April x, 2010 

Enhancing the Effectiveness of Supervision

Introduction

 The crisis that gripped the U.S. and global financial systems starting in the summer of 

2007 has abated in recent months, but many of its effects--ranging from high unemployment to 

tighter credit for households and businesses--will linger for some time to come. These economic 

strains have driven home the critical link between the health of the broader economy and the 

stability of the financial system; it is imperative that governments and financial regulators 

worldwide carefully evaluate the causes of this crisis and make the changes necessary to mitigate 

the risk of such episodes in the future. Our systems of regulation and oversight must be 

strengthened, and the forces that led to the nearly complete breakdown in market discipline that 

was exposed by the crisis must be addressed.

 The Federal Reserve strongly supports the ongoing efforts of the Congress and the 

administration to achieve comprehensive financial regulatory reform. For its part, the Federal 

Reserve has been conducting a comprehensive evaluation of how it carries out its regulatory and 

supervisory responsibilities and has been actively implementing improvements. The Federal 

Reserve supervises approximately 5,000 bank holding companies--a number of which are large, 

complex and globally active; approximately 850 banking organizations that are state-chartered 

and members of the Federal Reserve System (state member banks); and foreign banking 

organizations operating in the United States. Many other financial institutions--including 

nationally-chartered banks, state non-member banks, thrift institutions, investment banks,

insurance companies, and independent mortgage companies, are overseen by other regulatory 

agencies. 

While the crisis was still ongoing, the Federal Reserve established an internal working 

group comprised of senior officials from the Board of Governors and the Reserve Banks to 

identify key aspects of its supervisory process that needed improvement. This paper presents the 

working group’s findings and describes improvements initiated to date. The focus of this paper 

is safety and soundness supervision, primarily of the large banking organizations which were at 

the center of the crisis. Importantly, though different supervisory issues generally arose for 

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regional and community banks than for large institutions, some of the same challenges were 

present. Informed by efforts to overhaul the supervision of large institutions, the Federal 

Reserve is also strengthening supervision of regional and community banks. 

This paper explores the changes the Federal Reserve is implementing for its oversight of large, 

complex banking organizations, including: 

• Adoption of a macroprudential perspective to complement the traditional focus on individual 

firm safety and soundness, including an evaluation of the linkages across firms and markets 

and other mechanisms that have the potential to amplify both booms and busts. 

• Formalization of a multidisciplinary approach to supervision that more fully exploits the 

Federal Reserve’s considerable analytical expertise in macroeconomics and finance and the 

operation of money and capital markets, as well as in banking supervision and regulation. 

• Enhancing overall surveillance and analysis of large, complex banking organizations, 

including the incorporation of information from a more model-driven “quantitative 

surveillance” program to complement the work of examiners in the field.

• More centralized management of supervision by senior Board and Reserve Bank officials to

better support the timely identification, analysis and mitigation of systemic and firm-specific 

risks at large, complex banks and to ensure individual firms address risks more swiftly and 

consistently. 

The Federal Reserve’s internal efforts to enhance supervision have informed, and been 

informed by, the efforts of domestic and international groups in which the Federal Reserve is a 

leading participant. These groups include the Basel Committee on Bank Supervision, the 

President's Working Group on Financial Markets, the Financial Stability Board, and the Senior 

Supervisors Group.i The Federal Reserve is working with these groups and with other regulatory 

and supervisory agencies to strengthen capital and liquidity standards for all financial 

institutions, but most notably for the largest and most complex. The Federal Reserve has also 

played a leading role in implementing standards to ensure compensation practices focus on 

firms’ long-term financial condition and do not encourage undue risk-taking. 

The Federal Reserve will continue to work internally and with other agencies 

domestically and around the world to ensure rapid progress in improving supervision. But it is 

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important to understand that enhancing supervision, while necessary, is not sufficient to address 

all the issues that were exposed by the recent crisis. Among these issues were: 

• The internal risk-management practices and the corporate governance and oversight by both 

management and boards in many countries, including the United States, were weak or 

ineffective in a number of key financial institutions; 

• Market discipline did little to constrain excessive risk taking at financial institutions or to 

incent borrowers and lenders to price risk accurately and make careful and informed 

decisions 

Additionally, gaps in the overall regulatory framework left the financial system 

susceptible to instability and contagion, with some nonbank financial institutions receiving no 

effective consolidated oversight, and with risks increasing largely unchecked in the so-called 

“shadow banking system,” which operated without regulatory oversight. In its role as the 

consolidated supervisor of bank holding companies, the Federal Reserve was, by statute, 

narrowly focused on the risks posed by the companies’ non-bank subsidiaries to the safety and 

soundness of their bank subsidiaries. And, also by statute, the Federal Reserve was heavily 

reliant on functional supervisors of the bank and regulated nonbank subsidiaries. Those 

functional supervisors, in turn, were statutorily focused only on the safety and soundness or other 

defined aspects of the narrow entities they regulated. The net effect was no federal regulator had 

sufficient authority to effectively supervise all aspects of a holding company’s activities, or to 

identify and mitigate the risks these organizations might pose to the financial system.

All of the underlying factors that contributed to this crisis must be meaningfully 

addressed before Americans can be confident that our nation’s system of financial oversight 

effectively protects them from the economic hardships created by financial instability. 

Enhancing the Federal Reserve’s supervision is one critical step in that process. The rest of the 

paper will focus on efforts underway to complete that step. 

Enhancements to Federal Reserve Supervision

 The working group evaluated Federal Reserve supervision through the prism of riskfocused supervision, an approach developed by all of the federal bank supervisory agencies in 

the 1990s to strengthen the oversight of large financial institutions. The risk-focused supervision 

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framework consists of three critical steps: 1) identification of key risks and vulnerabilities; 2) 

design and execution of appropriate supervisory responses; and 3) effective communication to 

banks’ executive managers and boards of directors about the risks and vulnerabilities facing the 

firms, as well as specific practices that do not meet minimum supervisory expectations, followed 

by a requirement for swift remedial action. 

The working group identified areas for improvement in each of these three steps. These

areas for improvement, along with a consideration of the adequacy of resources devoted to the 

supervisory process, are discussed in Section I. The actions being taken to implement necessary

improvements are discussed in Section II. 

I. Areas for Improvement

Identification of risks and vulnerabilities

Supervision clearly did not adequately identify all of the material risks and vulnerabilities 

facing individual banking organizations or the financial industry as a whole. In particular, 

supervision did not provide a comprehensive picture of large firms’ vulnerability to the 

interaction between some of their most complex activities and changes in financial market and 

economic conditions. Examples of those vulnerabilities included the widespread distribution of 

relatively opaque structured credit products, many of which imbedded poorly underwritten 

mortgage securities, and the funding of these long-term structured products through short-term 

money market vehicles.

Supervisors generally understood many of the challenges associated with the valuation of 

these complex structured products. But they did not adequately understand the risks stemming 

from the growing use of off-balance sheet entities, particularly the increased use of banksponsored or supported short-term money market vehicles to fund senior tranches of asset 

securitizations and re-securitizations. In particular, risk exposures that were thought to have 

been widely dispersed across the financial system through the distribution of credit assets in fact 

were concentrated in the banking system, largely as a result of banks’ direct, indirect, or implicit 

support for the underlying securities and funding vehicles. The end result was that financial 

institutions of all types were more vulnerable to a rapid erosion in market liquidity than was 

recognized. Once housing and mortgage markets began to deteriorate in earnest, counterparty 

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exposures and risks escalated across large financial institutions and liquidity pressures quickly 

spread throughout the financial system. 

Understanding the impact of financial market and economic developments on the health 

and soundness of a banking organization has always been an element of the supervisory process. 

It has been reflected, for example, in the issuance of supervisory guidance for classes of lending 

or practices that suggested the potential for widespread mispricing of risks and vulnerabilities 

across institutions. However, the development of supervisory strategy, and more specifically the 

supervisory plans that guide supervision activities, were geared mostly toward addressing firmspecific risks and did not sufficiently incorporate a broader analysis of potential systemic issues

and risks. 

While supervisors were aware that underwriting standards for residential mortgages were 

progressively weakening, for example, they did not adequately appreciate the potential systemic 

impact of changes in the structure and marketing of residential mortgages, such as no- and lowdocumentation loans, high loan-to-value mortgages, adjustable-rate mortgages with low teaser 

rates, and mortgages underwritten without regard for the borrower’s ability to repay. These 

practices contributed to an unsustainable run up in house prices and to the intensification of the 

subsequent correction in house prices and its attendant effects on the health of the financial 

system. 

 In addition, the growth in the size and complexity of the largest financial institutions, and 

the increased use of complex financial products that generate risks across different legal entities 

and that may not be supervised using the same set of prudential standards, has heightened the 

need for cooperation among supervisors, and for greater clarity about the roles and authorities of 

the various supervisory agencies involved. 

Design and execution of supervisory actions 

In a number of areas, supervision processes quite effectively provided advance 

indications of weaknesses in banks’ risk-management practices that contributed to substantial 

funding and liquidity problems and unexpectedly large losses. For example, before the 

downturn, supervisors raised concerns about progressively weakening underwriting standards 

and the growth of non-traditional residential mortgages and commercial real estate exposures. In 

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addition, supervisors were aware of a variety of other challenges confronting large complex 

firms, including: 

• Weaknesses in management information systems that hindered effective measurement, 

aggregation, and management of risk exposures, on both a business-line and firm-wide basis; 

• Firms’ increasing vulnerability to a decline in asset market liquidity and potential weaknesses 

in their contingency funding plans; 

• The rapid expansion of new and complex business activities without robust risk-management 

and control processes; and,

• The potential for growing concentrations of exposures in certain risky positions (such as 

structured credit products and counterparty credit) that were being masked by the use of 

historical volatility- and sensitivity-based risk measures during an extended benign operating 

environment characterized by historically low market volatility and risk premiums. 

However, while a number of potential concerns were identified, for a variety of reasons 

supervisors did not always adequately address them through in-depth examinations or other 

initiatives. Reasons for this include: 

• Uncertainty about whether the concerns represented a significant potential for generating 

severe problems, particularly given the extended period of strong bank profits, and little 

to no evidence of material losses leading up to the crisis. For example, concerns about 

developments in mortgage markets notwithstanding, many observers saw the odds of a 

rapid and severe deterioration in the U.S. housing and mortgage markets as quite low. 

• Too little attention by supervisors, managers, and boards of directors to some 

fundamental risk-management practices, especially in emerging complex business 

activities. In an apparently benign environment, they did not fully appreciate the growing 

vulnerabilities created by the increasing speed at which shocks could be transmitted 

across the financial system. And neither supervisors nor bank managers gave sufficient 

priority to the identification of low probability events with potentially highly adverse 

outcomes or to mitigating actions that could be taken before such events occurred. 

• Uncertainty over legal authority to conduct examination activities in holding company 

subsidiaries, such as consumer compliance examinations in non-bank mortgage 

subsidiaries. 

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Engagement with firms on identified risks and vulnerabilities 

Even when potentially significant concerns were identified and generally agreed-upon, 

supervisors did not always forcefully communicate their concerns to senior managers and boards 

of directors at supervised institutions. Moreover, supervisors did not always demand swift 

corrective action or hold managers at financial institutions accountable when deficiencies were 

identified and communicated to firms. 

Confidence that market discipline was helping to constrain excessive risk taking 

contributed to delays in correcting fundamental risk-management weaknesses in some cases. In 

addition, a desire to limit regulatory burden on supervised firms raised the bar for determining 

whether issues were important enough to require prompt remediation. When supervisors raised 

concerns, they often met strong resistance from an industry that was earning record profits and 

was seen as expanding household and business access to credit. For example, the industry and 

its supporters strongly criticized supervisors when they preemptively developed guidance on 

commercial real estate and non-traditional mortgages, and the resulting guidance to the industry 

that was issued articulated less rigorous standards than were initially contemplated. 

Leading up to the crisis, changes in supervisory ratings for individual firms often lagged 

observable changes in firms’ risk profiles and financial condition. This was an important lapse. 

Ratings are used for a variety of important purposes, including determining the amount of 

scrutiny a banking organization might receive and the nature of the access a bank has to the 

Federal Reserve’s discount window. Supervisors also use ratings to communicate their views 

and concerns about a firm’s operations, financial condition, and risk management to boards of 

directors and management. A desire to improve their firm’s ratings can strongly incent a bank’s 

managers to address identified weaknesses. 

Sufficiency of supervision resources

The Federal Reserve did not have enough supervisors with expertise in the full range of 

risks facing the industry, especially given the rapid changes in banks’ business activities and in 

financial markets. Cost concerns and compensation limits often constrained efforts to recruit and 

retain expert staff, especially in key technical areas. Subject-matter experts often received 

considerably higher compensation in the private sector. 

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II. Actions Being Taken to Enhance Supervision 

 The Federal Reserve is taking a number of concrete actions to enhance its supervision 

practices. They have been designed to address the following key objectives: 

• Enhancing forward-looking risk identification processes by developing a more 

comprehensive understanding of supervised firms’ key business activities and risks. 

• Improving the identification of interconnections across firms and taking those into account in 

the supervision of individual organizations. 

• Assessing risk exposures and associated risk-management practices across the entire 

organization to better understand the potential impact of correlated risk exposures that may 

reside in distinct business lines as well as different legal entities and regulatory jurisdictions. 

• Putting more emphasis on understanding both firm-specific and broader financial sector 

consequences of particularly adverse events by more systematically using stress testing and 

scenario analyses, as well as cross-firm horizontal reviews. 

• Communicating more clearly and forcefully with supervised firms. 

• Ensuring more timely and consistent application of supervisory ratings and more active use 

of formal and informal enforcement actions. 

• Increasing supervision staff and enhancing its expertise. 

The Federal Reserve is making changes in the supervision of large financial institutions

designed to more consistently and fully draw from its broad range of expertise. Oversight and 

control of Federal Reserve supervision will be more centralized and multidisciplinary. A newlyformed group of senior officials from the Board and the Reserve Banks--representing 

supervision, research, markets, payments and settlement, and consumer compliance--will define 

supervisory priorities and coordinate plans for large financial firms. This group will oversee 

risk-identification processes and will be responsible for ensuring that strengthened surveillance 

and analysis of individual firms, financial markets and the broader economy will result in 

Federal Reserve supervision that appropriately addresses areas of potential concern. 

 In conjunction with these organizational changes, the Federal Reserve is taking a number 

of other concrete actions to enhance the effectiveness of its supervisory process. These actions 

are outlined below. 

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Strengthening surveillance and analysis 

To better address macroprudential issues and to enhance the understanding of important 

developments at the largest firms and the markets in which they operate, surveillance of large 

complex firms is being strengthened through a new program tailored specifically for them. 

Formalized surveillance procedures will encompass analysis of the operating performance, 

financial condition and vulnerabilities of large banks, taking into account the greater complexity 

of these firms and their critical roles in the economy and financial markets. This work will 

explicitly incorporate forward-looking analyses of economic conditions and developments in 

financial markets and will address the implications for the firms’ business activities and 

emerging risks. 

The surveillance and analysis of large financial institutions will be multidisciplinary, 

taking full advantage of the Federal Reserve staff’s expertise in economics, financial markets, 

and payments systems, as well as supervision. This broader perspective will help better identify 

key areas of focus, will inform the planning and execution of supervisory responsibilities, and 

will complement the expertise of supervisory risk specialists and on-site supervisory teams.

Conducting periodic stress testing and scenario analyses across large firms 

The Supervisory Capital Assessment Program (SCAP) in 2009 demonstrated the benefits 

of a simultaneous cross-portfolio horizontal review of a number of major firms--with a critical 

mass of banking system assets and positions--to develop a more complete view of the 

vulnerabilities at individual firms and in the financial system more broadly. 

 Building off of this effort, the Federal Reserve will conduct periodic horizontal reviews 

and stress tests and scenario analyses across the largest firms to identify the potential impact of 

possible adverse changes in the economy and financial markets. As with the SCAP, these efforts 

will be coordinated with and include participation of other federal banking regulatory agencies, 

where applicable. These exercises will serve a number of purposes, including: 

• Identifying firm-specific and financial system vulnerabilities; 

• Developing horizontal perspectives on key risk exposures, risk-management challenges, 

and best practices across the industry that can be used to inform requirements for 

corrective actions where weaknesses exist; 

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• Providing independent estimates of firms’ potential losses and earnings that supervisors 

can use to evaluate both the adequacy of firms’ capital and the firms’ own processes for 

assessing capital adequacy; and

• Informing the more timely development and communication of supervisory standards and 

expectations to address identified areas of concern for which standards may be outdated 

or otherwise insufficient. 

Increasing supervisory emphasis on firms’ internal capital assessment practices 

 The SCAP re-emphasized the importance of rigorous supervisory assessments of capital 

adequacy and highlighted the need for firms to improve their internal capital assessment, 

management and planning so as to maintain a prudent level and composition of capital, even in 

adverse environments. Supervisors are focusing substantial attention on bank holding 

companies’ internal capital assessment and planning and have already built further work in this 

area into supervision plans for the largest firms. 

• Sound internal capital assessment relies on accurate measurement and management of risk, 

including of risks under potential stressed operating environments. Accordingly, supervisors 

are working with large banks to ensure that they: 

o have comprehensive management information systems in place; 

o enhance firm-wide risk-measurement and -management practices, where needed; 

o make the information derived from these practices an integral part of their internal capital 

assessment and planning, and

o have in place appropriate controls and corporate governance over these processes. 

• More broadly, supervisors will be looking at large firms’ ability to respond to financial 

distress as reflected in their internal recovery and resolution plans. 

Requiring more comprehensive and timely reporting of risk positions and operating performance 

The Federal Reserve is working to enhance its access to more timely and consistent 

information on the risk exposures and operating performance of large firms in order to 

effectively identify potential vulnerabilities at individual institutions and in the banking sector 

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more broadly. This will include requiring the largest firms to report more systematic, timely and 

consistent information on material firm-wide risk positions and exposures, funding and liquidity 

profiles, as well as on earnings and revenues and other measures. 

More timely and detailed data reporting requirements will help improve riskidentification practices; provide earlier insights into drivers of revenues and costs, which are 

often the most valuable early indicators of emerging risks; and help to better target areas 

warranting explicit focus in the supervisory planning process. Enhanced supervisory reporting 

requirements will also promote better internal risk assessment at firms.

Clarifying the objectives of consolidated supervision 

The Federal Reserve has issued enhanced guidance reaffirming the importance of 

consolidated supervision of all bank holding companies, particularly of large complex firms. It 

emphasized that consolidated supervision should be conducted from a macroprudential 

perspective as well as firm-specific safety-and-soundness perspective. The guidance clarified 

expectations of Federal Reserve staff in identifying and addressing firm-specific and system risk 

in the normal course of supervision. Specifically, this guidance, among other things, directs 

Federal Reserve examiners to pay special attention to activities that have the potential to affect 

not only the institution, but the financial system more broadly. These include business lines with 

a significant presence in key financial markets, large-value payment operations, and clearing and 

settlement functions involving critical financial markets. The guidance also provides more 

explicit directions to supervisors for evaluating the capacity of a banking organization to 

measure and manage risks across the entire firm; reaffirms the importance of understanding and 

assessing the financial condition and risk profile of a holding company's nonbank subsidiaries; 

and clarifies the protocols for relying on, and communicating with, the primary supervisor of a 

bank or functionally regulated subsidiary. 

Communicating more clearly and forcefully with supervised firms

 To ensure banking managers and boards of directors respond appropriately to supervisory 

concerns, senior Federal Reserve officials will more regularly and consistently deliver messages 

at a higher level, with more frequent participation of senior managers and boards of directors at 

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supervised firms. During the SCAP, this approach proved to be especially effective in securing 

prompt increases in capital levels. 

• In addition, the Federal Reserve is enhancing the governance of its supervision to ensure that 

supervisory ratings for institutions are updated promptly as appropriate and are applied 

consistently across firms. 

• Requirements for timely remediation of identified weaknesses will also be enhanced through 

more proactive use of formal and informal enforcement actions, where necessary.

Promoting enhanced corporate governance 

The Federal Reserve expects greater and more active participation of firms’ boards of 

directors on major issues. For example, recent guidance on employee compensation and 

communications with firms about internal capital assessment practices have both emphasized 

that the board of directors should be involved in key aspects of oversight and decision making. 

In addition, the Federal Reserve has encouraged firms to strengthen the composition of their 

boards of directors, where needed, to increase the banking expertise on the board, and enhance 

the independence of their board audit committees. 

 

Improvements to the supervision of regional and community banks 

Fewer problems arose in supervisory processes for regional and community banks than 

for large institutions, but some of the same issues were present. The Federal Reserve is also 

strengthening supervision of regional and community banks. Importantly, these firms will 

continue to be subject to regular full-scope examinations. Greater emphasis will be placed on 

sound risk management of lending and funding concentrations, as well as on the collection of 

information on risk exposures in a format that permits testing for potential systemic risks across 

groups of institutions. For these organizations as well, timely and forceful communication of 

supervisory concerns to the most senior managers and the board of directors will be essential.

Enhancing supervision resources

Initiatives are under way to support the hiring, training, and retention of sufficient levels 

of staff with expertise suitable to support both on-site examinations and off-site analysis of 

complex financial institutions and financial markets. 

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• The Federal Reserve budget provides a significant increase of staff for 2010 relative to 2008, 

concentrated in the supervision of the largest banking organizations. 

• Enhanced training is in place to expand staff knowledge of emerging areas of supervisory 

focus. Other steps are being taken to broaden and deepen staff expertise, including more 

rotations across supervisory functions. 

• Even with these steps, challenges will remain in attracting and retaining enough staff with the 

skills necessary to understand the increasingly complex activities of the largest firms. As the 

financial sector recovers and job availability and compensation improve in the private sector, 

the Federal Reserve will need to budget enough resources to maintain an expert staff. 

i President's Working Group on Financial Markets (2008), "Policy Statement on Financial Market Developments" 

policy statement (Washington: U.S. Department of the Treasury, March 13); Financial Stability Forum (2008), 

Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, (Basel, Switzerland: FSF, 

April 7); Senior Supervisors Group (2008), Observations on Risk Management Practices during the Recent Market 

Turbulence (Basel, Switzerland: Bank for International Settlements, March 6).

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