Bank and Thrift Examinations: Adoption of Risk-Focused Examination
Strategies (Testimony, 10/08/97, GAO/T-GGD-98-13).

GAO discussed bank and thrift supervision and examination.

GAO noted that: (1) bank supervision and examination today show evidence
of lessons learned from the bank and thrift crises of the 1980s and
early 1990s; (2) these procedures are the primary basis for federal
regulatory agencies to assess the risks that banks and thrifts assume
and to take actions to maintain a safe and sound banking system and
protect deposit insurance funds; (3) one critical lesson of the earlier
crises was that excessive regulatory forbearance contributed to the
extent of the crises; (4) the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA) based regulatory practices on a simple
principle: if a depository institution fails to operate in a safe and
sound manner, it should be subject to timely and forceful supervisory
response, including, if necessary, prompt closure; (5) FDICIA also
required that banks reform their corporate governance and accounting
practices and that the regulatory agencies improve their supervision of
insured banks and thrifts; (6) in a November 1996 report, however, GAO
noted that questions remain about the effectiveness of FDICIA's
trip-wire provisions which are intended to limit regulatory discretion;
(7) as implemented, the trip-wire that enables regulatory action at the
early stage of problems in a bank does little to limit regulatory
discretion; (8) in several reports in the early 1990s, GAO also noted
limitations in the safety and soundness examinations conducted by the
regulatory agencies; (9) the limitations included a lack of
comprehensive internal control assessments, insufficient review of loan
quality and loan loss reserves, weaknesses related to insider lending,
and insufficient assessment of bank subsidiaries; (10) regulators have
made a number of changes in an effort to improve their examinations;
(11) the changes respond, in part, to the dynamic banking environment in
which institutions can rapidly reposition risk exposures; (12) to ensure
that banks and thrifts have the managerial ability and internal control
structure to effectively manage risk, the examination process is
evolving to put greater emphasis on risk management and internal
controls; and (13) in its recent report on foreign banking organizations
operating in the United States, GAO noted that regulators have begun to
put greater emphasis on risk management processes and operational
controls in examinations of these organizations.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-GGD-98-13
     TITLE:  Bank and Thrift Examinations: Adoption of Risk-Focused 
             Examination Strategies
      DATE:  10/08/97
   SUBJECT:  Internal controls
             Risk management
             Regulatory agencies
             Savings and loan associations
             Insured commercial banks
             Bank examination
             Bank management
             Banking regulation

             
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Cover
================================================================ COVER


Before the Subcommittee on Financial Institutions and Consumer
Credit, Committee on Banking and Financial Services, House of
Representatives

For Release on Delivery
Expected at
10:00 a.m., EDT
on Wednesday
October 8, 1997

BANK AND THRIFT EXAMINATIONS -
ADOPTION OF RISK-FOCUSED
EXAMINATION STRATEGIES

Statement of Thomas J.  McCool
Director, Financial Institutions and Markets Issues
General Government Division

GAO/T-GGD-98-13

GAO/GGD-98-13T


(233535)


Abbreviations
=============================================================== ABBREV

  CAMEL - capital adequacy, asset quality, management and
     administration, earnings, and liquidity
  CAMELS - capital adequacy, asset quality, management and
     administration, earnings, liquidity, and sensitivity to market
     risk
  FDIC - Federal Deposit Insurance Corporation
  FDICIA - Federal Deposit Insurance Corporation Improvement Act of
     1991
  FIRREA - Financial Institutions Reform, Recovery, and Enforcement
     Act of 1989
  FSLIC - Federal Savings and Loan Insurance Corporation
  OCC - Office of the Comptroller of the Currency
  ROCA - risk management, operational controls, compliance, and asset
     quality

BANK AND THRIFT EXAMINATIONS: 
ADOPTION OF RISK- FOCUSED
EXAMINATION STRATEGIES
====================================================== Chapter SUMMARY

Bank supervision and examination today show evidence of lessons
learned from the bank and thrift crises of the 1980s and early 1990s. 
These procedures are the primary basis for federal regulatory
agencies to assess the risks that banks and thrifts assume and to
take actions to maintain a safe and sound banking system and protect
deposit insurance funds. 

One critical lesson of the earlier crises was that excessive
regulatory forbearance contributed to the extent of the crises.  The
Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA) based regulatory practices on a simple principle:  if a
depository institution fails to operate in a safe and sound manner,
it should be subject to timely and forceful supervisory response,
including, if necessary, prompt closure.  FDICIA also required that
banks reform their corporate governance and accounting practices and
that the regulatory agencies improve their supervision of insured
banks and thrifts.  In a November 1996 report, however, GAO noted
that questions remain about the effectiveness of FDICIA's trip-wire
provisions which are intended to limit regulatory discretion.  As
implemented, the trip-wire that enables regulatory action at early
stage of problems in a bank does little to limit regulatory
discretion. 

In several reports in the early 1990s, GAO also noted limitations in
the safety and soundness examinations conducted by the regulatory
agencies.  The limitations included a lack of comprehensive internal
control assessments, insufficient review of loan quality and loan
loss reserves, weaknesses related to insider lending, and
insufficient assessment of bank holding company activities with
insured bank subsidiaries.  GAO recommended actions to address these
weaknesses, as well as weaknesses in the documentation of the
analysis that underlies the examination report and in the supervisory
review of examinations. 

Regulators have made a number of changes in an effort to improve
their examinations.  The changes respond, in part, to the dynamic
banking environment in which institutions can rapidly reposition risk
exposures.  To ensure that banks and thrifts have the managerial
ability and internal control structure to effectively manage risk,
the examination process is evolving to put greater emphasis on risk
management and internal controls.  An institution's sensitivity to
market risk is now a separate component in its supervisory rating,
for example.  In general, these changes appear appropriate and
consistent with the recommendations GAO has made.  In its recent
report on foreign banking organizations operating in the United
States, GAO noted that regulators have begun to put greater emphasis
on risk management processes and operational controls in examinations
of these organizations.  However, GAO has not fully assessed the
effectiveness of the changes for bank and thrift examination and
notes that they have been instituted during favorable economic
conditions that have contributed to strong bank and thrift profits. 
Also, several critical tasks remain for the regulatory agencies: 
ensuring consistency in the supervision and examination policies of
multiple regulatory agencies, ensuring staff expertise, and examining
increasingly complex banking organizations. 


BANK AND THRIFT EXAMINATIONS: 
ADOPTION OF RISK- FOCUSED
EXAMINATION STRATEGIES
==================================================== Chapter STATEMENT

Ms.  Chairwoman and Members of the Committee: 

We are pleased to be here today to discuss bank and thrift
supervision and examination. 

Supervisory and examination procedures today show evidence of lessons
learned from the bank and thrift crises of the 1980s and early 1990s. 
These procedures are the primary basis used by the federal regulatory
agencies to assess the risks that banks and thrifts assume and to
take actions that are needed to maintain a safe and sound banking
system and protect the deposit insurance funds. 

A combination of regulatory and legislative changes, along with
market forces, has expanded the number and scope of activities
undertaken by insured depository institutions, particularly the
largest ones, and thus the risks that they assume.  These expanded
activities include offering and/or dealing in a range of
nontraditional bank products, such as mutual funds, securities,
derivatives, and other off-balance sheet products.\1 The resulting
complex institutions represent a major supervisory and regulatory
challenge.  In keeping with the changes in the banking environment,
federal bank and thrift regulators have recently announced that bank
examinations will explicitly include an assessment of how effectively
banks manage risk and a rating on their sensitivity to risks posed by
a variety of market factors. 

Although we have not yet fully assessed the implementation of most of
the recent changes to supervisory and examination policy, they appear
to address some of our concerns about examinations in the aftermath
of bank failures in the 1980s and early 1990s.  Perhaps the most
important--yet unanswered--question to ask in assessing changes in
bank and thrift supervision is to what extent improvements in the
detection of problems can help ensure that regulators take timely and
forceful corrective action to prevent or minimize losses to the
deposit insurance funds. 

In my testimony today, I would like to review some of our prior
reports and more recent work that

  -- describe the history of the bank and thrift crises of the late
     1980s and early 1990s and the legislative response to these
     crises,

  -- highlight supervisory and examination weaknesses we have noted
     in the past and improvement efforts that have been made or are
     under way, and

  -- identify continuing issues. 


--------------------
\1 Off-balance sheet products represent wholesale activities and fall
into two broad categories:  (1) derivative products and (2)
contingent liabilities.  Derivative products--such as futures,
forwards, options, and swaps--are financial instruments whose value
depends on the value of another underlying financial product. 
Contingent liabilities represent agreements by a banking institution
to provide funds when certain conditions are met. 


   BANK AND THRIFT CRISES
   HIGHLIGHTED SHORTCOMINGS IN
   SUPERVISION AND RESOLUTION
-------------------------------------------------- Chapter STATEMENT:1

From 1980 to 1994, record losses were absorbed by the federal deposit
insurance funds.  In this period, nearly 1,300 thrifts failed, and
1,617 federally insured banks were closed or received FDIC financial
assistance.  Losses to deposit insurance funds have been estimated at
about $125 billion. 


      EXCESSIVE REGULATORY
      FORBEARANCE CONTRIBUTED TO
      PROBLEMS OF THRIFTS AND
      BANKS AND INSURANCE FUND
      LOSSES
------------------------------------------------ Chapter STATEMENT:1.1

Banks and thrifts failed during the 1980s for several reasons.  A
mismatch between the income from fixed rate mortgages and the costs
of borrowing funds at market rates in competition with nondepository
institutions were among the reasons for large losses that led to the
failure of thrifts.  Banks suffered losses from defaults on loans
concentrated in several industries that suffered economic downturns
over the decade, including agriculture, real estate, and developing
nation loans. 

One factor we and others cited as contributing to the problems of
both thrifts and banks during this period was excessive forbearance
by federal regulators.  Regulators had wide discretion in choosing
the severity and timing of enforcement actions to correct unsafe and
unsound practices.  They also had a common philosophy of trying to
work informally and cooperatively with troubled institutions.  In a
1991 report, we concluded that these conditions had resulted in
enforcement actions that were neither timely nor forceful enough to
(1) correct unsafe and unsound banking practices or (2) prevent or
minimize losses to the insurance funds.  The regulators themselves
have recognized that their supervisory practices failed to adequately
control risky practices that led to numerous thrift and bank
failures.  We made specific recommendations for changes to the
supervisory process that would help ensure that institutions failing
to operate in a safe and sound manner would be subject to timely and
forceful supervisory response, including, if necessary, prompt
closure. 


         LEGISLATION WAS ENACTED
         TO ADDRESS PROBLEMS
---------------------------------------------- Chapter STATEMENT:1.1.1

Congress passed two major laws to address the thrift and bank crisis
of the 1980s.  The first, the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 (FIRREA), primarily responded
to the bankruptcy of the Federal Savings and Loan Insurance
Corporation (FSLIC) and troubles in the thrift industry.  In addition
to creating the Savings Association Insurance Fund to replace FSLIC,
FIRREA created a new thrift industry regulator with increased
enforcement authority--the Office of Thrift Supervision.  It also
authorized FDIC to terminate a bank's or thrift's deposit insurance
for unsafe and unsound conditions. 

The second law, the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA), was enacted, in part, because of concerns that
the exercise of regulatory discretion during the 1980s did not
adequately protect the safety and soundness of the banking system or
minimize insurance fund losses.  FDICIA contains several safety and
soundness provisions based on a simple principle:  if a depository
institution fails to operate in a safe and sound manner, it should be
subject to timely and forceful supervisory response, including, if
necessary, prompt closure.  Also, FDICIA requires a number of
corporate governance and accounting reforms to (1) strengthen
corporate governance, (2) improve financial reporting, and (3) aid
early identification of safety and soundness problems.  Among the
corporate governance and accounting reforms, FDICIA establishes
generally accepted accounting principles as the standard for all
reports to regulators; requires that management and auditors annually
report on the financial condition and management of the largest
depository institutions, including effectiveness of and compliance
with internal controls; and requires that institutions have
independent audit committees composed of outside directors. 

In addition, FDICIA contains provisions for improving regulatory
supervision.  FDICIA mandates annual on-site examinations of insured
banks and thrifts.\2 Also, consistent with specific recommendations
we made, it requires implementation of a "trip wire" approach to
limit regulatory discretion in key areas, including capital, by
mandating specific regulatory responses to safety and soundness
problems.  These changes, incorporated in sections 38 and 39 of the
Federal Deposit Insurance Act, were intended to increase the
likelihood of prompt regulatory action to prevent or minimize loss to
the insurance funds. 


--------------------
\2 An 18-month cycle is allowed for qualified smaller institutions
with assets of less than $250 million. 


         THE EFFECTIVENESS OF NEW
         LAWS IN SAFEGUARDING
         DEPOSIT INSURANCE FUNDS
         COULD POTENTIALLY BE
         LIMITED
---------------------------------------------- Chapter STATEMENT:1.1.2

In November 1996, we reported that inherent limitations of section 38
requirements and the regulatory implementation of section 39 raise
questions about their potential for effectively ensuring that
regulators act early and forcefully enough to prevent or minimize
losses to the insurance funds.  Section 38 requires regulators to
take specific, increasingly severe regulatory action as an
institution's capital drops to lower levels.  Although this
requirement should strengthen oversight in several ways,\3 it is
inherently limited as a tool for early intervention to correct
problems and thus safeguard the insurance funds.  This is because
impaired capital levels often do not appear until after a bank has
experienced problems in other areas, such as asset quality and
management. 

Section 39 allows regulatory action before capital is impaired. 
However, section 39, as implemented, appears to do little to reduce
regulatory discretion.  The implementing guidelines and regulations
did not (1) establish clear and specific definitions of unsound
conditions and practices or (2) link such conditions or practices to
specific mandatory regulatory actions.  As we noted in our 1996
report, the subjective nature of the implementation continued the
wide discretion that regulators had in the 1980s over the timing and
forcefulness of enforcement actions. 


--------------------
\3 Section 38 should help prevent certain practices that rapidly
eroded the capital of troubled institutions and contributed to
deposit insurance fund losses.  Section 38 imposes growth
restrictions to prevent "undercapitalized" and "significantly
undercapitalized" institutions from trying to "grow" their way out of
financial difficulty. 


      OTHER WEAKNESSES WERE NOTED
      THAT COULD LIMIT
      EFFECTIVENESS OR RELIABILITY
      OF EXAMINATIONS
------------------------------------------------ Chapter STATEMENT:1.2

Of course, before regulators can initiate an enforcement action, they
must first identify problems within an institution.  The primary tool
regulators use for this is the full-scope safety and soundness
examination.  Traditionally, such examinations have relied
significantly on transaction testing.\4 Transaction testing is used
to evaluate the adequacy of the credit administration process, assess
the quality of loans, and ensure the adequacy of the allowance for
loan and lease losses.  In past reviews of bank and thrift
examinations, we found limitations that could undermine the
reliability and effectiveness of examinations.  These included the
following: 

  -- A lack of comprehensive internal control assessments:  In past
     work, we found that weak internal controls were a common
     characteristic of failed banks and thrifts.\5

Assessing the adequacy of internal controls is important, because
timely detection of inadequate controls can provide an early warning
of problems before they seriously erode asset quality and capital. 
Our past reports on the examination process found that examiners did
not systematically test critical internal controls such as compliance
with loan underwriting policies.  We recommended that a comprehensive
review of internal controls be a part of bank and thrift examinations
and that the condition of a bank's or thrift's system of internal
controls receive explicit consideration in a determination of an
institution's examination rating. 

  -- Insufficient review of loan quality and loan loss reserves: 
     Effective loan quality assessment is important, because loans
     generally make up the majority of bank and thrift assets and
     involve the greatest risk.  Determining the adequacy of loan
     loss reserves is critical because without such a determination,
     in combination with a proper assessment of loan quality,
     examiners have no reliable basis to understand an institution's
     true financial condition.  We recommended that examination
     policies require a representative sampling of loans and better
     documentation of loan quality and the development of a
     methodology to determine the adequacy of loan loss reserves. 

  -- Weaknesses in detecting and ensuring corrective actions related
     to insider lending:  Loans to insiders--such as bank directors,
     officers, or principals--should pose no greater risk than
     transactions with other bank customers.  Abusive insider
     activities can be among the most insidious of reasons for the
     deterioration of the health of a bank.  In 1994, we reported
     that examiners faced numerous impediments to determining the
     full extent of insider problems at banks and that such problems
     were not always corrected as a result of examinations.  We
     recommended that bank regulators review insider activities in
     their next examination of each bank, partly by comparing data
     provided during the examination with information from other
     sources.  We also recommended that federal bank regulators
     ensure that all directors understand their responsibility for
     seeing that effective corrective action is taken. 

  -- Insufficient assessment of actual and potential risks of bank
     holding company activities to insured bank subsidiaries:  In our
     reports, we have found that transactions between a bank holding
     company and its insured bank subsidiary were not always
     thoroughly reviewed.  Such transactions include loans from the
     bank to other, nonbank subsidiaries; fees charged by the bank
     holding company to the bank subsidiary; and asset transfers from
     nonbank subsidiaries to the bank subsidiary.  We recommended
     that the supervisors develop and require mandatory procedures
     for assessing the actual and potential risks to insured bank
     subsidiaries of bank holding company activities. 

We also found in past reviews the need for improvements in important
elements of examination quality control.  We regard these quality
controls as essential, because examiners have broad discretion and
must exercise considerable judgment in planning and conducting
examinations and in drawing conclusions about bank safety and
soundness.  Our findings led us to recommend that regulators
establish policies to ensure

  -- sufficient documentation of the analysis that underlies the
     examination report, and

  -- thorough supervisory review of all examination and inspection
     procedures

Finally, we have noted in past reports that improved coordination
among federal and state banking supervisors could result in more
efficient and effective use of examination resources.  Coordination
is also critical for the supervision of large banking institutions in
that it could foster consistency in examinations and reduce
regulatory burden. 


--------------------
\4 Regulatory guidance describes transaction testing as a reliable
and essential examination technique for use in the assessment of an
institution's condition and the verification of its adherence to
internal policies, procedures, and controls. 

\5 A financial institution's system of internal control provides the
framework for achieving management objectives, protecting assets from
loss, reporting financial information accurately, and complying with
pertinent laws and regulations. 


   REGULATORS HAVE MADE
   SIGNIFICANT EFFORTS TO IMPROVE
   EXAMINATIONS
-------------------------------------------------- Chapter STATEMENT:2

Regulators have made a number of changes in an effort to improve
their examinations since the bank and thrift crises of the late
1980s, and I would like to highlight some that seem most significant. 
In general, these changes appear appropriate and consistent with
recommendations we have made.  However, we have not fully assessed
the effectiveness of their implementation.  When evaluating these
changes, it is also important to note that they have occurred during
favorable economic conditions that have contributed to strong bank
and thrift profits.  The most important test for the changes will be
whether the information they provide in examination reports would
lessen the severity of problems for banks and thrifts during any
future economic downturn. 


      A CHANGING BANKING
      ENVIRONMENT HAS PROMPTED
      GREATER EMPHASIS ON RISK
      MANAGEMENT AND INTERNAL
      CONTROLS
------------------------------------------------ Chapter STATEMENT:2.1

One of the most significant efforts at improvement involves changes
in examinations to account for a dynamic banking environment in which
institutions can rapidly reposition their portfolio risk exposures. 
Regulators have recognized that in such an environment, periodic
assessments of the condition of financial institutions based on
transaction testing alone are not sufficient for ensuring the
continued safe and sound operation of financial institutions.  To
ensure that institutions have the internal controls and processes in
place necessary to identify, measure, monitor, and control risk
exposures that can change rapidly, the approach regulators are taking
to the examination process is evolving to emphasize evaluations of
the appropriateness of such internal controls and processes instead
of relying heavily on transaction testing. 


         ASSESSMENT OF RISK
         MANAGEMENT AND INTERNAL
         CONTROLS IS REFLECTED IN
         NEW RATING SYSTEM
---------------------------------------------- Chapter STATEMENT:2.1.1

Regulators have changed the system they use to rate the safety and
soundness of banks and thrifts to reflect an increasing emphasis on
risk management and internal controls.  Until January 1997, examiners
used the rating system known as CAMEL (capital adequacy, asset
quality, management and administration, earnings, and liquidity). 
Examiners were instructed in 1996 to give greater emphasis to the
adequacy of an institution's risk management processes, including its
internal controls when evaluating management under the CAMEL system. 

On December 9, 1996, the Federal Financial Institution Examination
Council added an "S" to create a new CAMELS rating, with the S
representing an institution's sensitivity to market risk.  The S
rating component is to represent the result of a combined assessment
of both the institution's level of market risk and its ability to
manage market risk.\6

Regulators expect the sophistication of an institution's risk
management system to be commensurate with the complexity of its
holdings and activities and appropriate to its specific needs and
circumstances. 

I should mention that in regulators' examinations of U.S.  branches
of foreign banks, an emphasis on risk management and internal
controls began in 1994 with implementation of a rating system known
as ROCA (risk management, operational controls, compliance, and asset
quality.)

As I noted earlier, we have recommended that the condition of a bank
or thrift's system of internal controls receive explicit
consideration in a determination of the institution's examination
rating.  We have also recommended that the regulators develop and
require minimum mandatory procedures to assess the actual and
potential risks of bank holding company activities to insured bank
subsidiaries.  Increased attention to internal controls and risk
management, if effectively implemented, should help enhance the
regulators' ability to keep pace with a changing banking environment. 
The supervisors' effective implementation of these initiatives is
essential to the success of their examination programs.  Regulators
also told us that they believe that these initiatives complement the
prompt corrective action policies mandated by FDICIA. 


--------------------
\6 Market risk--the potential for losses due to changes in interest
rates, foreign exchange rates, commodity prices, or equity
prices--can adversely affect a bank or thrift's earnings or economic
capital.  For many banks, market risk is largely the interest rate
risk associated with their loan portfolios. 


      REGULATORS HAVE MADE OTHER
      IMPROVEMENT EFFORTS
------------------------------------------------ Chapter STATEMENT:2.2

Other improvement efforts I'd like to highlight that we regard as
consistent with our earlier recommendations include the following: 

  -- Improvements in examination guidelines to detect insider lending
     problems:  The recommendations we made in this area have been
     adopted by the Federal Reserve Board, FDIC, and the OCC. 
     Specifically, examination guidance now explicitly calls for
     reviewing insider activities and ensuring that directors
     understand their responsibility for effective corrective action. 

  -- Improvements under way in examination documentation and
     supervisory review of examination findings:  Federal banking
     regulators have described relevant improvement efforts.  For
     example, according to the Federal Reserve's Framework for
     Risk-Focused Supervision of Large Complex Institutions, the
     Federal Reserve has been working to refine its standards for
     workpapers, especially for examinations of state member banks. 
     Also, the Federal Reserve and FDIC have recently implemented an
     automated examination process to standardize documentation. 
     Federal Reserve officials said that about 25 U.S.  states, to
     date, have also indicated they will begin using this
     standardized work process.  In addition, OCC issued a new policy
     in February 1997 describing workpaper requirements for all of
     its supervisory activities. 

  -- Agreements to coordinate examinations by federal and state
     banking regulators:  The Federal Reserve Board, FDIC, and state
     banking departments completed a single Nationwide State/Federal
     Supervisory Agreement in November 1996 covering state-chartered
     banks that open branches in other states.  This agreement
     modifies an April 1996 State/Federal Protocol and Model
     Agreement by including the Federal Reserve Board as a signatory. 
     Together, these agreements set out, among other things, the
     goals of supervision, division of responsibilities among the
     various regulators, and common examination and application
     processes.  Federal Reserve and FDIC officials told us that
     implementation to date has been successful.  These officials
     also said the examination process has been improved by assigning
     each institution a single case manager who is responsible for
     coordinating all examinations of that institution. 


   CONTINUING ISSUES
-------------------------------------------------- Chapter STATEMENT:3

Changes in examination procedures and in the banking industry will
lead to new challenges for the supervisory agencies.  A key task will
be ensuring consistency in the supervisory and examination policies
and practices of the agencies.  Further, the agencies face the tasks
of ensuring staff expertise and examining increasingly complex
banking organizations. 


      SUPERVISORY COORDINATION AND
      CONSISTENCY
------------------------------------------------ Chapter STATEMENT:3.1

Nontraditional lines of business and interstate branching will bring
increasing numbers of depository institutions under the jurisdiction
of several regulatory agencies.  One result of this will be a more
complex task of ensuring that the regulations and enforcement actions
of multiple agencies are consistent and that their examinations
provide a complete picture of the banks' and thrifts' operations. 

The division of responsibilities among the bank and thrift regulatory
agencies is not generally based on specific areas of expertise,
functions, or activities of either the regulatory agency or the banks
for which they are responsible.  Rather, responsibilities are divided
according to the type of charter-- thrift or bank, national or
state--and whether banks are members of the Federal Reserve System. 
Some analysts, bank industry representatives, and agency officials
credit the current structure with encouraging financial innovations
and providing checks and balances to guard against arbitrary
oversight decisions or actions.  We and others, however, have
identified concerns that arise from having four agencies with similar
responsibilities.  These concerns include possible inconsistent
treatment of institutions in examination policies and practices,
enforcement actions, and regulatory standards and decisionmaking.  In
the case of bank holding companies, with the Federal Reserve
responsible for the bank holding company and other federal regulators
responsible for the banking subsidiaries, divided supervisory
responsibility may hinder regulators from obtaining a complete
picture of an entire banking organization. 

Although we recognize that only Congress can make the policy
judgments in deciding whether and how to restructure the bank
oversight system, we have recommended that Congress reduce the number
of agencies with primary responsibilities for bank oversight.  If the
current structure, with multiple agencies, continues, coordinating
their activities and ensuring consistency in their regulations and
enforcement actions will remain difficult issues.  The regulatory
agencies have several initiatives under way that are intended to
better coordinate their activities and ensure consistency, such as
the automated examination process developed by the Federal Reserve
and FDIC.  Ultimately, these initiatives should be judged by their
results, particularly including the quality of the examinations. 


      SUPERVISORY EXPERTISE
------------------------------------------------ Chapter STATEMENT:3.2

As banking activities have become more complex, bank examinations
have required increasingly broader expertise.  As a result, another
issue that the regulators will continue to face is the need to build
and maintain the expertise needed for supervising these more complex
organizations. 

Federal regulators have hired specialists, such as economists with
technical expertise in the quantitative methods and economic models
underlying banks' risk management systems and specialists in
electronic banking, bank information systems, and risk management. 
Further, the agencies have a number of initiatives to improve the
scope and quality of information that is provided to field examiners
to help them understand banking activities and the risks that banks
undertake. 

In addition, the supervisory agencies have recently completed
training on the risk-focused examination process and the new CAMELS
rating system.  Previously, the Federal Reserve took steps to enhance
examiner training on internal controls by developing an Internal
Controls School in 1995 that was designed initially for examiners of
U.S.  branches and agencies of foreign banks and expanded to meet the
needs of examiners of U.S.  domestic banks.  Federal Reserve
officials told us that they also developed a training seminar in 1996
for examiners and in-house international supervisory staff that
emphasizes ensuring the appropriate supervisory strategy for the U.S. 
operations of foreign banks. 


      EXAMINATIONS OF COMPLEX
      FINANCIAL INSTITUTIONS
------------------------------------------------ Chapter STATEMENT:3.3

With the passage of interstate banking and the increased reliance of
banks on lines of business other than traditional lending, we
anticipate that the task of bank management will become more
difficult.  The bank regulatory agencies will face a similar
challengeï¿½ensuring that their examinations and enforcement strategies
lead to sound management practices as banks increasingly rely on
nontraditional lines of business.  Since large, complex bank
organizations are likely to come under the regulatory jurisdiction of
several agencies, the problem of coordination that I mentioned
earlier will be relevant for these organizations.  Several of our
recent reports point to other types of issues that are likely to
become increasingly common as banks move into more complex lines of
business. 

In our report on the operations of securities activities in banks and
bank holding companies, for instance, we noted that most banks
provided securities services in affiliates that are regulated
primarily by securities regulators.  Some securities activities are
overseen by the bank regulators, however, so the potential for
inconsistent oversight exists.  Because securities oversight would be
enhanced by increased cooperation, coordination, and sharing of
regulatory expertise among bank and securities regulators, we
recommended that the bank regulators work with the Securities and
Exchange Commission and the National Association of Securities
Dealers to develop consistent standards for investor protection and
to ensure the safety and soundness of banks that are engaged in some
form of securities business. 

In our report on the operations of foreign bank organizations in the
United States, we noted deficiencies in the internal controls of
these organizations.  Although federal bank regulators are aware of
these deficiencies and have initiatives under way that they believe
will address these problems, we noted that the regulators do not have
plans to evaluate the results of these initiatives.  We recommended
that the Federal Reserve Board develop a strategy for evaluating the
outcomes of the efforts to improve the internal controls of foreign
bank organizations. 

It will be important for the regulatory officials to develop a
strategy, including objective measures, for assessing the progress
they are making through their efforts to improve the examination
process and to ensure that the procedures and systems necessary to
collect the data relevant to those measures are in place and
operating.  Such objective evaluations should be useful in
determining whether the examinations are achieving their intended
results or whether additional initiatives may be needed. 

At the same time, we are encouraged by some of the changes that the
bank regulatory agencies have made in their examination procedures,
since they appear to address a number of the shortcomings that we had
addressed in our earlier reports.  As one official noted, the small
number of banks in difficulty has provided the regulatory agencies
with an opportunity to improve their operations.  However, the
business of banking has been changing at the same time, and banks are
taking on new risks.  Also, because of the differences in the
responsibilities and the examination and enforcement approaches among
regulators, such as those for the security activities of depository
institutions, a key question is whether improvement will be uniformly
adopted by all regulators and consistently implemented.  Whether
current examination strategies provide an adequate basis for the
regulatory agencies to anticipate problems and take appropriate and
prompt corrective actions to address those problems, especially
during any future economic downturn, is unknown. 


------------------------------------------------ Chapter STATEMENT:3.4

Ms.  Chairwoman, this concludes my statement.  My colleagues and I
would be pleased to respond to any questions you may have. 

RELATED GAO PRODUCTS

Foreign Banks:  Internal Control and Audit Weaknesses in U.S. 
Branches (GAO/GGD-97-181, Sept.  29, 1997). 

Financial Regulation:  Bank Modernization Legislation
(GAO/T-OCE/GGD-97-103, May 7, 1997). 

Bank and Thrift Regulation:  Implementation of FDICIA's Prompt
Regulatory Action Provisions (GAO/GGD-97-18, Nov.  21, 1996). 

Bank Oversight:  Fundamental Principles for Modernizing the U.S. 
Structure (GAO/T-GGD-96-117, May 2, 1996). 

Financial Regulation:  Modernization of the Financial Services
Regulatory System (GAO/T-GGD-95-121, Mar.15, 1995). 

Bank Insider Activities:  Insider Problems and Violations Indicate
Broader Management Deficiencies (GAO/GGD-94-88, Mar.  30, 1994). 

Bank Regulation:  Consolidation of the Regulatory Agencies
(GAO/T-GGD-94-106, Mar.  4, 1994). 

Bank and Thrift Regulation:  FDICIA Safety and Soundness Reforms Need
to Be Maintained (GAO/T-AIMD-93-5, Sept.  23, 1993). 

Bank and Thrift Regulation:  Improvements Needed in Examination
Quality and Structure (GAO/T-AFMD-93-2, Feb.  16, 1993). 

Bank Examination Quality:  OCC Examinations Do Not Fully Assess Bank
Safety and Soundness (GAO/AFMD-93-14, Feb.  16, 1993). 

Bank and Thrift Regulation:  Improvements Needed in Examination
Quality and Regulatory Structure (GAO/AFMD-93-15, Feb.  16, 1993). 

Bank Examination Quality:  FDIC Examinations Do Not Fully Assess Bank
Safety and Soundness (GAO/AFMD-93-12, Feb.  16, 1993). 

Bank Examination Quality:  FRB Examinations and Inspections Do Not
Fully Assess Bank Safety and Soundness (GAO/AFMD-93-13, Feb.  16,
1993). 

Banks and Thrifts:  Safety and Soundness Reforms Need To Be
Maintained (GAO/T-GGD-93-3, Jan.  27 1993). 

Bank Supervision:  Prompt and Forceful Regulatory Actions Needed
(GAO/GGD-91-69, Apr.  15, 1991). 

*** End of document. ***