EXAMINATIONS AND INSPECTIONS—Of State Member Banks

The purpose of this letter is to make revisions to the Federal Reserve’s frequency guidelines for safety-and-soundness examinations of state member banks (S-2493, October 7, 1985 at 3-1531). The revisions are being made in part to ensure that the text of the Federal Reserve’s examination guidelines is fully consistent with existing practice and with the provisions of section 10 of the Federal Deposit Insurance Act as amended by section 111 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). In addition, the Board has decided to adopt certain other revisions that were recommended by Reserve Bank and Board staff as a result of their review of the effectiveness, efficiency, and consistency of System examination policies and practices (the Consistency Project).

Section 111 of FDICIA requires that the appropriate federal banking or thrift agency conduct a full-scope, on-site examination of federally insured depository institutions under its jurisdiction at least once during each 12-month period. An exception to this requirement is allowed for well-capitalized, well-managed, CAMEL 1-rated institutions with total assets of less than $100 million and no change in control. Such institutions are required to be examined at least once during each 18-month period. In addition, section 111 provides for—

The Federal Reserve’s long-standing examination frequency guidelines, which were promulgated in 1985, generally conform to the specifications of section 111. They require annual, full-scope, on-site safety-and-soundness examinations of all state member banks. Also, under the Alternate Year Examination Program (AEP), the substitution of examinations by state agencies for Federal Reserve examinations is permitted in the case of all but large or troubled state member banks (state member banks with total assets in excess of $10 billion or those rated less than satisfactory). Moreover, the current guidelines specify that, in the case of state member banks with total assets between $500 million and $10 billion, a state examination can be substituted for a Federal Reserve examination on an every-other-year basis.

The text of the existing guidelines differs in some respects from the specifications of FDICIA, although Reserve Bank practice regarding frequency of examinations complies with the provisions of section 111. Specifically, the 1985 guidelines allow examinations by a state agency to be substituted for a Federal Reserve examination in three out of every four years for state member banks with total assets of less than $100 million and in two out of three years for state member banks with total assets between $100 million and $500 million. In addition, a precise definition of what is meant by an annual examination is not provided in the existing guidelines.

The purpose of this letter is to bring the text of the System’s guidelines into full conformance with current practice and with FDICIA. At the same time, the Board, taking into account recommendations developed during the Consistency Project, has decided to make certain other revisions in the guidelines. Changes and refinements to the Board’s existing safety-and-soundness examination frequency guidelines, to accomplish these goals, are specified in the following sections of this letter.

Under the current frequency guidelines, state member banks rated CAMEL 1 or 2 with assets below $500 million qualify for AEPs. That is, the annual safety-and-soundness examination requirements can be met by a combination of state and Federal Reserve examinations, with Federal Reserve examinations conducted less often than every other year.

Given the requirements of FDICIA, the use of AEP arrangements for meeting the safety-and-soundness examination frequency requirements must be limited to those in which examinations are conducted by the Federal Reserve, either independently or jointly with a state agency, no less frequently than every other 12-month period (or 18-month period in the case of well-capitalized, well-managed, CAMEL 1-rated institutions with total assets of less than $100 million and no change in control). AEP arrangements that involve less frequent Federal Reserve examinations should be discontinued. In addition, state examinations conducted under an AEP should meet the general requirements outlined below for AEP arrangements.

Under the 1985 guidelines, state member banks in this category qualify for the Federal Reserve’s AEP. In view of the risk posed by these institutions to the financial system and to the deposit insurance fund because of their size and complexity, it is essential, in today’s rapidly changing, intensely competitive banking environment, to ensure an especially close degree of Federal Reserve/state cooperation in the examination of these institutions.

Consequently, the Board has decided, in the case of state member banks with total assets between $1 billion and $10 billion, to strongly encourage annual Federal Reserve examinations for safety and soundness, conducted either jointly with a state agency or independently. At the same time, if a state banking department indicates a preference to conduct independent examinations on an every-other-year basis, the Reserve Bank may, in keeping with the Federal Reserve’s desire to cooperate with state banking departments, agree to that arrangement on condition that there will be a Federal Reserve presence during the conduct of the state’s on-site examination.

For state member banks with assets between $500 million and less than $1 billion examined under the AEP, there should be a Federal Reserve examiner presence during the alternate-year, state-agency examination. Reserve Banks may, however, on a case-by-case basis choose not to provide this examiner presence, if the individual circumstances of the organization being examined would indicate that an independent examination by the state is consistent with the full-scope requirement of the Federal Reserve. In addition, reports of examination conducted under this procedure should be reviewed by Reserve Bank personnel to ensure their conformance with the full-scope requirement.

The Federal Reserve presence described above is intended to be limited and is not meant to duplicate or interfere with any aspect of the examination being conducted by the state. Moreover, the Federal Reserve presence can take many forms. For example, involvement at the close-out meeting or an on-site presence during certain aspects of the examination may suffice depending on the circumstances of the individual institution under review. In addition, Reserve Banks should be willing to accommodate reasonable requests by state banking agencies for a similar presence during examinations conducted by the Federal Reserve.

The Board is making no change from the current policy that requires an annual full-scope examination and presumes an additional targeted examination during the year, if necessary, or other supervisory efforts to stay fully informed of the condition of the institution. These examinations should still be conducted under the current requirements of either a joint Federal Reserve and state examination or an independent Federal Reserve examination.

The Board is making no change from the current practice that requires an annual full-scope examination and an additional targeted examination during the year for institutions in a deteriorating condition. Stable or improving institutions should have an additional targeted examination, if necessary, or other supervisory efforts to stay fully informed of the condition of the institution. These examinations should still be conducted under the current requirements of either a joint Federal Reserve and state examination or an independent Federal Reserve examination.

Current provisions require a semiannual examination, with one full-scope, on-site safety-and-soundness examination and one targeted or limited-scope examination. At least one of these examinations is required to be a Federal Reserve or joint examination with the state supervisors. Given the nature of the concerns regarding these institutions, the frequency guidelines are revised to presume that the Federal Reserve will conduct, either jointly with the state banking department or independently, the full-scope, on-site safety-and-soundness examination.

In considering AEP arrangements for any state member bank, it is necessary for Reserve Banks to ensure that all examinations conducted under an AEP comply with the requirements of a full-scope, on-site examination at the federal level. Reserve Banks should ensure that state banking departments are both willing and able to perform the procedures necessary to meet the requirements of a full-scope examination, including a review of the bank’s compliance with relevant laws and regulations related to safety and soundness. Reserve Banks have the discretion to accept independent state examinations to fulfill the federal frequency requirement, even if the scope of the state’s review of federal laws and regulations differs to some extent from that of the Federal Reserve, provided the most recent Federal Reserve examination and other supervisory information indicates that the bank is considered well managed and has satisfactory management systems and controls in place to ensure compliance with all relevant federal laws and regulations and that, in the Reserve Bank’s judgement, these systems and controls are fully effective.

Should the state banking department be unable to carry out a full-scope examination, it will be incumbent on the Reserve Bank to either provide additional examiners to carry out those elements of a full-scope examination not conducted by the state’s examiners or, alternately, complete the requirements in a separate examination.

In order to fulfill FDICIA’s requirement that each federally insured depository institution must be examined at least once in every 12- or 18-month period, a precise definition of what constitutes a 12-/18-month period between examinations is needed for scheduling examinations. For this purpose, a 12-/18-month period is defined as extending from the closing date of an examination to the opening date of the next examination. The opening date is the day the examination commences, rather than the financial statement as-of date; the closing date is either the day a report of examination is mailed to an institution’s board of directors or 60 calendar days from the opening date of that examination, whichever comes first.

The Board is also discontinuing the use of limited-scope examinations for the second on-site presence in troubled institutions. In keeping with current practice, the Board has determined that targeted examinations (examinations that focus intensively on one or two bank activities) are acceptable for second on-site examinations and are effective in monitoring the problems unique to an individual institution.

Table 1 at 3-1531 provides a summary of the safety-and-soundness examination frequency guidelines as revised by this letter. S-2563; May 20, 1994.