Federal Reserve System: Update on GAO's 1996 Recommendations	 
(25-SEP-02, GAO-02-774).					 
                                                                 
In a 1996 report, GAO made a number of recommendations to the	 
Board of Governors of the Federal Reserve System for reducing	 
spending and improving the operations of the Federal Reserve	 
System (Federal Reserve). The Federal Reserve has taken actions  
responsive to most of the 1996 report's recommendations. The	 
Federal Reserve has retained its structure but has sought to	 
consolidate operations and bring common management practices to  
the 12 Federal Reserve District Banks.	In particular, the	 
Federal Reserve now manages the payment services it provides to  
banks on a systemwide basis. The Federal Reserve has also changed
its budgeting, internal oversight, and cost accounting processes 
in an effort to increase accountability. It has taken other steps
to decrease costs in areas identified by the 1996 report.	 
Specifically, the Reserve Banks have consolidated their purchase 
of some services, such as prescription drug coverage, to take	 
advantage of volume discounts, rather than continuing with the	 
former practice of each individual Reserve Bank purchasing	 
services separately. The Federal Reserve, however, continues not 
charging for bank examinations. Federal Reserve officials	 
explained that they continue to believe that charging for bank	 
examinations would tip the current balance against state charter 
banks, and thus be inconsistent with maintaining the dual banking
system of state and nationally charter banks. Although a strong  
argument exists for industry funding of federal supervision and  
regulation, GAO recognizes the benefits of the dual banking	 
system. Ultimately, it is up to Congress to decide how to fund	 
federal regulation and to balance the differences among the	 
different bank regulators.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-774 					        
    ACCNO:   A05180						        
  TITLE:     Federal Reserve System: Update on GAO's 1996	      
Recommendations 						 
     DATE:   09/25/2002 
  SUBJECT:   Agency missions					 
	     Bank examination					 
	     Bank management					 
	     Cost control					 
	     Federal reserve banks				 
	     Internal controls					 

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GAO-02-774

                                       A

Report to Congressional Requesters

September 2002 FEDERAL RESERVE SYSTEM Update on GAO*s 1996 Recommendations

GAO- 02- 774

Letter

September 25, 2002 The Honorable Harry Reid The Honorable Byron Dorgan
United States Senate

Our June 1996, report, 1 which we prepared at your request, made a number
of recommendations to the Board of Governors of the Federal Reserve System
(the Board) for reducing spending and improving the operations of the
Federal Reserve System (Federal Reserve). This report responds to your
request that we review the status of the Federal Reserve*s response to our
recommendations, which fall into four broad categories: (1) systemwide
mission and management issues, (2) control and oversight mechanisms, (3)
administrative functions, and (4) funding the cost of bank examinations.
For each category, we briefly review the report*s findings and
recommendations and then describe related actions taken by the

Federal Reserve following publication of the 1996 report. The 1996 report
also made a recommendation regarding the Federal Reserve*s practice of
maintaining a surplus account to protect the Federal Reserve from losses.
We address this issue in a separate report. 2

Results in Brief The Federal Reserve has taken actions responsive to most
of the 1996 report*s recommendations. The Federal Reserve has retained its
structure

but has sought to consolidate operations and bring common management
practices to the 12 Federal Reserve District Banks (Reserve Banks). In
particular, the Federal Reserve now manages the payments services it
provides to banks on a systemwide basis. The Federal Reserve has also
changed its budgeting, internal oversight, and cost accounting processes
in an effort to increase accountability. It has taken other steps to
decrease costs in areas identified by our 1996 report. For example, the
Reserve Banks have consolidated their purchases of some services, such as
prescription drug coverage, to take advantage of volume discounts, rather
than continuing with the former practice of each individual Reserve Bank 1
U. S. General Accounting Office, Federal Reserve System: Current and
Future Challenges Require Systemwide Attention, GAO/ GGD- 96- 128
(Washington, D. C.: June 17, 1996).

2 U. S. General Accounting Office, Federal Reserve System: The Surplus
Account, GAO- 02- 939 (Washington, D. C.: Sept. 18, 2002).

purchasing services separately. The Federal Reserve, however, continues
not charging for bank examinations. Federal Reserve officials explained
that they continue to believe that charging for bank examinations would
tip the current balance against state charters for banks, and thus be
inconsistent with maintaining the dual banking system of state and
nationally chartered banks. While we continue to believe that a strong

argument exists for industry funding of federal supervision and
regulation, we also recognize the benefits of the dual banking system.
Ultimately, it is up to Congress to decide how to fund federal regulation
and to balance the differences among the different bank regulators.

Background The Federal Reserve Act of 1913 established the Federal Reserve
System as the country*s central bank. The act made the Federal Reserve an
independent, decentralized bank to better ensure that monetary policy
would be based on a broad economic perspective from all regions of the
country. The Federal Reserve System consists of the Board of Governors
located in Washington, D. C., and 12 Reserve Banks, with 25 branches,
located throughout the nation.

Each Reserve Bank is a federally chartered corporation with a Board of
Directors representing the public and member banks in its district. Under
the Federal Reserve Act, Reserve Banks are subject to the general
supervision of the Board. The Board is a federal agency, responsible for
maintaining the stability of financial markets, supervising financial and
bank holding companies and state- chartered banks that are members of the
Federal Reserve and the U. S. operations of foreign banking organizations,
and overseeing the operations of the Reserve Banks. The Board has

delegated some of these responsibilities, including bank examinations, to
the Reserve Banks, which also provide payment services, such as check
clearing and wire transfers, to depository institutions and government
agencies. In 2001, there were approximately 25, 000 staff in the Federal
Reserve with

about 93 percent of these employees working at the Reserve Banks. From
1995 to 2001, Federal Reserve employment decreased by 482 employees.
Employment for 2002 is projected to grow by 314, largely because of plans
to increase security staff. Figure 1 shows Federal Reserve employment from
1995 to 2001.

Figure 1: Federal Reserve Employment from 1995 to 2001

Source: Federal Reserve Board staff.

In the 1996 report, we noted that the Federal Reserve is self- financed,
and that the income it collects but does not use to fund its operations is
turned over to the U. S. Treasury. 3 In 2001, the Federal Reserve had a
total income of $31.9 billion and expenses of approximately $2.1 billion;
it subsequently transferred $27.1 billion to the U. S. Treasury. 4 Since
1993, the operating expenses of the Federal Reserve have increased

an average of 4. 2 percent per year (2.2 percent when adjusted for
inflation). According to its 2002 Budget Review, the Federal Reserve*s
operating 3 The Federal Reserve earns most of its income from its
portfolio of Treasury securities. It

also receives revenue for payment services that it provides to financial
institutions. 4 The remaining $2.7 billion comprised net deductions from
income resulting primarily from unrealized losses on assets denominated in
foreign currencies revalued to reflect current market exchange rates;
assessments by the Board for its expenses and cost of currency; and

other distributions, which included dividends paid to member banks and
transfers to the surplus account.

expenses are budgeted at $2.8 billion, an increase of 4.5 percent from the
estimated 2001 expenses. Figure 2 shows the Federal Reserve*s operating
expenses from 1993 to 2001.

Figure 2: Federal Reserve Operating Expenses from 1993 to 2001

Source: Federal Reserve budget review.

Our 1996 report identified several inefficiencies in the Federal Reserve*s
policies and practices that had increased the cost of providing its
services, including its costs for travel, personnel benefits, and
contracting and procurement. Many of these inefficiencies related to the
decentralized nature of the Federal Reserve, which allowed each Reserve
Bank to set

many of its own policies, and to the absence of traditional cost-
minimizing forces, such as competition or appropriations, that are
commonplace in entities that are either purely private or public sector in
nature. With this in

mind, we suggested that the Federal Reserve could do more to increase its
cost consciousness and ensure that it is operating as efficiently as
possible. The 1996 report concluded that major cost reductions ultimately
depended

on the Federal Reserve*s carefully reexamining its mission, structure, and
work processes. The report identified areas that had potential for
reducing

the Federal Reserve*s costs. The recommendations from the report fall into
four broad categories:

 systemwide mission and management issues,  control and oversight
mechanisms,  cost of specific Federal Reserve administrative functions,
and  charging banks for the costs associated with bank examinations.

The Federal Reserve In 1996, we noted that the Federal Reserve faces major
challenges in its

Has Taken Steps to mission and lines of business, particularly in services
to depository

institutions and government agencies and in bank supervision. These
Address Systemwide

challenges included (1) increased competition from the private sector and
Mission and

increasing difficulties in recovering costs in priced services; (2)
Management Issues

increasingly widespread use of electronic transactions in the financial
services industry; and (3) continuing rapid consolidation of the banking
industry, which could affect both the need for and the distribution of
bank

examination staff. Because these areas accounted for the largest part of
the Federal Reserve*s expenses and staffing, we believed that addressing
these challenges effectively would likely result in major changes in how
the Federal Reserve operated.

The Federal Reserve*s strategic plans and programs under development at
the time of the 1996 report generally focused on individual divisions,
Reserve Banks, or functions. While these plans served an important purpose
in defining the direction of these Federal Reserve entities, we also
believed that the emerging issues and challenges facing the Federal
Reserve would necessitate strategic planning focused on the system as a
whole. We also found that each of the Reserve Banks administered various
functions independently, rather than as a single entity that could operate
more efficiently or possibly command more advantageous prices. These
findings led to the recommendations in figure 3.

Figure 3: 1996 Recommendations Affecting Federal Reserve Systemwide
Mission and Management Issues

Source: U. S. General Accounting Office, Federal Reserve System: Current
and Future Challenges Require Systemwide Attention, GAO/ GGD- 96- 128
(Washington D. C.: June 17, 1996).

Since 1996, the Federal Reserve has consolidated the management of the
services provided by the individual Reserve Banks, particularly payment
services. For example, payment system products and new technologies are
now managed on a systemwide basis. The Federal Reserve also has undertaken
an assessment of its role in providing payment services.

In January 1998, the Committee on the Federal Reserve in the Payments
Mechanism, chaired by the Vice Chair of the Board of Governors, issued its
report entitled The Federal Reserve in the Payments Mechanism. The study
examined the payment services provided by the Federal Reserve in light of
the rapid changes occurring in the financial services and technology
sectors. These services include check clearing and automated clearinghouse
services such as direct deposits. The committee undertook a

fundamental review of the Federal Reserve*s role in the payments system
and considered how alternative roles for the Federal Reserve might enhance
or undermine the integrity, efficiency, and accessibility of the payments
system. It concluded that the Federal Reserve*s current role, or even a
slightly enhanced role, in fostering technical change was preferred by
most payment system participants.

In July 1999, the Federal Reserve formed the Payments System Development
Committee (PSDC) to advise the Board and system officials on medium- and
long- term public policy issues surrounding developments in the retail
payments system. 5 This committee, which includes two Federal Reserve
Board Governors, a Reserve Bank President, and a Reserve Bank First Vice
President, was intended to follow up on the work of the Committee on the
Federal Reserve in the Payments System. PSDC*s work has included the Check
Truncation Act, proposed legislation

designed to remove certain legal impediments to check truncation and
enhance the overall efficiency of the nation*s payments system. It has
also worked with payments industry officials to develop standards to
facilitate increased use of electronic check processing. The Federal
Reserve has introduced new payment products, such as its imaging service,
to recognize the increasing role that image- based services are playing in
the evolution of the U. S. payments system and the migration toward more
electronic payments.

The Federal Reserve has also undertaken numerous initiatives to streamline
management structures, consolidate operations, and apply emerging
technologies to the Reserve Banks* business processes in order to improve
quality and reduce costs. Federal Reserve officials explained that many of
their initiatives have the effect of consolidating functions of the
Federal Reserve without consolidating the 12 Reserve Banks. For example,
in 1999, the Treasury Direct customer support function was consolidated so
that only 3 Reserve Banks are providing customer service support to
individuals who purchase Treasury securities directly from the Treasury.
From 1999 to 2002, the Federal Reserve consolidated several aspects of
Fedwire funds and securities transfer operations. Similarly, in 2000, the
Treasury Investment Program was implemented, centralizing services that
the Federal Reserve provides to the Treasury Tax and Loan Program.

The Federal Reserve continues to standardize and centralize the management
of computer applications used for common business needs. It has selected a
central site to develop and implement a centralized application for the
Reserve Bank Planning and Control System. The Federal Reserve estimates
that the centralization of applications such as

5 PSDC is cochaired by the Vice Chairman of the Federal Reserve Board and
the President of the Federal Reserve Bank of Boston.

the budget application will result in systemwide savings of $2.6 million
over a 5- year period.

The Federal Reserve In 1996, we noted a number of weaknesses in the
Federal Reserve*s

Has Strengthened Its budgeting and internal oversight processes. In
reviewing the budgeting

process for both the Board and Reserve Banks, we found that it was based
Control and Oversight

on a current services approach that assumed both that existing functions
Mechanisms

would be retained and that the budget would continue to grow
incrementally. We concluded that such an approach did not adequately
support top management in controlling costs and imposing the internal
self- discipline necessary for the Federal Reserve to respond effectively
to future priorities. We found that internal oversight processes, such as
performance measurement, internal audit, and financial audits, either did
not support performance evaluation from a systemwide perspective or were
becoming increasingly inappropriate in the changing environment. We also
noted that the Office of Inspector General was authorized to

review the activities of the Board, but not the Reserve Banks. As a
result, we concluded that the Federal Reserve might not be making the most
use of its resources devoted to Federal Reserve oversight. These findings
led to the recommendation in figure 4.

Figure 4: 1996 Recommendation Affecting Federal Reserve Control and
Oversight Mechanisms

Source: GAO/ GGD- 96- 128.

In addition to incorporating systemwide business strategies and resource
needs into the Federal Reserve Bank budget planning process, the Federal
Reserve Banks have changed their cost accounting system and have altered
their internal and external auditing practices.

The Federal Reserve recognized that its budget process required too much
effort and yielded an unrealistic spending outlook. Therefore, the Federal

Reserve*s Financial Support Office proposed changes to the budget process
in which system budget targets would be based on systemwide guidance
rather than on Reserve Bank projections of their expenses. Banks provided
their expense information later in the process when their budget
development would be further along* an approach that also could help align
budget planning with goal- setting for business strategies. In 2001, the
Federal Reserve*s Conference of First Vice Presidents recommended
incorporating this guidance to align the Reserve Bank budget projections
more closely with business strategies. The conference identified *national
business leaders,* that is, Federal Reserve staff with responsibility for
most Reserve Bank functions. These leaders provide business guidance as
input to the Reserve Banks as they prepare their Reserve Bank Budget
Outlook. They are responsible for almost 90 percent of the total Reserve
Bank spending. (The remaining 10 percent of spending is largely in support
of Federal Reserve monetary policy formulation and is not covered by
systemwide budget goals.)

The Board of Governors has also redefined its strategic plan and has now
implemented a more rigorous 4- year planning process and a 2- year budget
process. With this new plan in place, the Board has consolidated overhead
and several support functions to reduce costs.

In March 2000, the Conference of First Vice Presidents approved
recommendations designed to improve the cost- accounting practices of the
Federal Reserve Banks. Board staff told us that Reserve Bank staffs have
implemented these recommendations. Changes, according to Board staff,
include the following:

 Simplifying expense allocation by tying expenses to departments and
organizational units in Reserve Banks rather than to specific activities.
This change will eliminate a major portion of the manual process

currently in place, and in turn, will reduce the opportunity for erroneous
activity charges.

 Shifting some expenses from overhead to the service line that they
support to reflect expenses more accurately.  Eliminating sharing of
costs among Reserve Banks for all services and

operations that are provided centrally. Instead, the Reserve Bank that
provides the service will now report associated expenses in an effort to
enhance accountability.

The Board adopted several new policies aimed at safeguarding the
independence of its external auditor. An external auditor, under a
contract administered by Board staff, reviews each Reserve Bank*s
financial statements. To enhance independence, in May 2002, the Board
placed restrictions on Reserve Banks* ability to contract with the Board*s
external audit firm or to hire an auditor that has worked on the audit of
a Reserve Bank. The Board currently requires that the external auditor of
the Reserve Banks remain independent of Reserve Bank management, and that
it provide a written statement to the Board delineating all relationships
between the external auditor and the Reserve Banks.

In 2001, the Board revised its policy on Reserve Bank audit committee
duties and responsibilities, requiring that (1) audit committees adopt
formal written charters, (2) audit committee members be independent and
financially literate, and (3) audit committees meet with external auditors
to discuss the Reserve Bank*s financial statements and issues arising from
the annual external audit. The audit authority of the Inspector General
remains unchanged.

The Federal Reserve In 1996, we concluded that opportunities existed to
reduce the Federal

Has Consolidated Reserve*s spending in a number of different
administrative areas. We found in 1996 that Federal Reserve personnel
compensation (pay and benefits)

Some of Its varied within the Federal Reserve and included benefits that
were

Administrative relatively generous compared with those of government
agencies with

Functions similar responsibilities.

We also found that the Federal Reserve*s health care benefits were managed
on a decentralized basis, with each Bank negotiating its own health care
coverage. We noted that although the Reserve Banks had individually made
efforts to reduce health care costs, the Reserve Banks had not worked
together to determine whether their combined bargaining powers would
further reduce these expenses.

We found in 1996 that travel policies differed between the Board and the
Reserve Banks and among the Reserve Banks. Therefore, the same trip could
present different costs to different Reserve Banks. The differing travel
policies made it necessary for each Reserve Bank to manage its own travel
costs rather than allowing the Federal Reserve to manage travel costs on a
centralized basis.

We also found in 1996 that the Board and the Reserve Banks used different
procurement guidelines. The Board, while not specifically directed to do
so by the Federal Reserve Act, followed the spirit of the federal
government contracting rules. The Reserve Banks were required to follow
Uniform Acquisition Guidelines, which were adopted by the Reserve Banks in
1985. These guidelines were designed to provide minimum requirements for
Reserve Bank procurement activities. By providing opportunities for all
interested bidders to become a selected source, the guidelines attempted
to ensure that Reserve Banks treated sources fairly and impartially. By
fostering competition in the procurement process, Reserve Banks would have
greater opportunity to realize cost savings through lower competitive
pricing. Despite the Uniform Acquisition Guidelines, we observed instances
in which

 practices at individual Reserve Banks differed significantly and some
practices favored certain sources over others and

 proper controls over conflict of interest were not followed at certain
Reserve Banks.

Practices at certain Reserve Banks lacked independent checks and
reconciliations, and best practices used by certain Reserve Banks were not
disseminated among the Reserve Banks. These findings led to the
recommendations in figure 5.

Figure 5: 1996 Recommendations Affecting Federal Reserve Administrative
Functions Source: GAO/ GGD- 96- 128.

The Federal Reserve has taken or begun a number of actions in response to
the findings and recommendations in our 1996 report. These actions include
reassessing the compensation approach for the Federal Reserve,
consolidating health insurance for the Reserve Banks, and changing its

travel and acquisition practices. A work group of senior Reserve Bank and
Board officials was established to reassess the compensation philosophy
within the Federal Reserve System. The Board approved a new Reserve Bank
total compensation philosophy on June 18, 1997. The philosophy provided
broad principles for the design of benefit plans that were intended to be
competitive within relevant labor markets and sufficiently flexible to
attract, retain, and motivate the staff and officers required to fulfill
the mission of the Federal Reserve. The policy indicates the purpose and
objectives of Reserve Bank compensation and benefit programs as well as
relevant labor markets and

competitive position. In 1999, the Board approved in concept a Reserve
Bank strategic benefits plan, which was developed to be a more specific
plan for ensuring that benefits will be appropriately competitive into the
future.

The Federal Reserve is in the process of consolidating the administration
and selection of health benefits so that all Reserve Banks have similar
plans

that are administered uniformly. Initiatives in managing benefits also
have led to the consolidation of the administration and record keeping of
several other benefits, including the Thrift Plan, retirement plans,
retiree prescription plans, and worker*s compensation plans. According to
Federal Reserve staff, the thrift and retirement plans were consolidated a
number of years ago and are fully outsourced to a single vendor. Moreover,
the Board*s Office of Employee Benefits projects that it will save $4
million from implementing the consolidated health care plans.

In 2001, the Reserve Banks began a plan to reduce travel costs by
upgrading videoconferencing capabilities. A vendor for this system was
selected in the first quarter of 2002, and Federal Reserve officials said
installation of new facilities has been completed in offices that
previously had videoconferencing. The next phase of this effort will
include installing videoconferencing facilities in offices that did not
previously have them. The Board has also encouraged travel savings through
pursuing government discounts and traveling at nonpeak hours.

In March 1997, the Federal Reserve completed a fundamental review of its
Uniform Acquisition Guidance. As part of this effort, it reviewed
benchmarking and best practices efforts to determine if any changes were
necessary. In July 1998, a new Model Acquisition Guideline was approved,

replacing the 1985 Uniform Acquisition Guidelines. The Federal Reserve has
continued to engage in its benchmarking process. Federal Reserve staff
said that this process has revealed continued declines in the cost of
providing procurement services through the use of streamlined purchasing
procedures. Benchmarking studies have concluded that the Federal Reserve*s
enhanced use of the System Purchasing Service to gain economies of scale
has resulted in significant savings. Board staff explained that, where it
makes sense, the Board uses procurement resources available to government
agencies, such as the General Services Administration. However, they said
that in some cases, such as in their procurement of telecommunication
services, the Board and the Reserve Banks might negotiate together to
enhance their bargaining position.

The Federal Reserve Our 1996 report noted that the Federal Reserve*s
revenues, and hence its

Has Continued Its return to the taxpayers, would be enhanced by charging
fees for bank

examinations. Federal bank regulators differ in their policies regarding
the Policy of Not Charging

assessment of fees for bank examinations. The Office of the Comptroller of
for Bank Examinations

the Currency (OCC) charges national banks for examinations that it
conducts. In contrast, state- chartered banks, which are supervised by

either the Federal Reserve or the Federal Deposit Insurance Corporation
(FDIC) in conjunction with state banking agencies, are charged fees by
those state banking agencies but not by their federal regulator. Thus, the

costs of the Federal Reserve*s federal bank examinations are borne by the
taxpayers, while for national banks, the costs of examination are borne by
the banks that are examined. The Federal Reserve Act authorizes the

Federal Reserve to charge fees for bank examinations, but the Federal
Reserve has not done so, for the state member banks it examines. In
addition, the Federal Reserve inspects bank holding companies but does not
charge the institutions for those inspections. Similarly, FDIC is
authorized to charge for bank examinations but it does not do so. These
findings led to the recommendation in figure 6.

Figure 6: Recommendation Regarding Charging for Bank Examinations

Source: GAO/ GGD- 96- 128. The Federal Reserve continues to believe that
it should not charge for bank examinations. Federal Reserve officials told
us that, since state member banks already pay state banking commissions
for examinations, an additional charge for a Federal Reserve examination
would increase the cost and lessen the value of a state banking charter,
thus compromising the nation*s dual banking system. 6 Banks pay an array
of annual charges and assessments associated with their charters, as table
1 indicates.

6 The actual cost of bank regulation includes the cost of complying with
regulation as well as any direct charges. Compliance costs, however, are
difficult or impossible to observe or measure, while any direct costs are
reflected in a bank*s accounting records. This measurement issue is
discussed in G. Elliehausen, The Cost of Bank Regulation: A Review of the
Evidence, Federal Reserve Board Staff Study, April 1998.

Table 1: Charges and Assessments on Banks, by Charter, as of September
2002 Federal Federal Primary

Annual fees and Reserve deposit federal assessments

Bank insurance Bank charter

supervisor (federal/ state)

capital premiums

State- chartered Federal Federal: No

Yes Yes member of the Reserve State: Yes* states Federal Reserve charge a
variety of System

fees and assessments State- chartered

FDIC Federal: No No Yes

nonmember banks State: Yes* states charge a variety of fees and
assessments

National banks OCC Federal: Yes Yes Yes State: No Note: Since the Bank
Insurance Fund balance exceeded the Designated Reserve Ratio (DRR) target,

1.25 percent of deposits, in 1995, FDIC is not currently charging
insurance premiums except for banks that are considered to pose particular
risk of imposing charges on the Bank Insurance Fund. The Federal Deposit
Insurance Corporation Improvement Act of 1991 established the DRR target.

Source: GAO analysis of banking data.

All three federal bank regulators are self- funded. Differences in their
funding mechanisms, however, may lead to differences in who ultimately
pays the costs of supervision and regulation, even if the supervisory and
regulatory actions serve the common purposes of ensuring that banks are
operated in a safe and sound manner. The Federal Reserve funds its
operations from the earnings on its portfolio of Treasury securities, as
previously noted. Since the Federal Reserve*s transfers to the Treasury
are reduced by the expenses of its bank supervisory and regulatory
activities, the taxpayer ultimately pays for Federal Reserve activities.
FDIC may fund its operations from the premiums that banks pay for deposit
insurance.

However, since the Bank Insurance Fund is 1.25 percent of bank deposits,
which it has been since 1995, FDIC generally does not charge banks
premiums for deposit insurance. If FDIC were to begin charging insurance
premiums, then either the bank*s owners or customers, including
depositors, would be paying for FDIC examinations. OCC is funded by
assessments on the assets held by national banks and fees for services.
Under this arrangement, the owners or customers of national banks pay for

OCC operations. The differences among the funding approaches of the
federal bank regulators continue to raise questions about whether these

impose unequal burdens on banks* varying with their charter* and their
customers.

Bank decisions to select (or maintain) one charter over the alternatives
depend on the relative advantages of the charters as well as the
associated costs. Federal Reserve officials argue that the dual banking
system has worked well historically, allowing banks to choose the charter
that best serves their business plan and, thus, has promoted innovation
and a wider array of services for bank customers. In a 1997 speech,
Federal Reserve Chairman Alan Greenspan commented:

*The dual banking system not only fosters and preserves innovation but
also constitutes our main protection against overly zealous and rigid
federal regulation and supervision. A bank must have a choice of more than
one federal regulator, and must be permitted to change charters, to
protect itself against arbitrary and capricious regulatory behavior.
Naturally, some observers are concerned that two or more federal agencies
will engage in a

*competition in laxity, * and we must guard against that; but the greater
danger, I believe, is that a single federal regulator would become rigid
and insensitive to the needs of the marketplace.* 7 Further, Federal
Reserve officials note that the roughly even shares of

banks across the charters, and consistent shares of deposits among the
charters, suggest that the relative costs and benefits of the charters
balance. National banks, they believe, see a value in their charter that
at least offsets any additional costs.

OCC, however, has argued that the current fee structure may distort the
dual banking system:

*Healthy competition in the quality of supervision and innovation in
meeting the needs of banks and their customers should lie at the heart of
our dual banking system. Unfortunately, today a primary focus of this
competition is on price. Because state banks receive a federal subsidy for
the predominant part of their supervision, there is a cost incentive for
banks to avoid or depart from the national charter in favor of the heavily
subsidized state charter. This inevitably tends to undermine a vigorous
and healthy dual banking system.* 8 OCC has proposed that the costs of
supervising national banks (which OCC

performs) and state supervision of state- chartered banks be paid from
FDIC insurance funds. This approach would attempt to provide

7 Remarks by Chairman Alan Greenspan, Federal Reserve Board, at the Annual
Convention of the Independent Bankers Association of America, Phoenix,
Arizona, March 22, 1997. 8 OCC Quarterly Journal, vol. 20, no. 4, December
2001, p. 32.

consistency at the federal regulator- level by having the costs of
regulation borne by taxpayers or depositors. We have generally favored an
approach in which regulated entities pay for their own federal regulation.

Since the Federal Reserve continues to strongly disagree with our
recommendation regarding charging for bank examinations, actions to
implement the recommendation are unlikely. While we continue to believe
that a strong argument exists for industry funding of federal supervision
and regulation, we also recognize the benefits of the dual banking system.
Ultimately, however, it is up to Congress to decide how to fund federal
regulation and to balance the differences among the different bank
regulators.

Scope and To review the Federal Reserve*s actions in response to our

Methodology recommendations, we interviewed staff from the Federal Reserve
Board*s

Division of Reserve Bank Operations, Division of Banking Supervision and
Regulation, Office of Inspector General, as well as the Board*s Staff
Director for Management. We reviewed relevant policies and other Board
actions and documents. We did not visit any Reserve Banks to verify or
review implementation of these new policies.

We conducted our work in Washington, D. C., between April and August,
2002, in accordance with generally accepted government auditing standards.

Agency Comments We requested comments on a draft of this report from the
Board. In these comments, the Director of the Division of Reserve Bank
Operations and

Payment Systems agreed with the information presented in this report; the
comments are reprinted in appendix I. We incorporated the Board*s
technical comments where appropriate.

As agreed with your offices, unless you publicly release its contents
earlier, we plan no further distribution of this report until 30 days from
its date. At that time, we will send copies of this report to the Chairmen
and Ranking Minority Members of the Senate Committee on Banking, Housing,
and Urban Affairs, and the House Committee on Financial Services. We will
also send copies to the Chairman of the Board of Governors of the Federal
Reserve System, and we will make copies available to others on request. In

addition, this report is available at no charge on our Web site at http://
www. gao. gov.

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Appendi Appendi xes x I

Comments from the Federal Reserve System (250071)

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a

GAO United States General Accounting Office

Page i GAO- 02- 774 Federal Reserve System

Contents Letter 1

Results in Brief 1 Background 2 The Federal Reserve Has Taken Steps to
Address Systemwide

Mission and Management Issues 5 The Federal Reserve Has Strengthened Its
Control and Oversight

Mechanisms 8 The Federal Reserve Has Consolidated Some of Its
Administrative

Functions 10 The Federal Reserve Has Continued Its Policy of Not Charging
for

Bank Examinations 13 Scope and Methodology 17 Agency Comments 17

Appendix

Appendix I: Comments from the Federal Reserve System 19 Tables Table 1:
Charges and Assessments on Banks, by Charter, as of

September 2002 15 Figures Figure 1: Federal Reserve Employment from 1995
to 2001 3

Figure 2: Federal Reserve Operating Expenses from 1993 to 2001 4 Figure 3:
1996 Recommendations Affecting Federal Reserve

Systemwide Mission and Management Issues 6 Figure 4: 1996 Recommendation
Affecting Federal Reserve Control

and Oversight Mechanisms 8 Figure 5: 1996 Recommendations Affecting
Federal Reserve

Administrative Functions 12 Figure 6: Recommendation Regarding Charging
for Bank

Examinations 14

Abbreviations

FDIC Federal Deposit Insurance Corporation DRR Designated Reserve Ratio
OCC Office of the Comptroller of the Currency PSDC Payments System
Development Committee

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Appendix I

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