implementation of Current Expected Credit Losses (CECL) for CBOs in 2023

Liquidity Risk

• contingency funding plans
• liquidity coverage of uninsured deposits

Other Financial Risks

• interest rate risk
• declines in the fair value of securities and low tangible equity levels
• capital adequacy

Operational Risk

• information technology and cybersecurity preparedness
• fintech and banking-as-a-service activities
• third-party risk management

 

References

 

 14. See Board of Governors of the Federal Reserve System, 109th Annual Report of the Board of Governors of the Federal Reserve System (Washington: Board of Governors, July 2023), https://www.federalreserve.gov/publications/files/2022-annual-report.pdf. Return to text

 15. See "Understanding Federal Reserve Supervision," https://www.federalreserve.gov/supervisionreg/how-federal-reserve-supervisors-do-their-jobs.htm. Return to text

 16. See Board of Governors of the Federal Reserve System, "Creation of Novel Activities Supervision Program," SR Letter 23-7 (August 8, 2023), https://www.federalreserve.gov/supervisionreg/srletters/SR2307.htm. Return to text

 17. See Board of Governors of the Federal Reserve System, 2023 Federal Reserve Stress Test Results (Washington: Board of Governors, 2023), https://www.federalreserve.gov/publications/files/2023-dfast-results-20230628.pdf. Return to text

 18. See Board of Governors of the Federal Reserve System, "Large Financial Institution (LFI) Rating System," SR Letter 19-3/CA Letter 19-2, (February 26, 2019), https://www.federalreserve.gov/supervisionreg/srletters/sr1903.htm. Return to text

 19. See Board of Governors of the Federal Reserve System, Supervision and Regulation Report (Washington: Board of Governors, November 2019), https://www.federalreserve.gov/publications/files/201911-supervision-and-regulation-report.pdf. Return to text

 20. Matt Tracy, "U.S. Banks Increase Reserves for Commercial Real Estate Exposure," Reuters website, July 21, 2023, https://www.reuters.com/business/finance/us-banks-increase-reserves-commercial-real-estate-exposure-2023-07-21/. Return to text

 21. "Problem loans" are composed of 90-day-or-more past due loans, non-accrual loans, impaired loans, renegotiated or restructured loans, and loans that are internally criticized or classified by a bank, as well as loans that were classified by examiners during the previous examination. Return to text