United States General Accounting Office

GAO Testimony

Before the Subcommittee on Capital Markets, Securities,

and Government Sponsored Enterprises, Committee on

Banking and Financial Services

House of Representatives

For Release on Delivery

Expected at

11:00 a.m., EDT

on Thursday

September 24, 1998

FEDERAL HOUSING

FINANCE BOARD

Actions Needed to Improve

Regulatory Oversight

Statement of Nancy R. Kingsbury

Assistant Comptroller General

General Government Programs

GAO/T-GGD-98-185

Summary 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

GAO’s testimony, based on its recent report,1 discusses weaknesses found

and actions needed to improve the Federal Housing Finance Board’s

(FHFB) regulatory oversight of the Federal Home Loan Bank System

(System). Four primary conclusions were reached about FHFB’s oversight.

First, FHFB’s examination function did not ensure that annual examinations

met FHFB’s internal examination standards, including adequate

documentation for work performed. The examinations included reviews of

interest-rate and credit risk, two of the primary types of risk faced by the

Federal Home Loan Banks (Banks). However, the examinations did not

fully assess other areas that FHFB and others have identified as vital in

evaluating an institution’s risk-management capabilities, such as

management and board of directors oversight, internal control systems,

and internal audit function.

Second, weaknesses existed in FHFB’s off-site monitoring and supervisory

enforcement programs. FHFB lacks a coordinated off-site monitoring

system, which is an important part of effective safety and soundness

oversight, because it can provide an early warning of potential problems.

FHFB also lacks an enforcement program that clearly articulates policies

and procedures for taking corrective action. The situation is further

aggravated because the statute grants only general authority to enforce the

statute and make orders. The only authority delineated in the statute is the

authority to remove or suspend Bank employees, directors, officers, or

agents for cause.

Third, FHFB does not have policies or procedures, outside of its reviews of

the special affordable housing and community investment programs, to

determine whether or the extent to which Banks are supporting housing

finance. FHFB recognized this omission and has begun to take steps to

establish such a program, but no final actions have been taken to establish

a regulatory framework to ensure mission compliance.

Fourth, FHFB continues to be involved in System business. Many of the

authorities that involve FHFB in System business are specified in statute or

are carryover regulations from its predecessor agency. FHFB began to

devolve many of the functions in 1994, but it still plays a role in

coordination and promotion of Banks. GAO continues to believe that such

involvement in the System’s business functions may undermine FHFB’s

independence and lead to questions about its objectivity.

1

Federal Housing Finance Board: Actions Needed to Improve Regulatory Oversight (GAO/GGD-98-203,

Sept. 18, 1998).

Page 1 GAO/T-GGD-98-185
Summary 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

GAO makes recommendations to strengthen FHFB’s primary oversight role

as safety and soundness regulator of the System. GAO also continues to

support its position that a single housing regulator be created to oversee

the safety and soundness and mission compliance of the housing

government-sponsored enterprises.

Page 2 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

Mr. Chairman and Members of the Subcommittee:

We are pleased to be here today to discuss the Federal Housing Finance

Board’s (FHFB) regulatory oversight of the nation’s third largest

government-sponsored enterprise (GSE), the Federal Home Loan Bank

System (System). At your request, we recently issued a report on FHFB’s

oversight.1

 The specific objectives of our review were to evaluate

(1) FHFB’s annual safety and soundness and mission compliance

examinations of the Federal Home Loan Banks (Banks), (2) other aspects

of FHFB’s oversight, and (3) the status of FHFB’s involvement in System

business.

We reached four primary conclusions about FHFB’s oversight which I will

discuss today. First, FHFB did not ensure that all parts of the annual

examinations we reviewed met their internal standards for assessing

safety and soundness. Second, weaknesses exist in FHFB’s off-site

monitoring and supervisory enforcement programs. Third, FHFB does not

have policies or procedures, outside of its reviews of the special

affordable housing and community investment programs, to determine

whether or the extent to which Banks are supporting their public mission

of housing finance. Fourth, FHFB’s involvement in promoting System

programs and projects that it subsequently evaluates for mission

compliance and safety and soundness could complicate its primary duty as

safety and soundness regulator and may prompt questions about FHFB’s

objectivity.

In addition, I will discuss the concept of a single regulator for all the

housing GSEs. We have suggested in past work that Congress consider

creating one regulator to oversee the safety and soundness and mission

compliance of the three largest GSEs. Our recent work at FHFB and the

other GSE regulators has strengthened our belief that this single-regulator

concept would be more effective than the existing regulatory structure.

As you know, FHFB is the safety and soundness and mission compliance

regulator of the 12 Banks that, along with the Office of Finance, comprise

the System. However, FHFB is more than just the System’s regulator, it is

also involved in various aspects of System business, including

management decisionmaking. This type of regulator-manager structure is

unique among GSE regulators. That is, while other GSE regulators may be

responsible for mission and safety and soundness oversight, FHFB is the

1

Federal Housing Finance Board: Actions Needed to Improve Regulatory Oversight (GAO/GGD-98-203,

Sept. 18, 1998).

Page 3 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

only regulator that remains involved in the business of the System it

regulates. In certain instances, the Federal Home Loan Bank Act (Bank

Act) provides for FHFB’s involvement in System business. FHFB has

devolved some business or governance and management activities to the

Bank boards. However, FHFB continues to function as a promoter and

coordinator for the System.

To complete our objectives, we reviewed FHFB’s examination function and

other relevant oversight activities, such as off-site monitoring and

enforcement. This included a review of Bank examination reports and

selected supporting work papers. We also reviewed off-site monitoring

reports and related documents, as well as documents relevant to FHFB’s

enforcement activities. Finally, we reviewed information relevant to FHFB’s

managerial functions and the status of its devolution project.

FHFB Did Not Ensure

Examinations Met Its

Standards

As part of our evaluation of FHFB’s examination program, we reviewed the

1996 and 1997 examinations and supporting work papers for a stratified,

judgmental sample of six Banks whose assets represented 60 percent of

System assets at year-end 1996. We found that examiners performed

required examinations but failed to follow all the policies and procedures

specified in their examination manual. Most notably, examiners did not

always fully assess critical elements of Bank operations—such as internal

controls, board of director and management oversight, and the reliability

of internal audits—that FHFB, other financial regulators, and we have

identified as vital in evaluating an institution’s risk-management

capabilities. None of the examinations we reviewed fully assessed more

than one of the areas. All failed to assess board of director oversight.

While examiners generally assessed management of interest-rate and

credit risk, the critical elements just mentioned should be reviewed during

every on-site examination to ensure that operations risk is being

adequately managed. Operations risk poses the potential for unexpected

financial loss due to such problems as inadequate internal controls or

fraud.

Unlike other regulators, FHFB does not perform a top-down assessment of

Bank operations. In contrast, we found, and FHFB officials confirmed, that

examiners focus on identifying problems and then determining the causes

of the problems. Such an approach may not identify weaknesses in control

and management systems that could be identified through a broader

assessment of Bank operations. Office of Supervision officials—the FHFB

office whose primary responsibility is the examination function—said that,

Page 4 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

due to limited staff resources in their office, they were unable to take a

top-down examination approach. In addition, we found that examiners

relied on the work of Bank internal auditors without any regular

assessment of the adequacy of their work.

In each of the 12 examinations we reviewed, more than half of the work in

each area specified in FHFB’s examination manual was not conducted in

accordance with the manual’s procedures. That is, examiners did not

complete the examination program in the manual or use the manual’s

examination questionnaires. The examiners explained that they often did

not have time to complete the procedures described in the manual and

that the manual’s procedures often were not useful for certain parts of the

examination. In addition, we found that, for most areas covered in the

examination, examiners did not document examination procedures or

provide support for their conclusions, as required by FHFB standards.

In all but 1 of the 12 examinations reviewed, some planned examination

procedures were not completed during the course of the examination. In

each of the cases, examiners indicated in the work papers that those

procedures were not completed because of time constraints. In 2 of the 12

examinations, examiners curtailed the scope but provided no explanation

for the change in the work papers. OS officials told us that limited

examination staff resources sometimes resulted in scope reductions, and

that such reductions occurred in parts of the examination that examiners

believed involved less risk.

Examiners also failed to expand the examination scope when potentially

serious problems were found. Examiners found potentially serious

internal control problems at one Bank in consecutive examinations but did

not expand their reviews to determine whether there were additional

related problems. FHFB did not view those internal control weaknesses as

significant. Both cases involved an inadequate segregation of duties in a

Bank’s investment activities and were weaknesses that recurred at the

same Bank. In spite of the fact that adequate segregation of duties involves

a violation of fundamental principles of internal controls, FHFB did not

believe it was necessary to expand its review to the Bank’s system of

internal controls.

Based on these findings, we recommended that FHFB strengthen its

primary oversight role as the safety and soundness supervisor of the

System by (1) ensuring that critical aspects of Bank operations are

reviewed as part of every FHFB examination, (2) ensuring that examiners

Page 5 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

follow the guidance and complete the appropriate examination procedures

described in the examination manual, and, (3) adequately documenting the

work performed and conclusions drawn during examinations.

FHFB Is Now Developing a

Mission Compliance

Examination Program

In its almost 10 years of operation, FHFB has not developed a compliance

program to ensure mission compliance, one of its statutory duties.

Historically, mission compliance oversight included reviewing the Banks’

compliance with affordable housing program and community investment

program requirements—two programs mandated by law in 1989 that

represented less than 1 percent of the System’s total assets in 1997. More

recently, FHFB’s mission compliance efforts have included promoting

certain mission-related activities; however, FHFB continues to lack policies

and procedures that lay out how it will effectively regulate mission.

Recently, FHFB has taken a number of steps to try to better ensure and

assess mission compliance. Specifically, FHFB has (1) required that Banks

submit annual reports that describe their new products, pricing, and

investment partnerships; (2) commissioned a study to, among other

purposes, assist in developing procedures to oversee Bank mission

compliance; (3) tested draft examination procedures to ensure mission

compliance; and (4) amended regulations for Bank member community

support requirements, as well as FHFB’s oversight activities, to ensure

member compliance with those requirements. FHFB has also begun to study

the System’s investment activities and is considering whether it should

limit non-mission related investments. We view these as positive steps

because a high level of non-mission related investments would raise

questions about how Banks are fulfilling their mission. Investments at the

individual Banks ranged from 17 to 58 percent of assets at year-end 1997.

We encourage FHFB to continue its efforts to develop a regulatory

framework for a mission compliance oversight program. To be effective

we believe such a program must be based on well-defined policies that

delineate what constitutes mission compliance and prescribe the methods

to be used to measure whether Banks have fulfilled their mission.

Weaknesses Exist in Other

Areas of FHFB’s

Regulatory Oversight

Program

We found additional weaknesses in FHFB’s off-site monitoring and

enforcement programs that raise concerns about its regulatory

effectiveness. Both functions are vital to ensure that any problems are

identified promptly and that corrective action is taken when needed.

Page 6 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

Recognizing the need for timely monitoring, the Office of Supervision

developed a regulatory oversight and off-site monitoring system in 1996

that required monthly reviews of Bank data, including minutes of board of

directors meetings, internal audit reports, and financial data. In 1997, the

Office of Supervision suspended its monthly off-site monitoring due to

staff constraints. We found that examiners primarily reviewed the periodic

data submitted by the Banks to FHFB as part of their annual preparation for

examinations. The Office of Supervision also prepared several periodic

reports on financial management policy compliance and interest-rate risk

exposures, financial trends, and debt-issuance activities. In addition, the

Office of Policy produced several periodic monitoring reports, such as a

quarterly profile report that tracks Bank statistics (including Bank

membership), the affordable housing program, and unsecured credit. Both

offices shared their reports with the board of directors but they generally

did not coordinate their monitoring activities, which are viewed as having

different purposes. FHFB lacked policies and procedures for off-site

monitoring, and there appeared to be no correlation between Bank size or

scope of activities and the level or type of off-site monitoring performed by

these offices.

We found that FHFB’s supervisory enforcement program lacks clear

policies and procedures for taking enforcement actions and does not

specify what actions would be taken if certain conditions existed. We

recommended that FHFB clearly articulate and document its current

enforcement mechanism, policies, and procedures. The Bank Act

authorizes FHFB to “promulgate and enforce” regulations and orders but

only delineates one enforcement power for FHFB—the authority to remove

or suspend for cause any Bank director, officer, employee, or agent. FHFB

officials told us that they believe that the general provision in the statute

enables them to take corrective action, if necessary. The officials stated

that they consider examination reports that include “findings” requiring

corrective action the equivalent of an enforcement order. We did not find

instances when FHFB had been unable to obtain Bank compliance with its

findings. However, we believe, as we have recommended in past work for

any GSE regulator, that the statute should specifically give FHFB all

enforcement authorities granted other regulators. Further, in past GSE

work, we identified certain principles necessary for effective enforcement

of rules and regulations.2

 Two of these principles are that certain

enforcement actions should be mandatory when previously specified

conditions are met and should be the result of a clear and reasonable

2

Government-Sponsored Enterprises: A Framework for Limiting the Government’s Exposure to Risks

(GAO/GGD-91-90, May 22, 1991).

Page 7 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

process. We believe FHFB would be better prepared and assured of its

ability to take forceful action if its statute enumerated the authorities

granted other GSE regulators, such as cease and desist and civil money

penalty powers. Therefore, we suggest that Congress consider granting

FHFB the specific enforcement authority provided other GSE regulators.

FHFB Remains Involved in

System Business

Mr. Chairman, our review of FHFB oversight would not be complete

without a consideration of its unique role in some aspects of System

business. We remain concerned, as we have noted in the past, that

combining the roles of oversight and involvement in System business may

undermine the independence necessary for FHFB to be an effective safety

and soundness and mission regulator.3

 We recognize that the responsibility

for FHFB’s involvement in System business is, in part, due to statutory

authorities carried over from FHFB’s predecessor, the Bank Board. For

example, the Bank Act gives FHFB authority to issue the System’s

consolidated obligations and requires that FHFB approve Bank dividends

and bylaws. FHFB and System officials agree that a regulator should not be

involved in the day-to-day operations of Banks, but the degree and type of

involvement they consider appropriate varies. Since 1994, FHFB has

identified and devolved certain business or governance and management

activities, within specified limits, to Banks’ boards. These activities include

the authority to establish presidents’ salaries and incentive plans, approve

affordable housing program applications, determine the compensation of

Bank directors, and set Bank performance targets. Management activities

identified by as yet to be devolved include the authority to approve

dividends, certain general administrative matters, and setting credit

policies. Although FHFB has delegated some of these functions to the bank

boards, we suggest that Congress consider ensuring, through legislation,

that FHFB not be involved in the business of the System. We are aware of

and support the provisions of the legislation pending in the House and

Senate that would begin to correct some of our concerns about FHFB’s

involvement in System business.

In 1993, we expressed concerns about FHFB acting as a promoter and

coordinator for the System. On the basis of our latest review, we are still

concerned with the degree to which FHFB remains involved in System

business. Undertaking promotion and coordination activities may

undermine FHFB’s independence and raise questions about its objectivity as

a regulator. The Banks have organized two central groups with the

3

FHLBank System: Reforms Needed to Promote Its Safety, Soundness, and Effectiveness

(GAO/T-GGD-95-244, Sept. 27, 1995).

Page 8 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

potential to provide central coordination and promotion for the System.

Nevertheless, FHFB officials view promotion as part of FHFB’s role as a

regulator. Its 5-year strategic plan, which FHFB says is integral to its budget

and performance planning, illustrates the prominence of the promotion

and coordination roles in agency operations. Of the plan’s nine objectives,

one addresses the examination function, and five address changes FHFB

advocates to enhance Bank performance, such as expanding the

acceptable uses for advances and expanding acceptable collateral on

advances to include small business loans. Of the other three objectives,

two address the devolution effort, and one deals with disseminating public

information about FHFB’s performance.

We identified other examples of the FHFB’s promotion and coordination

activities during our review. For example, the FHFB chairman coordinates

and participates in periodic meetings with Bank chairs and vice chairs that

include coordinating congressional lobbying efforts. FHFB’s involvement

with these bank officials—whom it appoints—in lobbying for statutory

changes illustrates the potential FHFB has for influence over these

positions. We believe FHFB should have regulatory authority over business

functions to ensure safety and soundness and mission compliance, but we

emphasize that having such regulatory authority differs from being a

participant in System business on a regular basis and from promoting a

particular program or activity over other mission-related activities.

Further, mission promotion is not a substitute for mission regulation,

which has to be built on measurable and enforceable regulations and

policies.

A Single Housing Regulator

Would Have Advantages

Over FHFB

The last issue I want to address today is our suggestion that Congress

consider creating a single regulator to oversee the safety and soundness

and mission compliance of the three housing GSEs. In addition to the

System, these include the Federal National Mortgage Association (Fannie

Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac),

which are regulated for safety and soundness by the Office of Federal

Housing Enterprise Oversight (OFHEO), an independent regulator within the

Department of Housing and Urban Development (HUD), and HUD itself,

which has general regulatory authority and oversees Fannie Mae’s and

Freddie Mac’s mission compliance.

Page 9 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

In past work on the housing GSEs, we discussed the advantages and

disadvantages of creating a single housing GSE regulator.4

 Since then, we

have continued to monitor and evaluate the housing GSEs and their

regulators. For example, we issued a report on OFHEO in October 1997 and

updated that work in July 1998. We also reported on HUD’s mission

oversight of Fannie Mae and Freddie Mac in July 1998.5

We found that OFHEO had not fully completed two important duties:

establishing risk-based capital standards and implementing a

comprehensive and timely examination program. At your request, Mr.

Chairman, we provided new information to this subcommittee in July

regarding OFHEO’s progress in implementing a comprehensive oversight

program. We reported that OFHEO had made some progress but still faced

challenges in completing those two important duties.6

Our work at HUD raised a number of issues about its oversight of Fannie

Mae and Freddie Mac, some of which would be eliminated or at least

mitigated if there were a single regulator for the housing GSEs. For

example, HUD is required to establish goals for its GSEs’ purchase of

mortgages serving targeted groups and also maintain the GSEs financial

soundness because such purchases could increase credit risk. We found

that HUD had adopted a conservative approach to setting the goals that

placed a high priority on maintaining the GSEs’ financial soundness, but

that HUD had not fully analyzed the financial consequences of setting

higher goals.

As a result of our work at OFHEO and HUD, we found no evidence that would

cause us to alter our previous position regarding a single regulator. In

addition, our current work at FHFB has strengthened our conclusion that

FHFB’s, OFHEO’s, and HUD’s oversight of the housing GSEs would be more

effective if combined. Thus, we continue to support our 1994 and 1997

positions that a single housing GSE regulator be created to oversee the

safety and soundness and mission compliance oversight of the housing

GSEs.

4

Federal Home Loan Bank System: Reforms Needed to Promote Its Safety, Soundness, and

Effectiveness (GAO/GGD-94-38, Dec. 8, 1993) and Government-Sponsored Enterprises: Advantages and

Disadvantages of Creating a Single Housing GSE Regulator (GAO/GGD-97-139, July 19, 1997).

5

Federal Housing Enterprises: OFHEO Faces Challenges In Implementing a Comprehensive Oversight

Program (GAO/GGD-98-6, Oct. 22, 1997) and Federal Housing Enterprises: HUD’s Mission Oversight

Needs to Be Strengthened (GAO/GGD-98-173, July 28, 1998).

6

OFHEO’s Progress in Implementing a Comprehensive Oversight Program for Fannie Mae and Freddie

Mac (GAO/GGD-98-182R, July 29, 1998).

Page 10 GAO/T-GGD-98-185
Statement 

Federal Housing Finance Board: Actions

Needed to Improve Regulatory Oversight

A single regulator would be better able to evaluate the trade-off between

mission and safety and soundness as well as evaluate the financial aspects

of new mortgage products and other GSE activities, such as nonmission

investments, because it would combine expertise in housing and finance.

A single regulator would be more independent and objective than separate

agencies, because it would not be affiliated with one particular GSE, or

dependent on that GSE for its continued existence and thus subject to its

influence. A single regulator would be more prominent in government than

either FHFB or OFHEO is alone. This should further enhance the single

regulator’s independence and make it more competitive in attracting and

retaining staff with appropriate expertise and experience. In addition, a

single regulator could capitalize on sharing staff expertise in such areas as

examinations, risk monitoring, financial analysis, and economic research.

The examinations staffing constraints we identified at FHFB and similar

staffing concerns identified at OFHEO might be alleviated by combining

FHFB, OFHEO, and HUD resources. Similarly, OFHEO’s work in setting capital

standards and developing a stress test could be useful in oversight of the

System.

This concludes my prepared statement, Mr. Chairman. My colleagues and I

would be pleased to answer any questions.

(233586) Page 11 GAO/T-GGD-98-185
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