Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

DATE: February 20, 2002

TO: Michael J. Zamorski, Director, Division of Supervision

FROM: Russell A. Rau [Electronically produced version; original signed by Russell A. Rau], Assistant Inspector General for Audits

SUBJECT: Follow-up Audit of the FDIC’s Use of Special Examination Authority and DOS’s Efforts to Monitor Large Bank Insurance Risks (Audit Report No. 02-004)

This report presents the results of our follow-up audit of a 1999 Office of Inspector General (OIG) study of the Division of Supervision’s (DOS) efforts to monitor and assess risk at insured institutions for which the Federal Deposit Insurance Corporation (FDIC or the Corporation) is not the primary federal regulator (PFR). (Note: A bank’s primary federal regulator is determined by the bank’s charter and whether a bank is a member of the Federal Reserve System. The FDIC is the primary federal regulator for state-chartered banks that are not members of the Federal Reserve System. The Office of the Comptroller of the Currency (OCC) is the primary federal regulator for all national banks. The Board of Governors of the Federal Reserve System (FRB) is the primary federal regulator for state chartered banks that are members of the Federal Reserve System. The Office of Thrift Supervision (OTS) is the primary federal regulator for federal and state-chartered savings associations.) In a memorandum to the FDIC Chairman in October 1999, we reported that other federal regulators had occasionally restricted the FDIC’s efforts to participate in safety and soundness examinations at institutions for which the Corporation is not the PFR. (Note: Audit Memorandum to the Chairman – Results of OIG Review of the Backup Examination Process and DOS’s Efforts to Monitor Megabank Insurance Risks, October 19, 1999.) Such restrictions had limited the FDIC’s ability to assess risks to the deposit insurance funds. We also reported that because of limitations in the information routinely provided to DOS by the other regulators pertaining to the nation’s largest banks, DOS managers expressed serious concerns that they may not be able to adequately assess the risks that the country’s largest non-FDIC supervised banks pose to the insurance funds.

The objective of this follow-up review was to assess the progress that the FDIC has made since the issuance of our previous memorandum and to make recommendations that might improve the Corporation’s effectiveness in working with the other federal regulators. We conducted our audit from March through November 2001 in accordance with generally accepted government auditing standards. As the Office of Inspector General for the FDIC, we reviewed the issues addressed in this report solely based on information provided by the FDIC in its efforts to effectively carry out its mission. We did not perform audit fieldwork at the Board of Governors of the Federal Reserve System (FRB), the Office of the Comptroller of the Currency (OCC), or the Office of Thrift Supervision (OTS). A detailed discussion of the scope and methodology of our audit is included in Appendix I.

RESULTS OF AUDIT

In both our reviews, we noted that DOS managers have generally developed good working relationships with their regional counterparts in FRB, OCC, and OTS. In our first review, covering the 42-month period ending in March 1999, we identified 90 instances where DOS had participated in examinations with the other federal regulators. However, the FDIC has not always been able to promptly secure permission to participate in examinations of banks supervised by the OCC and OTS. Specifically, we learned of three situations that occurred during 1998 where these regulators turned down initial DOS requests to participate in scheduled safety and soundness examinations, and the end result in two of these cases dramatically illustrates the importance of regulators working together to effectively deal with evolving risks in the banking industry. One case involved an OCC supervised bank, the First National Bank of Keystone, Keystone, West Virginia, and the other case, Superior Bank, FSB, Hinsdale, Illinois, an institution supervised by OTS. Both banks were ultimately closed by the regulators (Keystone in September 1999 and Superior in July 2001) and both have captured congressional and national attention because of the significant loss estimates associated with these institutions. As of December 31, 2001, the combined estimated loss for the two banks was $1.13 billion - losses that will ultimately be borne by the federal deposit insurance funds. The OCC’s and OTS’s initial reluctance to allow DOS examiners to evaluate a number of concerns related to the activities of these banks may have prolonged their periods of operation and increased deposit insurance fund losses.

Our follow-up review did not identify any additional instances where another regulator turned down an FDIC request to participate in an examination. However, DOS officials informed us of several cases where examiners experienced delays in receiving requested information from another regulator or were not provided sufficient time during examinations to review certain bank conditions.

In our 1999 memorandum, we suggested that the Chairman (1) request delegated authority from the FDIC Board to initiate special examinations without having to secure the concurrence of the primary federal regulator or the approval of the Board or (2) seek a legislative change to vest this authority in the Chairman. Following Keystone’s failure and the issuance of our memorandum, Representative James Leach, the former Chairman of the House Committee on Banking and Financial Services, introduced legislation on November 16, 1999 (H.R. 3374) designed to strengthen the FDIC’s ability to monitor and assess risk in those financial institutions for which the FDIC is not the primary federal regulator. Following a hearing on H.R. 3374 in February 2000, no action was taken on the legislation based on the strength of the Comptroller of the Currency’s representations during the hearing that there should be no problems with the FDIC’s access to OCC regulated banks and that any disputes with the FDIC would be resolved at his level. The bill expired at the end of the 106^th Congress. Subsequently, the FDIC Chairman did not request a delegation of authority from the Board. Based on the results of our follow-up review, we believe the circumstances supporting our previous suggestion have not substantially changed, and that changes in the industry and the consequences of additional failures have increased risk to the deposit insurance funds. Accordingly, we are now formally recommending that the FDIC’s special examination authority be strengthened.

In our previous review, we also pointed out a number of factors that significantly limit the FDIC’s ability to effectively monitor the financial risks posed in the country’s largest banks, those with over $25 billion in assets (sometimes referred to as "megabanks"). At that time, 37 of the 39 largest institutions were supervised by OCC, FRB, and OTS. We reported that DOS officials had to evaluate risk exposures in megabanks by using information that is mostly historical in perspective and filtered or interpreted by the other regulators before it is made available to the FDIC. These same conditions continue to exist, with 35 of 38 megabanks supervised by the OCC, FRB, or OTS. Additionally, we observed in our previous report that DOS was prevented from gaining valuable insights into the operations and risks of the nation’s largest national banks because the OCC would not allow DOS personnel to attend meetings between OCC examiners and bank management. Over the past 2 years this situation has not changed. DOS personnel are attending bank management meetings with FRB and OTS, but not with OCC.

We are, therefore, reaffirming the position we expressed in our prior review by recommending that the Director of the FDIC’s DOS develop agreements with the other bank regulatory agencies to provide the FDIC with the real-time information and access to megabanks necessary to carry out the Corporation’s responsibilities as the insurer. Consistent with this recommendation, the FDIC worked with the OCC, FRB, and the OTS during the latter part of 2001 to develop an interagency agreement to improve the Corporation’s access to banks for purposes of performing special examinations and to provide DOS with more timely data on large banks. On January 29, 2001, the FDIC Board authorized implementation of the agreement that includes a provision for the FDIC to assign a dedicated examiner to each of the eight largest banking organizations.

In our 1999 memorandum, we also suggested that the Chairman direct DOS to: identify the specific information that DOS needs to monitor the insurance risk presented by megabanks and other insured institutions; establish well defined criteria for case managers to use in evaluating the insurance risks posed by non-FDIC supervised megabanks; and clearly articulate DOS’s monitoring goals and objectives. DOS initiatives undertaken since the completion of our previous fieldwork, such as instituting changes to improve the efficiency of its large bank supervision program and providing specific instructions to case managers in response to our memorandum, have met the intent of our suggestions. Accordingly, we are not making any recommendations that specifically pertain to these matters.

Legislative and Regulatory History

The FDIC’s special insurance examination authority is contained in subsection 10(b)(3) of the Federal Deposit Insurance Act (FDI Act). This subsection provides FDIC examiners the power to make special examinations of any insured depository institution, whenever the FDIC Board of Directors determines such an examination is necessary, to determine the institution’s condition for insurance purposes. During 1995, the Board delegated authority to the Director of DOS to perform examinations, visitations, and/or other examination activities with the concurrence of the PFR. However, under the current delegation, DOS examiners do not have the authority to perform an independent on-site evaluation of a bank's activities, even if the bank is in a troubled condition, without the approval of the bank’s PFR or the FDIC Board of Directors. The five-member Board is composed of the FDIC Chairman and Vice Chairman, the FDIC Director, the Comptroller of the Currency, and the Director of the Office of Thrift Supervision. The FDIC Vice Chairman position was vacant as of the date of this report. A more detailed history of the Corporation’s special examination authority is presented in Appendix IV.

Extent of Special Examination Activities

As required by current law, the FDIC maintains and protects separate insurance funds for banks and savings associations and shares supervisory and regulatory responsibility for FDIC-insured institutions with FRB, OCC, OTS, and state authorities. As shown in Table 1, the FDIC is the PFR for approximately 5,600 federally insured state-chartered commercial banks that are not members of the Federal Reserve System.

Table 1: Primary Federal Regulators and the Institutions They Supervise

Source: Fourth Quarter 2000 Banking Profile

In carrying out its responsibilities as the insurer, the FDIC also monitors the conditions of about 3,200 national and state member banks, and more than 1,000 thrift institutions. For the 17-month period ending February 28, 2001, we noted that DOS participated in the examination of 71 banks and thrifts regulated by the OCC, OTS, and FRB, or approximately 1.7 percent of the institutions that the FDIC monitored for insurance purposes over that time period.

Changes in the Banking Industry Environment

In our 1999 memorandum, we pointed out that since the early 1990s, the major banks have been rapidly developing into enormous and complex financial conglomerates. The continuing consolidation of the industry has resulted in fewer and fewer financial institutions controlling an ever-expanding percentage of the nation’s financial assets. The largest banks operate highly complex branch networks, have extensive international and capital market operations, and work on the cutting edge of technologically sophisticated finance and business. There are about 8,800 banks nationwide – down from more than 12,000 in 1990. In a relatively short period of time, the industry has undergone such a widespread consolidation that relatively few institutions now control almost half of the total bank assets of all FDIC insured depository institutions, about $3.6 trillion.

This trend toward the consolidation of financial resources is placing increasing risks on the deposit insurance funds. As of March 31, 2001, there were 38 megabanks in the country. The consolidation of banks serving different markets can moderate risk, decrease earnings volatility, and moderate the effect of economic downturns on the largest institutions, thereby decreasing the likelihood of failure. However, consolidation in the banking industry presents additional risks for the FDIC in its unique role as the deposit insurer because the deposit insurance funds face larger potential losses from the failure of a single large institution. (Note: The FDIC operates two insurance funds: the Bank Insurance Fund (BIF) insures deposits in commercial banks and savings banks, and the Savings Association Insurance Fund (SAIF) insures deposits in federal savings and loan associations, federal savings banks, and state savings and loans.)

In addition to controlling a high percentage of banking resources, today’s megabanks are frequently involved in non-traditional and highly complex business activities. The financial conditions faced by the largest banks can change direction with very little warning. In addition, the enactment of the Gramm-Leach-Bliley Act of 1999, which permits affiliations between insured banks, financial holding companies, and various subsidiary relationships including securities and insurance firms, may pose new challenges not only to the banking industry but also to each of the cognizant regulators. (Note: Signed into law by President Clinton on November 12, 1999, the Gramm-Leach-Bliley Act provides financial organizations with flexibility in structuring new financial affiliations through a holding company structure or a financial subsidiary, with appropriate safeguards.) For these reasons, the need for coordination, cooperation, and sharing of timely and accurate information among the regulators is essential.

Consequences of Additional Failures

Closing additional institutions with insurance fund losses on the magnitude of the Keystone and Superior failures could have a significant effect on the banking industry. FDI Act section 7(b), Assessments, requires the FDIC Board of Directors to set semiannual assessments for insured depository institutions if the required reserve ratio of the insurance fund balance to estimated insured deposits falls below 1.25 percent. In a speech before America’s Community Bankers on October 30, 2000, the former FDIC Chairman stated that if fund payouts push the fund below the 1.25 percent threshold, banks would face a 23 basis point premium spike that could reduce the pre-tax net income of all FDIC-insured institutions by almost $9 billion, which, in turn, could lead to a nation-wide lending contraction of more than $65 billion. This would create considerable stress on an already struggling economy.

Based on the estimated amount of insured deposits and the balances of the insurance funds as of September 30, 2001, losses of approximately $1.8 billion to the Bank Insurance Fund (BIF) and approximately $1.1 billion to the Savings Association Insurance Fund (SAIF) would require institutions insured by the respective fund to begin paying deposit insurance premiums. (Note: Because the reserve ratio of premiums held by the FDIC to deposits insured exceeds the 1.25 percent ratio established by FDIC regulation, most banks and thrifts were not paying insurance premiums as of the date of this report.) Thus, there is a compelling need for all the regulators to cooperate fully in order to minimize the losses associated with any bank failure that does occur and ensure the industry’s stability. Appendix III contains a discussion of loss rates and the amount of losses required before institutions would have to pay insurance premiums.

SPECIAL EXAMINATION ACTIVITIES

In responding to emerging safety and soundness concerns in financial institutions for which the FDIC is not the PFR, FDIC examiners have at times been denied permission to evaluate conditions on-site or to gain timely access to information relevant to situations that represented significant risks to the insurance funds. In our opinion, there has been a reluctance on the part of other PFRs to allow the FDIC to participate in examinations because the agencies wanted to avoid over-burdening institutions and, as is the natural tendency, preclude possible second-guessing by the FDIC. Also, given the time and effort required to prepare a Board case, DOS officials have been hesitant to petition the Board in situations where their suspicions were not backed up by substantial proof. Further, during the past several years, it is our perception that DOS believed it was unlikely that such cases would be approved because Board of Directors’ vacancies left the FDIC in a minority position. The frequency of the FDIC’s participation in examinations conducted by the PFRs has more than doubled since the time period covered during our 1999 review, and we found no additional instances where DOS was not allowed to participate in an examination. However, the FDIC continued to encounter instances where its efforts to address risks from the perspective of the insurer had been constrained by other PFRs.

While section 10(b)(3) of the FDI Act provides the FDIC special authority to examine any insured depository institution for insurance purposes, current procedures contained in the FDIC Board’s 1995 delegation to the DOS Director can prevent the FDIC from using its authority. Under the delegation, the FDIC cannot conduct a special examination of a financial institution, no matter how serious its financial condition, over the objection of the PFR unless DOS can successfully present a case before the FDIC Board to justify DOS’s involvement. Thus, under certain circumstances, the FDIC lacks the independence to promptly and directly respond to emerging risks within a particular institution from the perspective of the insurer.

When evaluating the effectiveness of the current delegation, it is important to recognize that the FDIC’s responsibilities are broader than those of the other PFRs. In addition to supervising state nonmember banks in the role of a primary regulator, the Corporation is also responsible for managing the insurance funds, ensuring that failing institutions are resolved in the least costly manner, and maximizing the value of failing banks’ receivership assets. (Note: A receiver is an agent (in the instance of a failed institution, the FDIC) appointed by a failed institution’s primary regulator to manage the orderly liquidation of the failed institution.) Each of these responsibilities involves the need for the FDIC to have prompt and direct access to information that may be directly controlled by one of the other PFRs. With respect to its supervision responsibilities, DOS requires direct and timely access to information, and at times bank management, for two primary reasons: first, to assess insurance risk to ensure that the FDIC, as underwriter for the insurance funds, is being properly compensated for the risk presented by all insured institutions, including those not directly supervised by DOS; and second, to ensure that insured institutions are supervised and regulated prudently.

Additionally, under the current delegation, situations could occur where the heads of the OCC and OTS, both of whom are members of the FDIC Board, would be voting on requests for special examination authority after actions had been taken by their respective organizations to oppose DOS requests to use that authority. Further, in situations where one or more of the Board’s positions are vacant, the vital balance between the regulators’ various interests implicit in the Board’s structure is not preserved and the FDIC’s independence to exercise special examination authority is impaired. As of the date of this report, the Board has operated with one vacancy, the Vice Chairman position, since January 2001, and during the 1990s one or more Presidentially-appointed Board positions frequently were vacant. Accordingly, our office has strongly urged that vacancies be filled as promptly as practicable in order to afford the FDIC the balanced governance and sustained leadership essential to the agency’s continued success.

As the insuring agency, the FDIC strives to keep abreast of developments that occur in all institutions to determine their potential risks to the deposit insurance funds and to assign institutions to categories within the risk-related premium system. When increases in risk raise concerns with the FDIC, the Corporation may ask to participate in the primary federal regulator’s next examination. Under FDI Act section 10(b)(3), the FDIC’s Board of Directors can authorize FDIC examiners to conduct a special examination of any insured depository institution for insurance purposes. While the FDIC’s usual practice is to review and rely on the examination reports of the other regulators, this special examination provision of the Act serves as an internal control by which the FDIC, as insurer, can provide a secondary level of on-site review for institutions perceived to pose a higher risk profile. However, the effectiveness of this internal control can be reduced by the current delegation from the FDIC’s Board because DOS must first obtain the concurrence of the primary federal regulator or go through the process of preparing a Board case and seeking Board approval.

The FDIC’s lack of independence to determine when and where DOS can obtain information related to safety and soundness and insurance concerns is inconsistent with the Corporation’s authority when ruling on rating differences with the other PFRs. In accordance with section 327 of the FDIC’s Rules and Regulations, the FDIC has the final word when assigning ratings for insurance purposes, which impact the insurance premium assessments banks are assigned. The FDIC uses a risk-based premium system that assesses higher rates on those institutions that pose greater risks to the insurance funds. In order to assess premiums on individual institutions, the FDIC places each institution in a risk category using a two-step process based first on capital ratios (the capital group assignment) and then on other relevant information (the supervisory subgroup assignment). The FDIC makes capital group assignments in accordance with section 327.4(a)(1) of the FDIC’s Rules and Regulations. The FDIC also makes supervisory subgroup assignments based on the Corporation’s consideration of supervisory evaluations provided by the institution’s PFR, in accordance with section 327.4(a)(2) of the FDIC’s Rules and Regulations. Thus, while the FDIC has full authority to assign risk ratings for insurance purposes, it does not have the equivalent autonomy to obtain the information needed to assign the ratings.

In our current review, we again assessed the cooperation the Corporation has received from OCC, FRB, and OTS in carrying out its responsibilities to protect the insurance funds. For the period October 1, 1999 through February 28, 2001, DOS requested and was allowed to participate in 89 examinations with the other regulators in 71 small and medium sized banks and thrifts – those with assets less than $25 billion. Table 2 summarizes the location and the number of instances where DOS participated in examinations during the 17-month period reviewed.

Table 2: Number of Instances Where FDIC Participated in Examinations of Small and Medium Sized Institutions as Reported to the FDIC Board of Directors for 10/1/99 through 2/28/01

Source: OIG Analysis of Examination Activities for Deposit Insurance Purposes

When dealing with issues related to small and medium sized banks, DOS managers believe that at the regional level, they have developed effective working relationships with their regulatory counterparts at the FRB, OCC, and OTS. However, DOS managers brought to our attention a number of situations where they believe that their examiners were not provided with the information or time to fully assess the risks present in banks supervised by OCC and OTS. We did not hold discussions with officials from OCC, OTS, or FRB regarding these situations, which are discussed below.

• During an OCC examination of a national bank in July 2000, OCC examiners became aware of loan portfolio irregularities. Although an OCC investigation revealed serious asset quality problems resulting from hazardous lending practices and alleged fraud and insider abuse, OCC did not notify DOS. DOS learned of the situation only when a DOS official contacted OCC while following up on an inquiry made by a third party. Despite OCC assurances that DOS would be kept advised of significant findings of the ongoing investigation and examination, DOS was not made aware of the extent of the bank’s losses or the CAMELS composite 5 rating until DOS received the examination report in January 2001. (Note: The CAMELS rating for an institution is part of the Uniform Financial Institutions Rating System which is used to evaluate the soundness of institutions on a uniform basis and to identify institutions requiring special attention. This rating system assigns a numerical score from 1 to 5 for each institution, with 1 signifying the highest rating and least degree of supervisory risk and 5 signifying the lowest rating and the highest degree of supervisory risk. The CAMELS acronym represents each of the factors that are rated: Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk.) The bank’s previous CAMELS composite rating (1999) had been a 2. We were also advised that DOS experienced difficulties and delays in obtaining information from OCC officials that was needed to calculate an accurate capital ratio. A DOS examiner participating in a subsequent on-site visit to the bank was able to obtain the necessary information. However, for a period of time, the FDIC lacked timely and necessary information to assess and prepare for potential losses to the insurance funds.
  
  
• During December 1999, the FDIC entered into a project with the FRB, the OCC, and state banking departments. The project involved a joint effort to examine several financial institutions with different charters. Relationships with the various FRB and state banking department personnel were considered excellent. Information was readily shared and views from each agency were welcomed. However, DOS experienced difficulties with the OCC, especially during the early stages of the project. DOS informed us that the OCC denied FDIC and FRB examiners the right to copy bank documents to retain for later use and did not provide them to the two agencies until from several weeks up to several months later.
  
  In one of the national banks examined during the project, the OCC would only allow FDIC personnel to input data onto a spreadsheet. No additional examination tasks were assigned to the DOS staff, and the OCC examiners did not accept DOS comments, conclusions, and suggestions. During the offsite review of this institution, DOS examiners noted what they considered to be instances of improper insider transactions. They requested copies of minutes from Board of Directors’ meetings and that the bank’s directors be questioned about their activities during a planned return visit to the bank. The OCC cancelled the return trip over the objections of DOS, and the OCC did not provide DOS with copies of the Board meeting minutes for several months. As of July 2001, the OCC’s planned investigation of the insider transactions had not begun. The OCC also requested and received documents from the various national banks involved in this project that it did not share with either the FDIC or FRB.
  
  
• During April 2001, DOS participated in a full-scope safety and soundness examination of a thrift supervised by OTS. Near the end of the examination, the OTS and DOS realized that several significant issues could not be resolved within the time that the OTS had allotted for the exam. One of the issues was support for the thrift’s valuation and modeling of subprime residual assets and subordinated debt. (Note: Residual assets represent claims on the cash flows resulting from the securitization process that remain after all obligations to investors and any related expenses have been paid, which normally include funds to build reserves and pay loan losses, servicing fees, and liquidation expenses. When the loans for the pools originate, they bear a stated interest rate. The securities are issued to investors at a lower rate than the stated rate on the loans. The difference between the rate that the loans are paying versus what the pools are paying to investors is called the residual. A subordinated note or debenture is a form of debt issued by a bank or a consolidated subsidiary. When issued by a bank, a subordinated note or debenture is not insured by a federal agency, is subordinated to the claims of depositors, and has an original weighted average maturity of 5 years or more.) The OTS examiner in charge asked his regional office for additional time to complete the examination but was turned down. Thus, DOS was not provided sufficient time to discuss the findings with OTS and resolve differences prior to the exit meeting with bank management. At the end of the examination, DOS did not agree with certain OTS conclusions and ratings. During August 2001, the OTS advised DOS that OTS concurred with the FDIC’s rating position and was lowering the bank’s rating to a composite 3.
  
  
• During DOS’s participation in a July 2000 examination of a bank supervised by the OTS, DOS and OTS examiners had differences in opinion on several issues including accounting treatments and the bank’s rating. OTS held its exit meeting with bank management before DOS’s concerns could be resolved, and the DOS examiners were not free to discuss their position during the meeting. Ultimately, the OTS agreed with DOS that the institution’s composite rating should be lowered from a 3 to a 4.

While none of the banks described in the above examples have caused losses to the deposit insurance funds, these situations demonstrate how another regulator can restrict access to information the FDIC believes necessary to fully assess its insurance risks.

In performing our 1999 review, however, we noted three instances where another regulator denied the FDIC’s initial requests to participate in safety and soundness examinations, and in two of these situations, the banks were subsequently closed. One case involved The First National Bank of Keystone, Keystone, West Virginia. On September 1, 1999, the OCC closed Keystone, a $1.1 billion institution, after finding evidence of apparent fraud that resulted in the depletion of the bank’s capital. In February 1998, the OCC received and denied DOS’s request to participate in its August 1998 examination. As a result, DOS prepared a Board case seeking approval to participate in the exam. In our opinion, DOS had a sound basis for wanting its examiners to participate in the exam.

In June 1998, prior to DOS presenting its case to the Board, the OCC reversed its position. Thus, the Board never heard the case. In reversing its position, however, the OCC restricted the number of DOS examiners that were allowed to work in the bank. This situation illustrates how the FDIC’s special examination authority can be subject to constraints imposed by the PFR and can limit the FDIC’s ability to assess risks to the deposit insurance funds. As of the date of this report, the loss to the Bank Insurance Fund associated with the closing of Keystone was estimated to be $780 million.

Another significant example involved an OTS-supervised institution, Superior Bank, FSB, Hinsdale, Illinois. On December 28, 1998, the Director of DOS’s Chicago Regional Office sent a letter to his OTS counterpart requesting that a DOS examiner be allowed to participate in OTS’s next examination of Superior, scheduled to begin in January 1999. The letter cited a number of concerns relative to the bank’s situation, including that Superior’s asset structure included substantial investments in residual interest securities. According to DOS officials, OTS regional management orally denied the request in January 1999.

We believe that the concerns detailed in DOS’s request presented sufficient justification for obtaining permission to participate in the exam. As an alternative, the OTS allowed DOS’s case manager and a regional capital markets specialist to meet offsite with OTS examiners about a week prior to the close of the exam. However, DOS found that meeting with examiners rather than participating directly in the examination resulted in a limited benefit. Over the succeeding months as the bank’s situation deteriorated, DOS continued to encounter difficulties in obtaining the OTS’s full cooperation.

On July 27, 2001, Superior Bank was deemed insolvent and the OTS appointed the FDIC as receiver. The bank held assets of $2.3 billion, and the loss to the Savings Association Insurance Fund is estimated to be $350 million. At the request of the Chairman of the Senate Committee on Banking, Housing, and Urban Affairs, our office is reviewing the causes of Superior’s failure and various aspects of the effectiveness with which the respective federal regulators supervised the institution prior to its closing. The Office of the Inspector General of the Department of the Treasury conducted a review of the circumstances leading to the thrift’s failure in accordance with section 38(k) of the FDI Act. Final reports on these reviews were issued in February 2002, and the Senate Committee held a hearing on this subject on February 7, 2002.

The limitations placed on DOS’s attempts to assess the problems related to Keystone and Superior, and the more recent instances where DOS’s supervisory activities have been constrained by the other regulators, illustrate that FDIC officials are not always provided with the information and access to banks they believe are needed to assess risk for insurance purposes. The restrictions imposed by the current delegation of authority from the FDIC Board to DOS can hinder timely action on the part of DOS in several respects. First, in seeking concurrence from the PFR, the PFR can significantly influence the timing and scope of the FDIC’s examination activities, reducing or blocking the benefit of the secondary level of review. Requiring concurrence by the primary federal regulator may impair the FDIC’s independence, may limit the control value of the secondary level of review, and could be viewed as an organizational conflict. Second, requiring Board approval on a case-by-case basis could delay an FDIC special examination in a critical situation, delay the start of enforcement action based on examination results, and detract from the internal control established in the FDI Act. As mentioned earlier, the five-member Board includes the heads of the OCC and the OTS, thus providing these two individuals with the opportunity to participate in any Board decision on whether the FDIC should be allowed to carry out its special examination authority in an institution supervised by another PFR. (Note: It should be noted that when special examination authority was first established in 1950, the FDIC Board consisted of three members: the Chairman, an FDIC Director, and the Comptroller of the Currency.)

Accordingly, to ensure the effectiveness of the internal control offered by the special examination provision of the FDI Act and that the FDIC takes the most effective approach to monitoring risks to the deposit insurance funds, the FDIC Chairman needs the independent authority to authorize special examinations that supplement those of the other regulators. A statutory amendment or delegation from the Board could allow the FDIC Chairman to make an independent decision to initiate special examination activities based on criteria of increased or unusual risk to the funds, and not require case-by-case concurrence by the primary federal regulator or the Board’s approval. As discussed previously, the heads of the OCC and OTS can impact FDIC independence in Board decisions during periods where one or more Board positions are vacant.

In our 1999 memorandum, we suggested that the former Chairman seek a legislative change that would vest special examination authority in the FDIC Chairman and thereby eliminate any requirements to secure the concurrence of the primary federal regulator or the approval of the Board. Alternatively, we suggested that the Chairman pursue a less complicated and more timely approach to resolving the current situation by requesting the FDIC Board of Directors to vest the Chairman with the authority to approve DOS requests for special examinations of insured institutions that pose significant safety and soundness concerns. However, it is critical to note that any delegation of authority granted by the Board to the Chairman could be rescinded or modified at any time by a majority of the Board members in a subsequent vote. Thus, the FDIC’s independence and the effectiveness of DOS’s secondary level of review could again be restricted. We therefore consider that seeking to change the current legislation is the preferred course of action for the Chairman to take and that revising the current Board delegation should serve as an interim measure.

Given the broad range of the FDIC’s supervisory responsibilities, and because of the Corporation’s role and responsibility as the deposit insurer for the nation’s banking industry, there is a clearly defined need to strengthen the FDIC’s authority to act in an independent manner in its efforts to evaluate insurance risk and gain access to financial records in banks supervised by the other PFRs. Vesting special examination authority directly with the FDIC Chairman would serve to strengthen the effectiveness of the Corporation’s secondary level of review of safety and soundness concerns and lessen the potential impact that Board vacancies create relative to the FDIC’s ability to quickly assess suspected insurance risk in an institution supervised by another regulator. The proper use of the FDIC’s special examination authority would not duplicate or disrupt the other PFR’s efforts, but would provide the FDIC with a more timely approach for gaining a firsthand understanding, along with the PFR, of potential risks facing both financial institutions and the insurance funds, or obtaining information critical to a resolution.

In an August 19, 1993 letter to the FDIC’s Acting Chairman, the Chairman of the House Committee on Banking, Finance and Urban Affairs, and the Ranking Member of the Committee, stated that given the FDIC’s responsibilities for prompt corrective action, as outlined in section 38 of the FDI Act, and as the backup regulator, the FDIC must be able to independently examine all depository institutions. They stated that "the FDIC has been granted specific responsibility for promoting the safety and soundness of the bank and savings association insurance funds and ensuring that insured institutions are supervised and regulated prudently. This responsibility requires independent enforcement and examination authority and that is what Congress granted to the FDIC in the FDI Act." They also stated that they hoped that the FDIC would coordinate its examinations with the primary regulator to the fullest extent possible.

The FDIC has a need and a responsibility to develop information on core risk areas to facilitate analyses of insurance fund exposures and continually maintain an up-to-date understanding of specific vulnerabilities that could lead to significant insurance losses. As discussed earlier in the report, the failure of a single large institution, coupled with the losses sustained in recent failures, could cause the reserve ratio of the insurance fund balance to estimated insured deposits to fall below 1.25 percent. This, in turn, would require all depository institutions to begin paying insurance premiums.

For the FDIC to most effectively carry out one of its principal responsibilities, the insurance function, its Chairman needs to be provided with a greater degree of independence to exercise the Corporation’s special examination authority. Based on the results of this follow-up review, the circumstances supporting our previous suggestions to strengthen the FDIC’s special examination authority remain essentially the same, and changes in the industry have increased risks to the deposit insurance funds. Accordingly, we are making the following recommendations.

Recommendations

We recommend that the Director, DOS, initiate actions within the Corporation to:

1. Pursue an amendment to Section 10(b)(3) of the FDI Act (12 U.S.C. section 1820(b)(3)) to vest special examination authority with the FDIC Chairman in consultation with the appropriate primary federal regulator.
2. Seek a revised Board delegation that vests special examination authority with the FDIC Chairman in consultation with the appropriate primary federal regulator, as an interim measure pending a legislative amendment.

Our follow-up review disclosed that DOS officials continue to evaluate risk exposures in megabanks by using information that is predominantly historical in perspective and sometimes filtered or interpreted by the other PFRs before it is made available to the FDIC. The FDIC does not have access to current and complete information in order to assess insurance fund risks. Because the FDIC does not have a presence in 35 of the country’s 38 largest banks (see Appendix II), it is almost totally dependent on the other PFRs for monitoring the largest potential risks to the deposit insurance funds. In the absence of agreements with the other PFRs that would provide the FDIC with real-time information, and because DOS representatives have been denied a presence by the OCC in meetings between the regulators and management in the nation’s largest national banks, the FDIC may not be able to adequately assess the risk that non-FDIC supervised megabanks present to the insurance funds.

A fundamental component of DOS’s decentralized approach to megabank monitoring is the personal relationships that case managers develop with their counterparts in the other regulatory agencies. Case managers (CMs) are located in DOS’s regional offices and are responsible for evaluating the level of insurance risk evident in their caseloads of financial institutions, which consist of banks supervised by the FDIC as well as the other regulators. Working with representatives from the other regulatory agencies, CMs must fully understand the operations of those institutions in their caseloads, develop supervisory strategies, and determine the deposit insurance risk ratings for each institution. A May 28, 1999 best practices memorandum sent to all DOS regional directors dealing with this subject states that a case manager’s ability to develop strong and effective working relationships with primary regulator counterparts is considered critical to properly evaluate institution and systemic risks and to ensure that the FDIC’s supervisory and insurance concerns are effectively and expediently communicated to the PFR.

To understand the significance of our observations relating to factors that are hindering the FDIC’s effectiveness in monitoring and supervising the country’s largest banks, it is important to relate our findings to our earlier discussion of the challenges facing the banking industry, and particularly our discussion of the ongoing consolidation process. Of the $5.3 trillion consolidated assets controlled by the 38 largest financial institutions, the FDIC is the primary federal regulator for only $162.5 billion in 3 institutions (see Figure 1). The failure of a megabank, along with the potential closing of closely affiliated smaller institutions, could result in huge losses to the deposit insurance funds.

Figure 1: Distribution of Consolidated Assets Between National, State Member, State Non-Member Banks and Thrifts as of 3/31/01 (Note: In July 2001, one of the banks supervised by the FDIC converted to a state member bank supervised by the FRB, thus lowering the number of megabanks directly supervised by the FDIC from 3 to 2.)

[This image appears in the non-508-compliant version of the audit report.]

Text description of Figure 1: As of March 31, 2001, the Distribution of Consolidated Assets Between National, State Member, State Non-Member Banks and Thrifts was as follows: OCC had $3.342 trillion (17 banks), or 63 percent; FRB had $1.379 trillion (12 banks), or 26 percent; OTS had $433 billion (6 banks), or 8 percent; and FDIC had $162.4 billion (3 banks), or 3 percent.

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01 and FDIC Institution List

One of the key conditions that has not changed significantly over the past 2 years is that the CMs have continued to evaluate risk exposures in the megabanks by using information that is historical in perspective, because much of the data received from the other PFRs and the banks is several months old. A substantial amount of the information that case managers use is dated because it has to be developed and processed through management channels at the other agencies before it is made available to DOS. While this information is useful, it does not sufficiently indicate for the CMs where the banks are planning to focus their future activities. In other words, the CMs do not have an adequate understanding of a bank’s planned strategic initiatives, which is a key element in assessing risks to the insurance funds and the sufficiency of the funds to cover such risks. Having access to current and complete information is especially critical today when trying to gauge risk in a financial institution because of the speed with which shifts in investment focus can occur and electronic transactions can take place.

Case manager comments regarding their sources of information relative to large banks were consistent with what we were told 2 years ago. There are still two primary sources of information that the CMs use to monitor bank activities and the corresponding risks that they present. The first source is information that is available to the general public: quarterly and annual bank financial statements filed with the Securities and Exchange Commission, press releases, newspapers and periodicals, and the Internet, which includes news stories, stock quotes/analyses, and reports from investment brokers. The second source is information provided by the PFR. Information routinely received from the PFR includes reports related to examination activities and assessments of risk in the institutions and a variety of quarterly and year-end financial reports prepared by the banks. In addition to containing material that is typically several months old, many information products the CMs receive or have access to are filtered since they are synopsized or interpreted by the PFR before they are made available to DOS. Such materials include, for example, summaries of meetings between examiners and bank managers and reports related to examination activities. Case managers also have access to examination-related data that are maintained on information systems developed by the OCC, the Supervisory Monitoring System, and by the FRB, the Bank Online National Database.

One of the most sensitive and important matters covered in our review is the issue of the FDIC’s presence in meetings between bank management and the primary federal regulator, meetings at which a bank’s examination findings and/or a bank’s plans to engage in new strategic initiatives are discussed. Attending such meetings provides the FDIC with the most effective and real-time means by which to evaluate insurance risks and is more effective than reading meeting summaries several weeks or months after meetings occur. DOS managers stated that the FRB and OTS are generally receptive to FDIC attendance at various management meetings. In the case of the OCC, however, little if any progress has been achieved since the issuance of our memorandum in October 1999. Specifically, the OCC still does not allow DOS examiners to attend meetings with bank management, other than meetings where basic information is also being made available to the public. Thus, for the 17 largest national banks and most national banks in general, FDIC representatives are not being afforded the opportunity to observe discussions relating to emerging risks, supervisory concerns, or new initiatives and management plans. We did not meet with OCC officials to discuss this issue.

During our conversation with one case manager, we were told of a situation that seems to exemplify the reluctance and increased concern that OCC’s Washington officials apparently have regarding FDIC participation in OCC examinations compared to the examiners-in-charge who are located in the OCC’s District Offices. During a meeting in Washington that was attended by DOS CMs, an OCC executive informed the CMs that it was permissible for them to work with their OCC counterparts in the regions to arrange for participation in examinations and meetings with bank management. He stressed that this process was to be used on an infrequent basis. Following the conference, a DOS case manager discussed the proposal with his OCC counterpart and they agreed that it would be beneficial for the FDIC to assist the OCC in an upcoming examination that targeted middle market lending. (Note: Middle market lending consists of commercial loans to companies with sales ranging from $50 million and up and lending relationships in the $5 million and higher range.) They decided that one FDIC examiner would accompany the OCC to assist in loan review. An examination was starting within a month at another large national bank that was under the domain of the same OCC examiner. The case manager inquired if the FDIC could send the same FDIC examiner to that bank as well to assist in the targeted review of structured finance. (Note: Structured finance relationships are a combination of cash-flow based structures and conventional asset-based loans used to finance mergers and acquisitions, business recapitalizations, and business expansions. They are characterized by a degree of financial leverage that significantly exceeds industry norms as measured by various debt, cash flow, or other ratios.) Both parties agreed to the proposal. After the FDIC examiner arrived at the first institution and worked approximately 3 days, the FDIC case manager received a call from his OCC counterpart notifying him that the FDIC’s participation in the bank examination was to terminate immediately. No explanation was provided other than that this decision came from the OCC’s Washington office and not from the OCC examiner in charge. The FDIC’s participation in the next examination was also canceled.

A DOS executive told us that while the OCC has no written policies prohibiting FDIC attendance at meetings in large banks, OCC managers have verbally indicated that unless a bank is troubled, they will not invite the FDIC to attend meetings. DOS further asserted that sitting in on meetings for the purpose of becoming better informed of a bank’s activities is not permitted by the OCC. In a memorandum to the former FDIC Chairman dated May 25, 1999, the DOS Director stated that a DOS Associate Director had been informed by a senior OCC official that OCC examiners have been specifically instructed not to invite FDIC examiners to attend quarterly meetings with bank management and to turn down requests for attendance made by the FDIC. Our conversations with many DOS case managers confirmed that they have been told that they are not welcome to attend OCC meetings with large banks. On December 16, 1999, the DOS Director and the Director, Division of Insurance, signed a memorandum to The Chairman’s Working Group that presented their position regarding the importance of allowing DOS representatives to attend meetings between bankers and their primary federal regulator. (Note: A group formed by former Chairman Tanoue to address corporate operational and policy issues. Group membership included the Directors of Supervision, Insurance, and Research and Statistics, as well as the Corporation’s General Counsel and Chief Operating Officer.) The memorandum stated in part:

It is undisputed that a regulator can learn more, and therefore better understand the practices of an insured financial institution, by listening to bank management’s presentations, ideas, strategic plans, and responses to the PFR. It also is undisputed that regulators must understand the practices and policies of bank management, at all levels, to adequately assess the company’s risk to the deposit insurance fund. A common response by the PFR to the concept of FDIC presence at management meetings is to suggest that its examiners can effectively relay such discussions and presentations to the FDIC. We disagree. It is simply human nature to filter information and to relay information based on the presenter’s value structure. In other words, the FDIC loses the ability to determine what is important or not important when such information is conveyed by a third party. Moreover, we may occasionally have information needs that are not identical to the PFR (for example, there may be times that we need to focus more on the insurance funds’ risk to systemic issues than a specific bank only issue). Given the size, complexity, and speed upon which these entities move, FDIC presence is critical for complete and real time understanding of the institution, and allows us to better assess its risk to the deposit insurance fund, without adding any regulatory burden.

The second point we would like to discuss is the role we would play at such meetings. As stated earlier, our premise is that we must hear, firsthand, the ideas and strategies of management. Concurrent with that premise, our role at these meetings could be limited mostly to an observation capacity; provided that we would not be totally mute if a few points of clarification were needed. Otherwise, we would commit to discuss any areas of concern or need for clarification with the PFR after any such meetings so as not to usurp its relationship with bank management. The PFR has expressed concern that FDIC presence at such meetings could stifle open communication. While we disagree with that assertion, as FDIC presence became routine such concerns would cease to be an issue. We all play a critical role in the banking sector and, we believe, principals of all the agencies support the free flow of communication between and among insured banks and the banking agencies. Bankers are aware of that as well.

According to DOS management, there have been numerous examples where the FDIC has participated in management meetings, without incident, at large banks supervised by FRB and OTS. Further, senior management officials of these large banking companies are receptive to the Corporation’s presence and understand the FDIC’s mission as deposit insurer. DOS believes that attending such meetings has greatly improved the Division’s risk assessment capability.

We agree with DOS’s assertion that the FDIC’s presence in meetings between the regulators and bank management does not represent an increase in regulatory burden, and that as the insurer, the FDIC should attend such meetings. As we mentioned previously, DOS personnel are already attending such meetings with the FRB and OTS, and only the OCC seems to be resisting a more open climate of information sharing.

The FDIC’s attendance at meetings may not necessarily provide DOS’s CMs with the level of knowledge they will need to fully understand the risks posed by the largest and most complex banks, and a more complete grasp of megabank activities may only be achieved through an expanded commitment of DOS’s staffing resources. Under the current case manager program, a single case manager may be responsible for simultaneously monitoring three megabanks. This equates to one-third of one person attempting to assess the risks in a bank where the PFR may have committed as many as 30 or more examiners on a full-time basis.

Because of the limitations under which case managers must operate, as discussed above, the FDIC will need to continue to pursue new ways to carry out its responsibilities, such as arranging for DOS personnel to be onsite at selected megabanks with the other PFRs. We understand that there is probably no single strategy that will meet all of the FDIC’s information needs for each of the large institutions it monitors and that DOS’s effectiveness in monitoring large banks supervised by the other PFRs may evolve over time along a variety of approaches.

In our 1999 memorandum, we suggested to the former Chairman that in order for the FDIC to attain a higher level of understanding of the risks posed by the megabanks, she needed to direct the highest levels of corporate management to develop information sharing agreements with the other PFRs. Such an agreement would especially be needed with the OCC, because the numerous megabanks it supervises are centrally managed from Washington (see Appendix II, Table 3). The OCC has since verbally agreed to allow DOS to review examination workpapers. When we issued our draft report to DOS for comment, no other formal agreements had been entered into with the other regulators. However, on January 29, 2002, the FDIC’s Board of Directors approved an agreement developed by the FDIC and the other regulators that establishes an FDIC examiner program at the eight largest megabanks and provides the Corporation with more autonomy to conduct exams in non-FDIC supervised institutions. The agreement is discussed in greater detail in the last section of this report, Corporation Comments and OIG Evaluation.

An outcome of the conditions under which the CMs are currently operating is that DOS does not always have a comprehensive up-to-date understanding of the emerging risks that may be developing in some of the largest banks in the country – those banks that present the greatest insurance risk. Effective supervision of the largest financial institutions, some with worldwide operations, requires continual monitoring and the commitment of extensive resources on the part of the OCC, FRB, and, to a lesser extent, OTS. Although the FDIC is not the PFR for most of the megabanks, it would be called on to deal with the failure of a megabank and the financial consequences. Thus, the Corporation has a compelling need to become more familiar with the activities of these institutions and with the current development of potential risks. Because the FDIC does not have the resources to duplicate the efforts of the other regulators and because such efforts would be disruptive to insured institutions, the Corporation must develop closer ties to its regulatory counterparts, particularly the OCC, and continue its efforts to obtain real-time information relative to megabank financial activities and initiatives. We are, therefore, reaffirming the position we expressed during our prior review and making a formal recommendation to address this matter.

We recommend that the Director, DOS:

3. Work to develop agreements with the other bank regulatory agencies to provide the FDIC with the timely information and access to megabanks necessary to carry out the Corporation’s responsibilities as the insurer.

CORPORATION COMMENTS AND OIG EVALUATION

On January 29, 2002, the DOS Director provided a written response to the recommendations contained in the draft report. The DOS Director agreed with the report’s three recommendations and his response is presented in Appendix V of this report.

Following the failure of Superior Bank, FSB, in July 2001, the FDIC, OCC, FRB, and OTS formed a committee (Committee) and developed a proposal to address factors that have restricted the FDIC’s special examination authority and the Corporation’s concerns relative to information sharing. On January 29, 2002, the FDIC’s Board of Directors acted on the Committee’s proposal by authorizing an expanded delegation of authority to grant the FDIC more autonomy in terms of examining banks that pose a heightened risk to the deposit insurance funds. Under the delegation, DOS will be able to authorize special examination activities at banks with a composite rating of 3, 4, or 5, or at banks that are undercapitalized as defined under Prompt Corrective Action, without having to obtain the approval of the primary federal regulator. (Note: Part 325 of the FDIC Rules and Regulations, 12 CFR section 325.101, et. seq, implements section 38 of the FDI Act, 12 USC section 1831(o), by establishing a framework for taking prompt supervisory actions against insured nonmember banks that are not adequately capitalized.) The new delegation also provides for the creation of a dedicated FDIC examiner program at the eight largest megabanks and is intended to provide more timely access to information related to those banks.

Prior to the issuance of this report, we had an opportunity to review the draft interagency proposal and discuss it with DOS management. We commended the Corporation’s effort to address past problems in gaining access to and information on institutions for which the FDIC is not the primary federal regulator. We also expressed several concerns related to limitations the language of the agreement may place on the FDIC’s statutory authority to independently assess risks to the deposit insurance funds.

We recommended in this report that the FDIC pursue a legislative change that would vest special examination authority in the FDIC Chairman. We believe this is the best approach to resolving problems related to the Corporation’s special examination authority because any agreement is subject to interpretation and varying degrees of support when there is change among the leadership of the four federal banking agencies. The DOS Director stated in his response that DOS agrees with the recommendation and that revising Section 10(b)(3) of the FDI Act would achieve a more permanent solution to inefficiencies related to the FDIC’s use of special examination authority. As a result, the Director stated that DOS has included amending Section 10(b)(3) in its Legislative Priorities list for 2002. The decision as to whether the FDIC pursues a legislative solution rests with the Chairman.

Recommendations 1, 2 and 3 will remain undispositioned and open until we have determined that corrective actions have been completed and are effective.

SCOPE AND METHODOLOGY

This is a follow-up review of DOS’s efforts to monitor risk at insured institutions for which the FDIC is not the primary federal regulator. The objective of this review was to assess the progress that the FDIC has made since our previous review and to make recommendations that might improve the Corporation’s effectiveness in working with the other federal regulators.

Our audit work included reviewing and analyzing monthly reports prepared by DOS and presented to the FDIC Board detailing instances where DOS had carried out special examination activities derived from Section 10(b) of the Federal Deposit Insurance Act. We reviewed DOS’s nationwide special examination activities for the 17-month period ending February 28, 2001. We also identified, by regulator, those financial institutions with $25 billion or more in total assets. We visited DOS’s Atlanta, Chicago, and New York Regional Offices and interviewed Regional Directors, Deputy Regional Directors, Assistant Regional Directors, and Case Managers. We also interviewed DOS officials in Washington. We reviewed policies, procedures, Regional Director Memoranda, and documents related to the closing of Superior Bank, FSB, Hinsdale, Illinois, on July 27, 2001. In addition, we contacted the DOS Regional Directors in Boston, Dallas, Kansas City, Memphis, and San Francisco to inquire about the cooperation received from the other federal regulators. Our analysis of cases those offices reported to us included a review of supporting documentation submitted by DOS.

As the Office of Inspector General for the FDIC, we reviewed the issues addressed in this report solely from the perspective of the FDIC in its efforts to effectively carry out its mission. We, therefore, did not hold discussions or solicit the opinions of FRB, OCC, or OTS officials regarding any of the matters addressed in this report, nor did we collect or review documents from these organizations.

Table 3: National Megabanks Regulated by the OCC as of 3/31/01 (000s Omitted)

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01 and FDIC Institution List

Table 4: State Member Megabanks Regulated by the FRB as of 3/31/01 (000s omitted)

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01 and FDIC Institution List

Table 5: Thrift Megabanks Regulated by the OTS as of 3/31/01 (000s omitted)

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01 and FDIC Institution List

Table 6: State Non-Member Megabanks Regulated by the FDIC as of 3/31/01 (000s omitted)

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01 and FDIC Institution List

Table 7: Comparison of Megabanks According to Primary Federal Regulator as of 3/31/01 (000s omitted)

Source: OIG Analysis from DOS Large Insured Depository Institution Report as of 3/31/01and FDIC Institution List

INSURANCE FUND LOSS RATES

The FDIC maintains statistical information regarding the losses incurred by the deposit insurance funds resulting from the failure of insured institutions. The total estimated losses as a percentage of the institutions’ total assets (loss rate) are detailed below.

Table 8: Estimated Loss Rates for All Failed Insured Depository Institutions for the Past 5, 10, and 15 Years

Source: OIG Analysis from DOF’s Failed Bank Cost Analysis 1986-2000

The loss rate percentage for the 5-year period is more than five times the loss rate for the 10-year period due to costly failures that were incurred in 1998 and 1999.

If the deposit insurance funds incur additional losses, all insured depository institutions could be required to begin paying insurance premiums. As of September 30, 2001, losses of approximately $1.8 billion against the BIF and approximately $1.1 billion against the SAIF would be sufficient to trigger insurance premiums for all institutions covered by the respective fund. Using the loss rates in the above table, we calculated the size of the financial institution or combination of institutions that would cause the BIF or SAIF to fall below the reserve ratio as shown in the tables below.

Table 9: Dollar Size of Insured Depository Institution(s) that Would Cause the BIF to Fall Below the Minimum 1.25% ($ in billions)

Source: OIG Analysis from DOF’s Failed Bank Cost Analysis 1986-2000

Table 10: Dollar Size of Insured Depository Institution(s) that Would Cause the SAIF to Fall Below the Minimum 1.25% ($ in billions)

Source: OIG Analysis from DOF’s Failed Bank Cost Analysis 1986-2000

LEGISLATIVE AND REGULATORY HISTORY

The FDIC’s special insurance examination authority is derived from Section 10(b)(3) of the Federal Deposit Insurance Act. However, under current delegated authority within FDIC, DOS examiners do not have the authority to perform an independent on-site evaluation of a bank's activities, even if the bank is in a troubled condition, without the approval of the bank’s primary federal regulator or the FDIC Board of Directors.

With the addition of Section 10(b)(3) to the FDI Act in 1950, the Board of Directors of the FDIC was granted the unilateral authority it has today to examine any insured bank for insurance purposes without concurrence by the other federal or state regulators. This subsection, entitled Special Examination of Any Insured Depository Institution, provides that FDIC examiners shall have power, on behalf of the Corporation, to make any special examination of any insured depository institution whenever the Board of Directors determines a special examination of any such depository institution is necessary to determine the condition of such depository institution for insurance purposes. The FDIC supported the addition of this authority to the FDI Act because, prior to that time, the FDIC’s only access to information concerning banks for which it was not the primary regulator was through the primary federal regulator. The FDIC believed this authority was necessary to discharge its role as deposit insurer. Congress agreed, despite objection, that the special examination power could result in duplicative and burdensome examinations.

In 1982, the Board authorized the Division of Bank Supervision (DBS, now DOS) to assign FDIC examiners to participate in the examination of a national or state member bank when invited by the OCC or the Federal Reserve, respectively, and to negotiate with the OCC and the FRB on the "triggering points" for the issuance of such invitations. Subsequently, on December 23, 1983 the FDIC Board of Directors authorized FDIC examiners to participate in the examination of national banks, pursuant to certain terms and conditions contained in the "Cooperative Examination Program" agreed to by the OCC Senior Deputy for Bank Supervision and the FDIC Director of DBS as of December 2, 1983.

In August 1989, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), created the Savings Association Insurance Fund and extended the FDIC’s special examination authority to cover insured savings associations. In connection with these changes, the FDIC Board of Directors delegated authority to the DOS Director to: (1) initiate an examination or special examination of any insured savings association to determine its condition for insurance purposes and (2) work toward establishing a cooperative examination program with the OTS for insured savings associations. During 1989 and 1990, the FDIC examined many federally chartered savings and loan associations pursuant to a directive from then FDIC Chairman William Seidman.

The enactment of FIRREA also caused the composition of the FDIC Board of Directors to be increased from 3 to 5 members. The FDIC Vice Chairman and the Director of the Office of Thrift Supervision were added to the Board, joining the FDIC Chairman, the FDIC Director, and the Comptroller of the Currency.

In 1993, the FDIC Board of Directors rescinded the earlier delegations of special examination authority unless extraordinary threats to a deposit insurance fund could be demonstrated. Any such examination would require Board approval. At the time the earlier delegation was rescinded, the FDIC Board was comprised of the Acting Chairman, the Acting Director of OTS, and the Comptroller of the Currency.

In March 1995, the FDIC Board of Directors delegated authority to the FDIC Director of DOS to approve special examinations: (1) when the primary federal regulator has invited FDIC participation, (2) for institutions rated CAMELS 4 or 5 or situations of potential or likely failure of an institution within a 1-year time frame and when the primary federal regulator does not object to FDIC’s participation, and (3) for examination activities where there are material deteriorating conditions not reflected in an institution’s current CAMELS rating and when the primary federal regulator does not object to FDIC’s participation. In all other cases, DOS is required to prepare a case for presentation to the FDIC Board that is sufficient to justify FDIC participation over the objection of the primary federal regulator.

APPENDIX V

Federal Deposit Insurance Corporation
550 17th Street NW, Washington, DC 20429
Division of Supervision

January 25, 2002

TO: Stephen M. Beard, Deputy Assistant Inspector General, Office of the Inspector General

FROM: Michael J. Zamorski, Director [Electronically produced version; original signed by Michael J. Zamorski], Division of Supervision

SUBJECT: Draft Report on the FDIC's Use of Special Examination Authority and the Division of Supervision’s Efforts to Monitor Large Bank Insurance Risks

The Division of Supervision (DOS) appreciates the opportunity to respond to this draft report. We share your concerns regarding the current limitations on the FDIC’s use of Special Examination Authority, and we agree that these limitations restrict the FDIC’s ability to assess emerging risks to the deposit insurance fund in a timely and efficient manner. Shortly after the Superior Bank, FSB, failure in July 2001, the FDIC, Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), and Federal Reserve Board (FRB) formed a committee (Committee) to address the FDIC’s special examination authority and supervisory information sharing. The Committee is finalizing a proposal that addresses these issues. The proposal will allow the FDIC greater flexibility in conducting timely assessments of insured depository institutions (IDI) that present heightened risk to the deposit insurance funds. Under the proposed program, the FDIC Board of Directors would delegate special examination authority for institutions presenting heightened risk to the deposit insurance funds to DOS. The Committee’s proposal also addresses OIG concerns regarding FDIC access to megabanks and acquisition of timely information about those banks. The proposal establishes a dedicated FDIC examiner program for the eight largest institutions, and it sets forth protocols on enhanced information sharing that will allow more efficient and comprehensive analysis of large (megabanks) and small IDIs alike. The Committee’s proposals will be presented to the Board on January 29, 2002.

Recommendations Concerning Special Examination Authority:

Pursue an amendment to Section 10(b)(3) of the FDI Act (12 U.S.C. section 1820(b)(3)) to vest special examination authority with the FDIC Chairman in consultation with the appropriate primary federal regulator.

We agree with this recommendation. The proposed program (discussed in detail below) addresses OIG concerns regarding the FDIC’s special examination authority; nonetheless, a revision of Section 10(b)(3) of the FDI Act would achieve a more permanent solution to inefficiencies related to the FDIC’s use of special examination authority. In that light, we have already included amending 10(b)(3) in our Legislative Priorities list for 2002. The Chairman will decide whether the FDIC pursues a legislative solution to this problem.

Seek a revised Board delegation that vests special examination authority with the FDIC Chairman in consultation with the appropriate primary federal regulator, as an interim measure pending a legislative amendment.

We agree with this recommendation. As stated previously, a committee comprised of representatives of the FDIC, OTS, OCC, and FRB are in the final stages of developing special examination program that will, among other things, grant the FDIC more autonomy in terms of examining banks that pose a heightened risk to the deposit insurance fund. If the Board approves the Committee’s proposal, responsibility for authorizing special examination activities at banks that pose heightened risk to the deposit insurance fund will be delegated to the Division of Supervision. Institutions that pose heightened risk to the deposit insurance funds will include IDIs with a composite rating of 3, 4, or 5; and IDI’s that are undercapitalized as defined under Prompt Corrective Action.

Under the proposed program, the FDIC will be required to ask the primary federal regulator (PFR) if it can participate in examinations of IDIs rated 1 or 2 that are exhibiting material deteriorating conditions or other adverse developments. If the agencies (PFR and FDIC) cannot agree as to whether the FDIC should be allowed to participate in an examination, the two agencies’ Representatives to the FFIEC Supervision Task Force will determine whether such a material deteriorating condition or adverse development exists. In the event the two representatives cannot agree, the Chairman of the FDIC and the principal of the relevant agency (or the Governor that is a member of the FFIEC in the case of the FRB) will determine whether FDIC participation is warranted. The FDIC will not prepare a separate report of examination for these activities except in situations where it anticipates an enforcement action.

The Committee’s proposal will be presented to the Board on January 29, 2002.

Recommendation Concerning the FDIC’s Efforts to Monitor Large Bank Insurance Risks:

Work to develop agreements with the other bank regulatory agencies to provide the FDIC with the timely information and access to megabanks necessary to carry out the Corporation’s responsibilities as the insurer.

We agree with this recommendation, and the Committee’s proposal will ensure that the OCC, OTS, and FRB provide the FDIC with the information and access that it needs to carry out its role as insurer. As discussed previously, the Committee’s proposal will create a dedicated FDIC examiner program at the eight largest megabanks and ensure more timely access to relevant information related to those and other banks. The dedicated examiner program will work within existing supervisory programs of the appropriate agencies in order to avoid any increase in regulatory burden or duplication of effort. The proposal requires supervisory personnel of the primary federal regulator (PFR) to keep the FDIC’s dedicated examiner informed of all material developments in the supervision of the institution. The proposal also requires the PFR to invite the dedicated examiner to observe and participate in certain examination activities to ensure the FDIC has an understanding of the supervisory issues and risk management structure of the institution.

The dedicated FDIC examiner will be allowed to participate in selected supervisory reviews, including meetings with bank management relating to those reviews, if the relevant agency agrees that participation by the FDIC is necessary to evaluating the risk a particular activity poses to the deposit insurance fund. In the event the agencies’ staffs cannot agree, the respective agencies’ representatives to the FFIEC Supervision Task Force will determine whether FDIC participation is appropriate. In the event the two representatives cannot agree, the Chairman of the FDIC and the principal of the relevant Agency (or the governor that is a member of the FFIEC in the case of the FRB) will resolve the dispute.

The proposal will also require the OCC, OTS, and FRB to share relevant supervisory information related to large insured depository institutions with the FDIC. In addition, the Program will mandate quarterly meetings between the agencies to discuss the risk profile, current condition, and status of identified supervisory matters at large IDIs. The Program also requires FDIC participation of credits within the Shared National Credit Program in Large IDIs.

The Committee’s proposals regarding the monitoring of large bank insurance risks will be presented to the Board on January 29, 2002.

Federal Deposit Insurance Corporation
Office of Audits
Office of Inspector General
Washington, D.C. 20434

DATE: November 6, 2002

TO: Donald E. Powell, Chairman

FROM: Gaston L. Gianni, Jr. [Electronically produced version; original signed by Gaston L. Gianni], Inspector General

SUBJECT: OCC’s and OTS’s Responses to the OIG’s February 2002 Follow-Up Report on the FDIC’s Use of Special Examination Authority and DOS’s Efforts to Monitor Large Bank Insurance Risks (Audit Report No. 02-004) (Audit Report No. 03-004)

This report (No. 03-004) responds to comments that we received from the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) on our audit report entitled, Follow-Up Audit of the FDIC’s Use of Special Examination Authority and DOS’s Efforts to Monitor Large Bank Insurance Risks (Audit Report No. 02-004, dated February 20, 2002). The comments were provided in letters to the FDIC Chairman from the Comptroller of the Currency and the Director of OTS following the issuance of our report. (Note: The OCC’s letter was dated May 30, 2002, and the OTS’s letter was dated June 13, 2002.) The OCC and the OTS letters to the Chairman are presented in their entirety as Appendixes I and II. These appendixes also present our views and comments on a number of specific points that the OCC and the OTS raised relative to our February 2002 report.

BACKGROUND

In a memorandum to the FDIC Chairman in October 1999, we reported the results of a study we conducted of the Division of Supervision’s (DOS) efforts to monitor and assess risks at insured institutions for which the Federal Deposit Insurance Corporation (FDIC) is not the primary federal regulator (PFR). (Note: As part of an FDIC reorganization implemented on June 30, 2002, the Division of Supervision (DOS) merged with the Division of Compliance and Consumer Affairs (DCA) and was renamed the Division of Supervision and Consumer Protection (DSC). In most cases throughout the report, we refer to this Division as DOS. A bank’s primary federal regulator is determined by the bank’s charter and whether a bank is a member of the Federal Reserve System. The FDIC is the primary federal regulator for state-chartered banks that are not members of the Federal Reserve System. The OCC is the primary federal regulator for all national banks. The Board of Governors of the Federal Reserve System (FRB) is the primary federal regulator for state chartered banks that are members of the Federal Reserve System. The OTS is the primary federal regulator for federal and state-chartered savings associations.) We reported that other federal regulators had in several instances restricted the FDIC’s efforts to participate in safety and soundness examinations at institutions for which the Corporation is not the PFR. Such restrictions had limited the FDIC’s ability to assess risks to the deposit insurance funds. We also reported that because of limitations in the information routinely provided to DOS by the other regulators pertaining to the nation’s largest banks, DOS may not be able to adequately assess the risks that the country’s largest non-FDIC supervised banks pose to the insurance funds. In our 1999 memorandum, we suggested that the Chairman (1) request delegated authority from the FDIC Board of Directors to initiate special examinations without having to secure the concurrence of the primary federal regulator or the approval of the Board or (2) seek a legislative change to vest this authority in the Chairman. (Note: Th