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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.