Federal Deposit Insurance Corporation
Division of Supervision and Consumer Protection
Washington, D.C. 20429-9990

DATE: September 24, 2004

MEMORANDUM TO: Stephen M. Beard, Deputy Assistant Inspector General for Audits

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

CONCUR: John F. Bovenzi [Electronically produced version; original signed by John F. Bovenzi], Deputy to the Chairman and Chief Operating Officer

SUBJECT: Draft Report Entitled, "DSC's Approach for Supervising Limited Charier Depository Institutions" (Assignment Number 2004-035)

The Division of Supervision and Consumer Protection (DSC) appreciates the opportunity to respond to this Draft Report prepared by the FDIC's Office of Inspector General (OIG). DSC agrees with the OIG's overall perspective that the changing landscape of the financial services industry requires ongoing reassessment of industry practices and of the appropriate supervisory response to these changes. As the results of OIG's review affirm, DSC's existing policies and procedures serve to mitigate any additional risks which might be presented by ILCs. The report identifies some opportunities for improvement pertaining to changes in the relevant sections of the Manual of Examination Policies and suggestions for ED Module procedures.

DSC continues to believe that, overall, ILC charters, as well as other charter types operated by parent companies not subject to oversight by the Federal Reserve Board (FRB), pose no greater safety and soundness risk to the insurance fund than any other charter type. The risk posed by any insured depository institution is a factor of the appropriateness of the business plan and model, management's competency in administering the institution's affairs, and the quality and implementation of risk management programs. Similar to institutions with other charter types, an institution's capital adequacy and overall safety and soundness is driven by the composition and stability of the institution's lending, investing and funding activities and the competence of management. Moreover, any perceived additional risks to the insurance fund presented by the ILC charter, in and of itself, are not evident in the failure or loss experience of ILCs compared to other financial institutions.

The report concludes that ILCs do pose some additional risk if an affiliated company is not regulated, and that the ILC charter does permit some mixing of banking and commerce otherwise prohibited for most depository institutions, but that DSC has established controls to help mitigate these possible risks. The report recommends several enhancements to existing policies and procedures regarding ILCs and other affiliates of insured institutions. We agree that FRB's authority to mandate consolidated capital for bank holding companies, under the current statutory framework, affords that agency an additional mechanism to address risks present within the consolidated company. Further, there are, at this time, statutory limitations on the FDIC's cross-guaranty authority and ability to restrict golden parachute payments with respect to ILCs.

However, FDIC has considerable supervisory and enforcement authority available under the "institution affiliated party" provisions of the FDI Act. The report appropriately cites the FDIC's position that we can impose cease and desist actions against non-bank holding company parents or any other institution affiliated party for any violation of law, rule, or regulation. The report also recognizes the general efficacy of our existing policies and procedures in addressing risks to the deposit insurance funds.

DSC generally concurs with the recommendations detailed in the report, and agrees to incorporate the improvements suggested by the eight recommendations in the audit report. We appreciate the work of OIG staff assigned to this audit and the opportunity they afforded us to make sure that our positions were fully and accurately reflected in the final report.

Response to Recommendations:

The following summarizes the draft report's recommendations and DSC's response, grouped by DSC's planned action:

OIG recommends that the Director, DSC:

1. Revise RDM 02-008, Revisions to the Report of Investigation, to include discussion of prudential conditions that might be considered during investigations for deposit insurance applications from ILCs or other banks.

   DSC concurs with the intent of this recommendation. However, it should be noted that the decision to impose prudential conditions on a deposit insurance applicant rests with the Regional Office or the Washington Office, and that such conditions are rarely recommended by examiners during the preparation of a Report of Investigation (ROI). We believe the most appropriate place to include a detailed discussion of prudential conditions is in the Case Manager Procedures Manual. We have already incorporated such a discussion in the most recent update. Nevertheless, DSC agrees that it would be beneficial to introduce the concept of prudential conditions to examiners preparing ROls; therefore, we agree to incorporate a brief discussion of such issues into the instructions for preparing a ROI (as distributed by RDM 02-008) by the third quarter of 2005.

2. Revise Chapter 4.3 of the Manual of Examination Policies to expand the discussion of the "source of strength" provided to a subsidiary bank by the managerial and financial capabilities of the parent company, and provide guidance for including comments on the parent's source of strength in the Report of Examination.

4. Revise Chapter 4.3 of the Manual of Examination Policies to include a discussion of the 11 factors discussed in the Supervisory Insights article.

5. Revise Chapter 4.3 of the Manual of Examination Policies to include a discussion of possible sources for examiners to obtain relevant financial ratios when analyzing nonbank holding companies or commercial parents.

6. Include the "Relationships with Affiliates and Holding Companies" page in the ROE when necessary.

   DSC agrees to incorporate the substance of the above recommended revisions, particularly to
   Chapter 4.3 covering Related Organizations, as part of the ongoing revision to the Manual of Examination Policies. The revisions should be completed by the first quarter of 2005.

   The revisions will include an expanded discussion of the various contributions, sometimes referred to collectively as the "source of strength", which may be provided by a parent company to a subsidiary bank. DSC has not established or adapted a standardized "source of strength" principle or doctrine. We see no reason to do so because of both the difficulty in crafting a uniform definition and because it would not be relevant in all eases. However, the expanded discussion in Chapter 4.3 will include both the managerial and financial capabilities of the parent company and guidance for when these capacities are relevant to the supervisory assessment of the bank and when comments should be made part of the Report of Examination.

   DSC will also include in the relevant chapters of the Manual of Examination Policies, with cross references in the Related Organizations chapter as necessary, a discussion of any of the best practices identified in the Supervisory Insights article which are not already addressed in the Related Organizations chapter.

   We note that three of the items identified in the OIG audit report [changes to the business plan, contracts covering service relationships, and contingency plans for functions performed by affiliate companies] are not unique issues for related organizations and are therefore appropriately addressed in other chapters or examination guidance that cover these functional areas. For example, the business plans of operating banks are more likely to be included in their ongoing budget function and strategic or profit planning. Examination review of these areas is addressed in the chapters covering Management and Administration, and Internal Routines and Controls. Likewise, evaluation of service relationships and contingency planning is addressed in the Information Technologies work programs, which will soon be incorporated into a new FFIEC Information Systems Examination Handbook. However, for improved clarity, DSC will make appropriate reference to these other chapters or sources in Chapter 4.3.

   The fourth factor listed in the Supervisory Insights article, considered by the OIG to be only partially addressed in Chapter 4.3, is the evaluation of financial risks which may be presented by an affiliate relationship. DSC agrees hat as part of recommendation 2, an expanded discussion of the "source of strength" will be included in this chapter. However, the suggestion in the body of the report that standard holding company financial ratios used to analyze Bank Holding Company Performance Reports can be applied to the analysis of all ILC parent companies is not practicable. DSC will include a more general discussion of this issue in the expanded discussion on "source of strength" to be included in the revision of Chapter 4.3.

   DSC also agrees to include in Chapter 4.3, a discussion of the possible sources for examiners to obtain relevant financial ratios when analyzing non-bank holding companies or commercial parents, as recommended. We believe that this is a more appropriate way to address the issue of evaluating the potential financial or other operating impact of commercial holding companies and affiliates. The report appropriately credits DSC examiners for applying the standard ratios to financial companies, and we believe that examiners also review other ratios and metrics for non-financial companies in the cases where these are relevant to the assessment of the insured institution. However, we believe that mandating uniform ratio analysis for ILC parents, whose business lines range from manufacturing to retail to insurance, is neither practicable nor useful. Employing standard ratios to diverse businesses will not yield meaningful results for risk analysis purposes. DSC believes that encouraging examiners to determine what financial information or ratios are applicable to understanding individual commercial parents will result in better analyses.

   Finally, DSC agrees to incorporate into Chapter 4.3, a discussion of when the "Relationships with Affiliates and Holding Companies" page should be included in the Report of Examination.

Discussion of recommendations 3, and 5:

3. Revise the Related Organizations ED module to include procedures and corresponding Core Analysis Decision Factor for analyzing the parent's "source of strength."

5. Revise the Related Organizations ED module to incorporate the various procedures mentioned in the Supervisory Insights article.

   With respect to Recommendation 5, we believe clarification is necessary. The referenced "Supervisory Insights" article, while well considered and comprehensive, was only intended to provide insight on DSC's existing experience and practice. Page 1 of the "Supervisory Insights" journal clearly states, "The views expressed in Supervisory Insights are those of the authors and do not necessarily reflect official positions of the Federal Deposit Insurance Corporation. In particular, articles should not be construed as regulatory or supervisory guidance." We do not believe that a journal article is the appropriate vehicle for internally recommending procedural changes, nor should it be relied upon by others to do so.

   With that caveat, DSC generally concurs with the recommendations. We will submit, at the next meeting of the Interagency ED Module Maintenance Committee (EMMC), recommendations for revising such procedures and adding a Core Analysis Decision Factor, to the extent these are suggested by the policy guidance to be revised in Chapter 4.3 of the Manual of Examination Policies and are necessary to guide the examination procedures. The next meeting of the EMMC has not yet been scheduled, but should occur by the first quarter of 2005.

   DSC also agrees to recommend revisions to the Related Organizations ED module to the extent that revised procedures are necessary to support the analysis and examination review suggested by the policy guidance to be revised in Chapter 4.3 of the Manual of Examination Policies. However, not all policy discussions directly translate into procedural instructions in the ED modules. Examiners are expected to use considerable judgment in determining the scope and detail of any analysis, particularly when evaluating unusual businesses or situations. Moreover, not all procedures need to be repeated in more than one module.

8. Establish a 2005 divisional objective to consider the expansion of the FDIC's examination program for all non-bank parents and affiliates.

   DSC concurs with this recommendation and agrees to establish a corresponding 2005 objective, and to consider the issues involved carefully during 2005.

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