Federal Reserve Operations

Banking Supervision and Regulation

The Federal Reserve has supervisory historically high levels since the mid- and regulatory authority over a variety 1990s, helping to provide banks with a of financial institutions and activities. It substantial base of capital. Risk-based plays an important role as umbrella su- capital ratios declined modestly over the pervisor of bank holding companies, in- year, but at year-end more than 99 per- cluding financial holding companies. cent of all commercial banks continued And it is the primary federal supervisor to report capital ratios consistent with a of state banks that are members of the “well capitalized” designation under Federal Reserve System. prompt corrective action standards. Al- Two thousand seven was a challeng- though credit quality indicators also ing year for bank holding companies worsened during the year, overall loan (BHCs) and state member banks. BHC quality measures remained relatively asset quality and earnings deteriorated sound by historical standards. over the second half of the year, mainly In 2007 the banking industry saw because of the effects of developments bank failures for the first time in three in the residential housing market. Non- years as three insured institutions—two performing assets increased notably as state nonmember banks and one thrift the quality of mortgages, home equity institution with assets totaling approxi- lines of credit, and loans to real estate mately $2.6 billion—were closed. developers weakened. Nevertheless, Banking supervisors focused in 2007 BHCs reported net income exceeding on credit risk issues related to subprime $90 billion for the full year. A sharp lending activities. During the course of increase in subprime mortgage delin- the year the federal financial regulatory quencies adversely affected the securiti- agencies—the Federal Reserve, Federal zation market. Liquidity and capital Deposit Insurance Corporation (FDIC), were strained as some BHCs brought National Credit Union Administration certain off-balance-sheet exposures onto (NCUA), Office of the Comptroller of their books. Several institutions also rec- the Currency (OCC), and Office of ognized significant valuation write- Thrift Supervision (OTS)—issued guid- downs on assets affected by market con- ance encouraging supervised institutions ditions. Despite these pressures, BHCs to work constructively with homeown- continued to maintain regulatory capital ers unable to continue meeting their ratios in excess of minimum regulatory mortgage payments. The agencies also requirements. released a statement emphasizing the Most state member banks entered need to maintain prudent underwriting 2007 after a sustained period of strong standards and to provide clear and bal- earnings performance, partly mitigating anced information to consumers so that developments in the market. Although institutions and consumers can assess net income and return on assets fell late the risks arising from certain adjustable- in the year, reflecting asset write-downs rate mortgage (ARM) products that of- and higher loan-loss provisions, these fer discounted or low introductory rates. measures of profitability have been at The Federal Reserve also joined with 86 94th Annual Report, 2007 the FDIC, NCUA, OCC, OTS, and the ganizations, the Federal Reserve seeks Conference of State Bank Supervisors primarily to promote their safe and to issue a statement encouraging feder- sound operation, including their compli- ally regulated financial institutions and ance with laws and regulations. state-supervised entities that service se- The Federal Reserve also has respon- curitized residential mortgages to review sibility for supervising the operations of their authority under pooling and servic- all Edge Act and agreement corpora- ing agreements so as to identify borrow- tions, the international operations of ers at risk of default and pursue state member banks and U.S. bank hold- appropriate loss-mitigation strategies ing companies, and the U.S. operations designed to preserve sustainable home of foreign banking organizations. ownership. The Federal Reserve exercises impor- Federal Reserve staff continued to tant regulatory influence over entry into work with the other federal banking the U.S. banking system, and the struc- agencies in 2007 to prepare for U.S. ture of the system, through its adminis- implementation of the Basel II capital tration of the Bank Holding Company accord.1 In November the Board of Gov- Act, the Bank Merger Act (with regard ernors approved final rules implement- to state member banks), the Change in ing new risk-based capital requirements Bank Control Act (with regard to bank for large, internationally active banking holding companies and state member organizations (the Basel II advanced ap- banks), and the International Banking proaches framework) and joined the Act. The Federal Reserve is also respon- OCC, FDIC, and OTS in publishing sible for imposing margin requirements those rules in December. on securities transactions. In carrying out these responsibilities, the Federal Reserve coordinates its supervisory ac- Scope of Responsibilities for tivities with the other federal banking Supervision and Regulation agencies, state agencies, functional regulators, and the bank regulatory The Federal Reserve is the federal su- agencies of other nations. pervisor and regulator of all U.S. bank holding companies, including financial holding companies formed under the au- Supervision for thority of the 1999 Gramm-Leach-Bliley Safety and Soundness Act, and state-chartered commercial banks that are members of the Federal To promote the safety and soundness of Reserve System. In overseeing these or- banking organizations, the Federal Reserve conducts on-site examinations and inspections and off-site surveillance 1. The Basel II capital accord, an international agreement formally titled “International Conver- and monitoring. It also takes enforce- gence of Capital Measurement and Capital Stan- ment and other supervisory actions as dards: A Revised Framework,” was developed by necessary. the Basel Committee on Banking Supervision, which is made up of representatives of the central banks or other supervisory authorities of thirteen countries. The original document was issued in Examinations and Inspections 2004; the original version and an updated version issued in November 2005 are available on the The Federal Reserve conducts examina- website of the Bank for International Settlements tions of state member banks, the U.S. (www.bis.org). branches and agencies of foreign banks, Banking Supervision and Regulation 87

State Member Banks and Bank Holding Companies, 2003–2007

Entity/Item 2007 2006 2005 2004 2003

State member banks Total number ...... 878 901 907 919 935 Total assets (billions of dollars) ...... 1,519 1,405 1,318 1,275 1,912 Number of examinations ...... 694 761 783 809 822 By Federal Reserve System ...... 479 500 563 581 581 By state banking agency ...... 215 261 220 228 241 Top-tier bank holding companies Large (assets of more than $1 billion) Total number ...... 459 448 394 355 365 Total assets (billions of dollars) ...... 13,281 12,179 10,261 8,429 8,295 Number of inspections ...... 492 566 501 500 454 By Federal Reserve System1 ...... 476 557 496 491 446 On site ...... 438 500 457 440 399 Off site ...... 38 57 39 51 47 By state banking agency ...... 16 9 5 9 8 Small (assets of $1 billion or less) Total number ...... 4,611 4,654 4,760 4,796 4,787 Total assets (billions of dollars) ...... 974 947 890 852 847 Number of inspections ...... 3,186 3,449 3,420 3,703 3,453 By Federal Reserve System ...... 3,007 3,257 3,233 3,526 3,324 On site ...... 120 112 170 186 183 Off site ...... 2,887 3,145 3,063 3,340 3,141 By state banking agency ...... 179 192 187 177 129 Financial holding companies Domestic ...... 597 599 591 600 612 Foreign ...... 43 44 38 36 32

1. For large bank holding companies subject to con- tinuous, risk-focused supervision, includes multiple targeted reviews. and Edge Act and agreement corpora- by the Federal Reserve during the past tions. In a process distinct from exami- five years. nations, it conducts inspections of bank Inspections of bank holding compa- holding companies and their nonbank nies, including financial holding compa- subsidiaries. Whether an examination or nies, are built around a rating system an inspection is being conducted, the re- introduced in 2005 that reflects the review of operations entails (1) an assess- cent shift in supervisory practices for ment of the quality of the processes in these organizations away from a histori- place to identify, measure, monitor, and cal analysis of financial condition to- control risks; (2) an assessment of the ward a more dynamic, forward looking quality of the organization’s assets; (3) assessment of risk-management prac- an evaluation of management, including tices and financial factors. Under the an assessment of internal policies, pro- system, known as RFI but more fully cedures, controls, and operations; (4) an termed RFI/C(D), holding companies assessment of the key financial factors are assigned a composite rating (C) that of capital, asset quality, earnings, and is based on assessments of three compo- liquidity; and (5) a review for compli- nents: Risk Management (R), Financial ance with applicable laws and regula- Condition (F), and the potential Impact tions. The table provides information on (I) of the parent company and its nonde- examinations and inspections conducted pository subsidiaries on the subsidiary 88 94th Annual Report, 2007 depository institution.2 The fourth com- tailored to each banking organization’s ponent, Depository Institution (D), is in- size, complexity, and risk profile. As tended to mirror the primary regulator’s with the LCBOs, examinations entail rating of the subsidiary depository both off-site and on-site work, including institution. planning, pre-examination visits, de- In managing the supervisory process, tailed documentation, and examination the Federal Reserve takes a risk-focused reports tailored to the scope and find- approach that directs resources to ings of the examination. (1) those business activities posing the greatest risk to banking organizations State Member Banks and (2) the organizations’ management processes for identifying, measuring, At the end of 2007, 878 state-chartered monitoring, and controlling risks. The banks (excluding nondepository trust key features of the supervision program companies and private banks) were for large complex banking organizations members of the Federal Reserve Sys- (LCBOs) are (1) identifying those tem. These banks represented approxi- LCBOs that are judged, on the basis of mately 12 percent of all insured U.S. their shared risk characteristics, to commercial banks and held approxi- present the highest level of supervisory mately 14 percent of all insured com- risk to the Federal Reserve; (2) main- mercial bank assets in the United States. taining continual supervision of these The guidelines for Federal Reserve organizations so that the Federal Re- examinations of state member banks are serve’s assessment of each organiza- fully consistent with section 10 of the tion’s condition is current; (3) assigning Federal Deposit Insurance Act, as to each LCBO a supervisory team com- amended by section 111 of the Federal posed of Reserve Bank staff members Deposit Insurance Corporation Improve- who have skills appropriate for the orga- ment Act of 1991 and by the Riegle nization’s risk profile (the team leader is Community Development and Regula- the Federal Reserve System’s central tory Improvement Act of 1994. A full- point of contact for the organization, has scope, on-site examination of these responsibility for only one LCBO, and banks is required at least once a year, is supported by specialists capable of although certain well-capitalized, well- evaluating the risks of LCBO business managed organizations having total as- activities and functions); and (4) pro- sets of less than $500 million may be moting Systemwide and interagency examined once every eighteen months.3 information-sharing through automated The Federal Reserve conducted 479 ex- systems. ams of state member banks in 2007. For other banking organizations, the risk-focused supervision program provides that examination procedures are 3. The total assets threshold for this group of well-capitalized, well-managed organizations was 2. Each of the first two components has four increased during the year. The Financial Services subcomponents: Risk Management—Board and Regulatory Relief Act of 2006, which became ef- Senior Management Oversight; Policies, Proce- fective in October 2006, authorized the federal dures, and Limits; Risk Monitoring and Manage- banking agencies to raise the threshold from $250 ment Information Systems; and Internal Controls. million to $500 million, and final rules incorporat- Financial Condition—Capital; Asset Quality; ing the change into existing regulations were is- Earnings; and Liquidity. sued on September 21, 2007. Banking Supervision and Regulation 89

Bank Holding Companies statute streamlines the Federal Reserve’s supervision of all bank holding compa- At year-end 2007, a total of 5,793 U.S. nies, including financial holding compa- bank holding companies were in opera- nies, and sets forth parameters for the tion, of which 5,070 were top-tier bank supervisory relationship between the holding companies. These organizations Federal Reserve and other regulators. controlled 6,038 insured commercial The statute also differentiates between banks and held approximately 96 per- the Federal Reserve’s relations with cent of all insured commercial bank as- regulators of depository institutions and sets in the United States. its relations with functional regulators Federal Reserve guidelines call for (that is, regulators for insurance, securi- annual inspections of large bank holding ties, and commodities firms). companies and complex smaller compa- As of year-end 2007, 597 domestic nies. In judging the financial condition bank holding companies and 43 foreign of the subsidiary banks owned by hold- banking organizations had financial ing companies, Federal Reserve examin- holding company status. Of the domes- ers consult examination reports prepared tic financial holding companies, 33 had by the federal and state banking authori- consolidated assets of $15 billion or ties that have primary responsibility for more; 136, between $1 billion and the supervision of those banks, thereby $15 billion; 93, between $500 million minimizing duplication of effort and re- and $1 billion; and 335, less than ducing the supervisory burden on bank- $500 million. ing organizations. Noncomplex bank holding companies with consolidated assets of $1 billion or less are subject to a International Activities special supervisory program that per- The Federal Reserve supervises the for- mits a more flexible approach.4 In 2007, eign branches and overseas investments the Federal Reserve conducted 476 in- of member banks, Edge Act and agree- spections of large bank holding compa- ment corporations, and bank holding nies and 3,007 inspections of small, non- companies and also the investments by complex bank holding companies. bank holding companies in export trading companies. In addition, it supervises Financial Holding Companies the activities that foreign banking Under the Gramm-Leach-Bliley Act, organizations conduct through entities bank holding companies that meet cer- in the United States, including branches, tain capital, managerial, and other re- agencies, representative offices, and quirements may elect to become finan- subsidiaries. cial holding companies and thereby engage in a wider range of financial ac- Foreign Operations of tivities, including full-scope securities U.S. Banking Organizations underwriting, merchant banking, and in- In supervising the international opera- surance underwriting and sales. The tions of state member banks, Edge Act and agreement corporations, and bank 4. The special supervisory program was holding companies, the Federal Reserve implemented in 1997 and modified in 2002. See generally conducts its examinations or SR letter 02-01 for a discussion of the factors considered in determining whether a bank holding inspections at the U.S. head offices of company is complex or noncomplex (www. these organizations where the ultimate federalreserve.gov/boarddocs/srletters/). responsibility for the foreign offices lies. 90 94th Annual Report, 2007

Examiners also visit the overseas offices vestments that are broader than those of U.S. banks to obtain financial and permissible for member banks. operating information and, in some in- At year-end 2007, 67 banking organi- stances, to evaluate the organizations’ zations, operating 12 branches, were efforts to implement corrective measures chartered as Edge Act or agreement cor- or to test their adherence to safe and porations. These corporations are exam- sound banking practices. Examinations ined annually. abroad are conducted with the cooperation of the supervisory authorities of the U.S. Activities of Foreign Banks countries in which they take place; for national banks, the examinations are co- The Federal Reserve has broad authority ordinated with the OCC. to supervise and regulate the U.S. activi- At the end of 2007, 55 member banks ties of foreign banks that engage in were operating 619 branches in foreign banking and related activities in the countries and overseas areas of the United States through branches, agen- United States; 33 national banks were cies, representative offices, commercial operating 567 of these branches, and 22 lending companies, Edge Act corpora- state member banks were operating the tions, commercial banks, bank holding remaining 52. In addition, 17 nonmem- companies, and certain nonbanking ber banks were operating 23 branches in companies. Foreign banks continue to foreign countries and overseas areas of be significant participants in the U.S. the United States. banking system. As of year-end 2007, 172 foreign Edge Act and Agreement Corporations banks from 53 countries were operating 211 state-licensed branches and agen- Edge Act corporations are international cies, of which 8 were insured by the banking organizations chartered by the FDIC, and 47 OCC-licensed branches Board to provide all segments of the and agencies, of which 4 were insured U.S. economy with a means of financing by the FDIC. These foreign banks also international business, especially ex- owned 9 Edge Act and agreement cor- ports. Agreement corporations are porations and 2 commercial lending similar organizations, state chartered or companies; in addition, they held a con- federally chartered, that enter into an trolling interest in 62 U.S. commercial agreement with the Board to refrain banks. Altogether, the U.S. offices of from exercising any power that is these foreign banks at the end of 2007 not permissible for an Edge Act controlled approximately 18 percent of corporation. U.S. commercial banking assets. These Sections 25 and 25A of the Federal 172 foreign banks also operated 91 rep- Reserve Act grant Edge Act and agree- resentative offices; an additional 49 for- ment corporations permission to engage eign banks operated in the United States in international banking and foreign fi- through a representative office. nancial transactions. These corporations, State-licensed and federally licensed most of which are subsidiaries of mem- branches and agencies of foreign banks ber banks, may (1) conduct a deposit are examined on-site at least once every and loan business in states other than eighteen months, either by the Federal that of the parent, provided that the busi- Reserve or by a state or other federal ness is strictly related to international regulator. In most cases, on-site exami- transactions, and (2) make foreign in- nations are conducted at least once ev- Banking Supervision and Regulation 91 ery twelve months, but the period may supervision for compliance with legal be extended to eighteen months if the requirements. branch or agency meets certain criteria. In cooperation with the other federal Anti-Money-Laundering and state banking agencies, the Federal Examinations Reserve conducts a joint program for supervising the U.S. operations of for- With regard to anti-money-laundering eign banking organizations. The pro- requirements, U.S. Department of the gram has two main parts. One part in- Treasury regulations (31 CFR 103) volves examination of those foreign implementing the Bank Secrecy Act banking organizations that have multiple (BSA) generally require banks and other U.S. operations and is intended to ensure types of financial institutions to file cer- coordination among the various U.S. su- tain reports and maintain certain records pervisory agencies. The other part is a that are useful in criminal or regulatory review of the financial and operational proceedings. The BSA and separate profile of each organization to assess its Board regulations require banking orga- general ability to support its U.S. opera- nizations supervised by the Board to file tions and to determine what risks, if any, reports on suspicious activity related to the organization poses through its U.S. possible violations of federal law, in- operations. Together, these two pro- cluding money laundering, terrorism financing, and other financial crimes. In cesses provide critical information to addition, BSA and Board regulations re- U.S. supervisors in a logical, uniform, quire that banks develop written pro- and timely manner. The Federal Reserve grams on BSA/anti-money-laundering conducted or participated with state and compliance and that the programs be federal regulatory authorities in 357 ex- formally approved by bank boards of aminations in 2007. directors. An institution’s compliance program must (1) establish a system of Compliance with internal controls to ensure compliance Regulatory Requirements with the BSA, (2) provide for independent compliance testing, (3) identify in- The Federal Reserve examines super- dividuals responsible for coordinating vised institutions for compliance with a and monitoring day-to-day compliance, broad range of legal requirements, in- and (4) provide training for personnel as cluding anti-money-laundering and con- appropriate. sumer protection laws and regulations, The Federal Reserve is responsible and other laws pertaining to certain for examining its supervised institutions banking and financial activities. Most for compliance with various anti- compliance supervision is conducted un- money-laundering laws and regulations. der the oversight of the Division of During examinations of state member Banking Supervision and Regulation, banks and U.S. branches and agencies of but consumer compliance supervision is foreign banks and, when appropriate, in- conducted under the oversight of the Di- spections of bank holding companies, vision of Community and Consumer Af- examiners review the institution’s com- fairs. The two divisions coordinate their pliance with the BSA and determine efforts with each other and also with the whether adequate procedures and con- Board’s Legal Division to ensure consis- trols to guard against money laundering tent and comprehensive Federal Reserve and terrorism financing are in place. 92 94th Annual Report, 2007

Specialized Examinations tential conflicts of interest are reviewed; its management and operations, includ- The Federal Reserve conducts special- ing its asset- and account-management, ized examinations of banking organiza- risk-management, and audit and control tions in the areas of information technol- procedures, are also evaluated. In 2007, ogy, fiduciary activities, transfer agent Federal Reserve examiners conducted activities, and government and munici- 98 on-site fiduciary examinations. pal securities dealing and brokering. The Federal Reserve also conducts special- Transfer Agents and ized examinations of certain entities, Securities Clearing Agencies other than banks, brokers, or dealers, that extend credit subject to the Board’s As directed by the Securities Exchange margin regulations. Act of 1934, the Federal Reserve conducts specialized examinations of those Information Technology Activities state member banks and bank holding companies that are registered with the In recognition of the importance of in- Board as transfer agents. Among other formation technology to safe and sound things, transfer agents countersign and operations in the financial industry, the monitor the issuance of securities, regis- Federal Reserve reviews the informa- ter the transfer of securities, and ex- tion technology activities of supervised change or convert securities. On-site ex- banking organizations as well as certain aminations focus on the effectiveness of independent data centers that provide in- an organization’s operations and its formation technology services to these compliance with relevant securities organizations. All safety and soundness regulations. During 2007, the Federal examinations include a risk-focused re- Reserve conducted on-site examinations view of information technology risk at 18 of the 68 state member banks and management activities. During 2007, the bank holding companies that were regis- Federal Reserve was the lead agency in tered as transfer agents and examined 2 cooperative, interagency examinations 1 state member limited-purpose trust of large, multiregional data processing company acting as a national securities servicers. depository.

Fiduciary Activities Government and Municipal Securities Dealers and Brokers The Federal Reserve has supervisory responsibility for state member commer- The Federal Reserve is responsible for cial banks and depository trust compa- examining state member banks and for- nies that together reported, at the end of eign banks for compliance with the Gov- 2007, $39 trillion of assets in various ernment Securities Act of 1986 and with fiduciary or custodial capacities. Addi- Treasury regulations governing dealing tionally, state member nondepository and brokering in government securities. trust companies supervised by the Fed- Thirty state member banks and 6 state eral Reserve reported $40 trillion of as- branches of foreign banks have notified sets held in a fiduciary or custodial ca- the Board that they are government se- pacity. During on-site examinations of curities dealers or brokers not exempt fiduciary activities, an organization’s from Treasury’s regulations. During compliance with laws, regulations, and 2007, the Federal Reserve conducted general fiduciary principles and its po- 7 examinations of broker-dealer activi- Banking Supervision and Regulation 93 ties in government securities at these or- Federal Reserve exempted 246 lenders ganizations. These examinations are from its on-site inspection program. generally conducted concurrently with Nonexempt lenders are subject to either the Federal Reserve’s examination of biennial or triennial inspection. Sixty- the state member bank or branch. eight inspections were conducted during The Federal Reserve is also respon- the year. sible for ensuring that state member banks and bank holding companies that Business Continuity act as municipal securities dealers com- In 2007, the Federal Reserve continued ply with the Securities Act Amendments its efforts to strengthen the resilience of of 1975. Municipal securities dealers are the U.S. financial system in the event of examined pursuant to the Municipal Se- unexpected disruptions. The Federal Re- curities Rulemaking Board’s rule G-16 serve, the OCC, and the Securities and at least once every two calendar years. Exchange Commission (SEC) continued Of the 22 entities that dealt in municipal joint supervisory assessments of the ac- securities during 2007, 7 were examined tivities of core clearing and settlement during the year. firms and significant market participants in implementing and maintaining sound Securities Credit Lenders business resiliency and continuity practices as outlined in “Interagency Paper Under the Securities Exchange Act of on Sound Practices to Strengthen the 1934, the Board is responsible for regu- Resilience of the U.S. Financial Sys- lating credit in certain transactions in- tem.” The Federal Reserve and the other volving the purchase or carrying of Federal Financial Institutions Examina- securities. As part of its general exami- tion Council (FFIEC) agencies contin- nation program, the Federal Reserve ex- ued to coordinate their efforts to ensure amines the banks under its jurisdiction a consistent supervisory approach for for compliance with the Board’s Regula- business continuity practices.5 tion U (Credit by Banks and Persons other than Brokers or Dealers for the Purpose of Purchasing or Carrying Mar- Enforcement Actions gin Stock). In addition, the Federal Re- The Federal Reserve has enforcement serve maintains a registry of persons authority over the banking organizations other than banks, brokers, and dealers it supervises and their affiliated parties. who extend credit subject to Regulation Enforcement actions may be taken to U. The Federal Reserve may conduct address unsafe and unsound practices or specialized examinations of these lend- violations of any law or regulation. For- ers if they are not already subject to mal enforcement actions include cease- supervision by the Farm Credit Admin- and-desist orders, written agreements, istration (FCA), the NCUA, or the OTS. removal and prohibition orders, and At the end of 2007, 621 lenders other civil money penalties. In 2007, the Fed- than banks, brokers, or dealers were reg- eral Reserve completed 34 formal en- istered with the Federal Reserve. Other forcement actions. Civil money penal- federal regulators supervised 200 of ties totaling $20,255,290 were assessed. these lenders, and the remaining 421 were subject to limited Federal Reserve 5. The FFIEC member agencies are the Federal supervision. On the basis of regulatory Reserve Board, the FDIC, the NCUA, the OCC, requirements and annual reports, the and the OTS. 94 94th Annual Report, 2007

As directed by statute, all civil money including equity prices, debt spreads, penalties are remitted to either the Trea- agency ratings, and measures of ex- sury or the Federal Emergency Manage- pected default frequency, to gauge mar- ment Agency. Enforcement orders, ket perceptions of the risk in banking which are issued by the Board, and writ- organizations. In addition, the Federal ten agreements, which are executed by Reserve prepares quarterly Bank Hold- the Reserve Banks, are made public ing Company Performance Reports and are posted on the Board’s website (BHCPRs) for use in monitoring and in- (www.federalreserve.gov/boarddocs/ specting supervised banking organiza- enforcement). tions. The BHCPRs, which are compiled In addition to taking these formal en- from data provided by large bank hold- forcement actions, the Reserve Banks ing companies in quarterly regulatory completed 67 informal enforcement ac- reports (FR Y-9C and FR Y-9LP), con- tions in 2007. Informal enforcement ac- tain, for individual companies, financial tions include memoranda of understand- statistics and comparisons with peer ing and board of directors resolutions. companies. BHCPRs are made available Information about these actions is not to the public on the National Informa- available to the public. tion Center (NIC) website, which can be accessed at www.ffiec.gov. Surveillance and During 2007, three major upgrades to Off-Site Monitoring the web-based Performance Report In- formation and Surveillance Monitoring The Federal Reserve uses automated (PRISM) application were completed. screening systems to monitor the finan- PRISM is a querying tool used by Fed- cial condition and performance of state member banks and bank holding compa- eral Reserve analysts to access and dis- nies between on-site examinations. Such play financial, surveillance, and exami- monitoring and analysis helps direct ex- nation data. In the analytical module, amination resources to institutions that users can customize the presentation of have higher risk profiles. Screening sys- institutional financial information drawn tems also assist in the planning of ex- from Call Reports, Uniform Bank Per- aminations by identifying companies formance Reports, FR Y-9 statements, that are engaging in new or complex BHCPRs, and other regulatory reports. activities. In the surveillance module, users can The primary off-site monitoring tool generate reports summarizing the results used by the Federal Reserve is the Su- of surveillance screening for banks and pervision and Regulation Statistical As- bank holding companies. The upgrades sessment of Bank Risk model (SR- made more regulatory data available for SABR). Drawing primarily on the querying, gave users the ability to dis- financial data that banks report on their play commercial real estate guidance Reports of Condition and Income (Call data, and provided a way to access struc- Reports), SR-SABR uses econometric ture information for all institutions in techniques to identify banks that report NIC. financial characteristics weaker than The Federal Reserve works through those of other banks assigned similar the FFIEC Task Force on Surveillance supervisory ratings. To supplement the Systems to coordinate surveillance ac- SR-SABR screening, the Federal Re- tivities with the other federal banking serve also monitors various market data, agencies. Banking Supervision and Regulation 95

International Training that conform to international best prac- and Technical Assistance tices. The Federal Reserve contributes significantly to ASBA’s organizational In 2007, the Federal Reserve continued management and to its training and tech- to provide technical assistance on bank nical assistance activities. supervisory matters to foreign central banks and supervisory authorities. Tech- nical assistance involves visits by Fed- Supervisory Policy eral Reserve staff members to foreign The Federal Reserve’s supervisory authorities as well as consultations with policy function is responsible for devel- foreign supervisors who visit the Board oping guidance for examiners and bank- or the Reserve Banks. Technical assis- ing organizations as well as regulations tance in 2007 was concentrated in Latin for banking organizations under the Fed- America, Asia, and former Soviet bloc eral Reserve’s supervision. Staff mem- countries. The Federal Reserve, along bers participate in supervisory and regu- with the OCC, the FDIC, and the Trea- latory forums, provide support for the sury, was also an active participant in work of the FFIEC, and participate in the Middle East and North Africa Finan- international forums such as the Basel cial Regulators’ Training Initiative, Committee, the Joint Forum, and which is part of the U.S. government’s the International Accounting Standards Middle East Partnership Initiative. Board. During the year the Federal Reserve offered training courses exclusively for foreign supervisory authorities, both in Capital Adequacy Standards the United States and in a number of Risk-Based Capital Standards for foreign jurisdictions. System staff also Certain Internationally Active took part in technical assistance and Banking Organizations training missions led by the Interna- tional Monetary Fund, the World Bank, On December 7, 2007, the Federal Re- the Inter-American Development Bank, serve, OCC, FDIC, and OTS published the Asian Development Bank, the Basel final rules implementing new risk-based Committee on Banking Supervision capital requirements for large, interna- (Basel Committee), and the Financial tionally active banking organizations Stability Institute. (the Basel II advanced approaches The Federal Reserve is also an associ- framework). The advanced approaches ate member of the Association of Super- framework is broadly consistent with in- visors of Banks of the Americas ternational approaches to implementa- (ASBA), an umbrella group of bank su- tion of Basel II and includes a number pervisors from countries in the Western of prudential safeguards, such as the re- Hemisphere. The group, headquartered quirement that banking organizations in Mexico, promotes communication satisfactorily complete a four-quarter and cooperation among bank supervi- parallel run period before operating un- sors in the region; coordinates training der the Basel II framework, and the use programs throughout the region, with of transitional capital floors. It retains the help of national banking supervisors the long-standing minimum risk-based and international agencies; and aims to capital requirement of 4 percent tier 1 help members develop banking laws, capital and 8 percent total qualifying regulations, and supervisory practices capital and the tier 1 leverage ratio. 96 94th Annual Report, 2007

New Capital Adequacy Framework for U.S. Banking Organizations

Aligning regulatory capital requirements with risk and fostering good risk measurement and management practices for our largest and most complex banking organizations will, I believe, contribute to safer and sounder banks and a more resilient financial system. Randall S. Kroszner, Member, Board of Governors November 2007

On December 7, 2007, the U.S. banking adopted in 2006 by international banking agencies published a new risk-based capi- authorities working through the Basel tal adequacy framework.1 The new Committee on Banking Supervision. framework—known as the advanced ap- The need for a new capital adequacy proaches framework—is designed to align framework arose from continuing rapid more closely the amount of capital U.S. and extensive evolution and innovation in banking organizations are required to hold the financial marketplace, which has sub- as a cushion against potential losses with stantially reduced the effectiveness of the the risks to which they are exposed. Effec- existing risk-based capital rules (the tive April 2008, large, internationally ac- Basel I-based rules) for large, internation- tive U.S. banking organizations will be ally active banking organizations. The required to transition to the advanced Basel II-based rules are more sensitive to approaches framework to calculate the risk and are tailored to the different kinds amount of capital they must hold relative of risk to which banking organizations are to their risk profile; other banking organi- exposed. Basel II regulatory capital re- zations may choose to use the new frame- quirements will vary from organization to work.2 The advanced approaches frame- organization in line with the organiza- work for U.S. banking organizations is tion’s actual risk profile, so that a banking based on the revised international capital organization exposed to greater risk will accord known as Basel II, which was have higher requirements than one exposed to less risk. Both the international and the U.S. 1. The U.S. banking agencies are the Federal frameworks encompass three elements, or Reserve, the Federal Deposit Insurance Corpora- pillars: minimum risk-based capital re- tion, the Office of the Comptroller of the Cur- quirements (pillar 1); supervisory review rency, and the Office of Thrift Supervision. of capital adequacy (pillar 2); and market 2. Banking organizations with at least discipline through enhanced public disclo- $250 billion of consolidated total assets or at sure (pillar 3). least $10 billion of foreign exposure are required Pillar 1 addresses calculation of regula- to use the advanced approaches and to meet the rule’s rigorous qualification requirements; other tory capital requirements in relation to cer- banking organizations may opt into the advanced tain risk exposures. To calculate their min- approaches framework, provided they also meet imum requirements in relation to the credit its requirements. risk arising from wholesale and retail

Banking organizations subject to the action rules for banks that are not ad- framework are expected to meet certain equately capitalized remain in effect. public disclosure requirements designed (For more information, see the box to foster transparency and market disci- “New Capital Adequacy Framework for pline. In addition, the prompt corrective U.S. Banking Organizations.”) Banking Supervision and Regulation 97

exposures, U.S. banking organizations will the risk-based regulatory measure of capi- use an internal ratings-based approach, in- tal adequacy and a banking organization’s serting their own internal estimates of key actual risk exposures and its day-to-day credit risk parameters into formulas pro- risk management will be stronger and vided by supervisors. They will calculate more consistent. their minimum requirements in relation to Pillars 2 and 3 are also essential ele- operational risk using advanced measurements of the advanced approaches frame- ment approaches, which rely on the institu- work. Under pillar 2, banking organizations’ internal risk-measurement and capi- tions are required to have an internal tal calculation processes. The advanced process for ensuring that they are holding approaches framework also specifies sepa- enough capital to support their overall risk rate methodologies for calculating capital profile (including those risks not captured requirements in relation to securitization or not fully addressed under pillar 1), par- and equity exposures. ticularly during economic downturns and Compared with the Basel I-based rules, periods of financial stress. These internal banking organizations under Basel II-based processes will be subject to rigorous su- rules will be required to take greater ac- pervisory review. count of their off-balance-sheet activities in Pillar 3 addresses banking organiza- calculating their capital requirements. The tions’ communication with market partici- new framework also provides a more-risk- pants about their risks, the associated lev- sensitive regulatory capital approach to els of capital, and the manner in which capital markets activities and transactions, they are meeting the requirements of the such as repurchase agreements, securities advanced approaches framework. The borrowing and lending, margin loans, and public disclosures called for under pillar 3 over-the-counter derivatives. The enhanced are expected to increase the transparency risk sensitivity of the advanced approaches of banking organizations’ activities and framework should provide incentives for exposures, giving market participants use- lending to creditworthy counterparties and ful information about banking organiza- using effective credit-risk mitigation tech- tions’ risk profiles and their ability to niques, such as requiring collateral. manage risk. The advanced approaches build on the Adoption of the advanced approaches risk-measurement and risk-management framework is an important milestone for approaches already being used by sophisti- the U.S. banking agencies, but effective cated banking organizations and are de- implementation in the coming years will signed to evolve over time as these organi- be just as important. Implementation of zations refine and enhance their internal the Basel II-based rules, and the associ- practices. As a result, these approaches are ated improvements in risk management, better able than the Basel I-based rules to will not be a one-time event, but rather an be adapted to innovations in banking and ongoing process. The agencies will ob- financial markets and to capture the risks serve carefully how the advanced ap- arising from new products and activities. proaches work in practice, assessing their This increased adaptability and flexibility advantages and limitations, to ensure that suggests that the relationship between they are operating as intended.

Revisions to the ments on a September 2006 notice of Market Risk Capital Rule proposed rulemaking that presented re- During 2007, the Federal Reserve, OCC, visions to the market risk capital rule FDIC, and OTS considered public com- used by the Federal Reserve, OCC, and 98 94th Annual Report, 2007

FDIC since 1997 for banking organiza- posed standardized Basel II capital rule tions having significant exposure to in the first half of 2008. market risk. Under the existing market risk capital rule, certain banking organi- Other Capital Issues zations are required to calculate a capi- Board staff conduct supervisory analy- tal requirement for the general market ses of innovative capital instruments and risk of their covered positions and the novel transactions to determine whether specific risk of their covered debt and such instruments qualify for inclusion in equity positions. The proposed revisions tier 1 capital.6 Much of this work in would enhance the rule’s risk sensitiv- 2007 involved evaluating enhanced ity, require banking organizations that forms of trust preferred securities and model specific risk to reflect any incre- mandatory convertible securities. mental default risk of traded positions, Staff members also identify and ad- and require public disclosure of certain dress supervisory concerns related to su- qualitative and quantitative market risk pervised banking organizations’ capital information. The agencies expect to fi- issuances and work with the Reserve nalize this rule in the first half of 2008. Banks to evaluate the overall composi- In July 2007, the Federal Reserve is- tion of banking organizations’ capital. sued a letter reminding supervised bank- In this work, the staff often must review ing organizations that the application of the funding strategies proposed in appli- the fair value option to securities may cations for acquisitions and other trans- subject the organization to the market actions submitted to the Federal Reserve risk capital rule. The letter directed by banking organizations. those organizations to contact their Re- serve Bank to discuss their plans to address the rule’s requirements. Accounting Policy The supervisory policy function is also Risk-Based Capital Standards responsible for monitoring major do- for Banking Organizations mestic and international proposals, stan- Not Subject to Basel II dards, and other developments affecting During 2007, the Federal Reserve, OCC, the banking industry in the areas of FDIC, and OTS considered public com- accounting, auditing, internal controls ments on a notice of proposed rulemak- over financial reporting, financial ing (NPR) issued in December 2006 disclosure, and supervisory financial proposing modifications to the current reporting. Federal Reserve staff Basel I-based capital rules. The pro- members interact with key constituents posed rules would provide an option to in the accounting and auditing profes- those banking organizations that are not sions, including regulators, standard- required to adopt Basel II and do not setters, accounting firms, accounting wish to voluntarily follow the advanced and banking industry trade groups, and approaches. This option is known as the the banking industry, and issue Basel I-A proposal. supervisory guidance as appropriate. In response to comments calling for an option to adopt the standardized ap- 6. Tier 1 capital comprises common stockhold- proach under Basel II, the agencies re- ers’ equity and qualifying forms of preferred vised the Basel I-A proposal and intend stock, less required deductions such as goodwill to issue a new NPR setting forth a pro- and certain intangible assets. Banking Supervision and Regulation 99

Domestic Accounting nancial Reporting, which was established to examine the U.S. financial The Federal Reserve continues to reporting system with the goals of re- closely monitor domestic and interna- ducing unnecessary complexity and tional accounting standard-setting re- making information more useful and un- lated to the use of fair value accounting. derstandable for investors. Federal Re- In previous comment letters to the Fi- serve staff also participated in FASB ef- nancial Accounting Standards Board forts to improve financial reporting, (FASB), the Federal Reserve has raised including roundtable discussions on concerns about the reliability of reported modifications of securitized subprime financial results based on fair value mortgage loans and the joint FASB− measurements, especially when finan- International Accounting Standards cial instruments are illiquid. In May Board (IASB) project on Financial 2007, Federal Reserve staff issued a Statement Presentation. comment letter to the FASB regarding its “Invitation to Comment on Valua- Bank Secrecy Act and tion Guidance for Financial Reporting” Anti–Money Laundering that strongly supported efforts to consider the need for additional valuation In 2007, the FFIEC again updated the guidance. Bank Secrecy Act/Anti–Money Launder- The FASB’s Statement of Financial ing Examination Manual (originally Accounting Standards No. 159, The Fair issued in 2005) to further clarify super- Value Option for Financial Assets and visory expectations, incorporate new Financial Liabilities, issued in February regulatory issuances, and respond to in- 2007, allows most financial assets and dustry requests for additional guidance. financial liabilities to be reported at fair Significant revisions included updates to value. As part of its continued focus on the chapters on customer due diligence, the use of fair value accounting at bank- suspicious activity reporting, foreign ing organizations, and in light of the correspondent accounts, electronic potential increased use of fair value ac- banking, and trade finance. The manual counting for loans, the Federal Reserve provides current and consistent risk- staff conducted a study of fair value based guidance to help banking measurements of commercial loan val- organizations comply with the BSA and ues. The study was intended to provide safeguard operations from money additional insight into valuation method- laundering and terrorism financing. ologies used and related control frame- Also during the year, the FFIEC agen- works for loans at a number of large, cies issued “Interagency Statement on internationally active banking organiza- Enforcement of Bank Secrecy Act/Anti− tions. The study report, issued in June Money Laundering Requirements” set- 2007, summarizes commercial loan fair ting forth their interpretation of the re- value measurement practices at these quirement in the Federal Deposit organizations. Insurance Act relating to supervisory ac- Federal Reserve staff participated in a tions to address certain BSA compliance number of SEC and FASB efforts to ad- issues. The statement provides greater dress current accounting issues. A se- consistency among the agencies on cer- nior Federal Reserve representative is tain BSA enforcement decisions and de- an official observer on the SEC Advi- scribes considerations that affect those sory Committee on Improvements to Fi- decisions. 100 94th Annual Report, 2007

The Federal Reserve and other fed- of developing a definition of capital. eral banking agencies continued during The Federal Reserve also participated in 2007 to share information with the Fi- a workshop addressing supervisory and nancial Crimes Enforcement Network industry expectations with regard to (FinCEN) under the interagency memo- implementation of pillar 2 of Basel II randum of understanding (MOU) that (supervisory review). was finalized in 2004, and with the Treasury’s Office of Foreign Assets Risk Management Control (OFAC) under the interagency The Federal Reserve contributed to su- MOU that was finalized in 2006. pervisory policy papers, reports, and The Federal Reserve continues to par- recommendations issued by the Basel ticipate in efforts to promote transpar- Committee during 2007 that were ency and address risks faced by finan- generally aimed at improving the cial institutions that act as intermediaries supervision of banking organizations’ in international funds transfers. The risk-management practices.7 Two of Federal Reserve, other U.S. banking these were agencies, and the Treasury have supported private-sector efforts to address • “Principles for Home-Host Supervi- the anti-money-laundering and sanctions sory Cooperation and Allocation concerns of banks that have interna- Mechanisms in the Context of Ad- tional operations. In addition, the Fed- vanced Measurement Approaches,” eral Reserve participates in the Anti− consultative document published in Money Laundering and Countering the February and final document pub- Financing of Terrorism Expert Group, a lished in November subcommittee of the Basel Committee’s • “Guidelines for Computing Capital International Liaison Group. for Incremental Default Risk in the Trading Book,” consultative docu- International Guidance on ment published in October Supervisory Policies The Federal Reserve contributed to ef- As a member of the Basel Committee, forts begun in January 2007 to look at the Federal Reserve participates in ef- liquidity regulation across jurisdictions forts to advance sound supervisory poli- and to review the 2000 Basel Commit- cies for internationally active banking tee paper “Sound Practices for Manag- organizations and to improve the stabil- ing Liquidity in Banking Organisations” ity of the international banking system. with a view toward updating the paper. In 2007, the Federal Reserve participated in ongoing cooperative work on Joint Forum implementation of Basel II and on de- In 2007, the Federal Reserve continued velopment of international supervisory to participate in the Joint Forum—a guidance, particularly in the area of group established under the aegis of the funding liquidity risk management. Basel Committee to address issues re- The Federal Reserve also continued lated to the banking, securities, and in- to participate in Basel Committee work- surance sectors, including the regulation ing groups addressing issues not fully resolved in the Basel II framework. One 7. Papers issued by the Basel Committee can effort is a look at eligible capital instru- be accessed via the Bank for International Settle- ments across jurisdictions with the goal ments website at www.bis.org. Banking Supervision and Regulation 101 of financial conglomerates. The Joint guidance on fair value measurement, Forum is made up of representatives of particularly as part of the joint FASB- the Basel Committee, the International IASB program on convergence between Organization of Securities Commis- International Financial Reporting Stan- sions, and the International Association dards and U.S. generally accepted ac- of Insurance Supervisors. The Federal counting principles (GAAP). Reserve contributed to the development In 2007 the Basel Committee also is- of supervisory policy papers, reports, sued a series of comment letters to the and recommendations issued by the IAASB related to the international stan- Joint Forum during 2007, including dards on auditing (ISAs) that are being work on risk concentrations, credit risk revised as part of the IAASB’s Clarity transfer, customer suitability, and imple- Project. The Clarity Project is part of an mentation of principles for the supervi- effort by the IAASB to increase consis- sion of financial conglomerates.8 The tency in the application of auditing stan- Federal Reserve also participated in dards around the world and to improve Joint Forum-sponsored information- the clarity of the ISAs. The revised ISAs sharing on pandemic planning and other cover such audit areas as planning the business continuity initiatives. audit, auditing different types of financial statements, audit evidence, related International Accounting parties, going concern, fair value mea- The Federal Reserve participates in the surements, internal audit, and the audi- Basel Committee’s Accounting Task tor’s report. Force (ATF), which represents the Basel Committee at international meetings on Credit Risk Management accounting, auditing, and disclosure issues affecting global banking organiza- The Federal Reserve works with the tions. During 2007, Federal Reserve other federal banking agencies to de- staff contributed to the development of velop guidance on the management of numerous Basel Committee comment credit risk. letters related to accounting and auditing matters that were submitted to the Working with Mortgage Borrowers IASB and the International Auditing and In April 2007 the Federal Reserve, Assurance Standards Board (IAASB). FDIC, NCUA, OCC, and OTS issued The Basel Committee in May 2007 staff guidance to encourage supervised issued a comment letter to the IASB on institutions to work constructively with its discussion paper “Fair Value Mea- homeowners who are financially unable surements.” The paper was prepared by to continue meeting their mortgage pay- the IASB as part of its efforts to develop ments. The agencies reminded institu- a standard for fair value measurements tions that prudent workout arrangements similar to the FASB Statement of Finan- that are consistent with safe and sound cial Accounting Standards No. 157, Fair lending practices are generally in the Value Measurements, issued in Septem- long-term best interest of both the finan- ber 2006. In its letter, the Basel Commit- cial institution and the borrower. tee emphasized the importance of sound Subprime Mortgage Lending 8. Papers issued by the Joint Forum can be accessed via the Bank for International Settle- In June the Federal Reserve, FDIC, ments website at www.bis.org. NCUA, OCC, and OTS issued “State- 102 94th Annual Report, 2007 ment on Subprime Mortgage Lending” The statement outlines the steps a ser- to address issues and questions related vicer may take when there is an in- to certain adjustable-rate mortgage creased risk of default, including identi- (ARM) products marketed to subprime fying borrowers at heightened risk of borrowers. The statement emphasizes delinquency or default, contacting bor- the need for prudent underwriting stan- rowers to assess their ability to repay, dards and clear and balanced consumer and determining whether default is rea- information, so that institutions and con- sonably foreseeable. The statement goes sumers can assess the risks arising from on to explain possible loss-mitigation certain ARM products that have dis- techniques that a servicer may pursue counted or low introductory rates. It de- with a borrower, recognizing that the scribes the prudent safety and soundness servicer must consider the documents and consumer protection standards that governing the securitization trust to de- institutions should follow to ensure that termine its authority to restructure loans borrowers obtain loans they can afford that are delinquent or are at risk of im- to repay. These standards include quali- minent default. fying borrowers on a fully indexed, fully amortized basis and guidelines on the Pandemic Planning use of risk-layering features, including an expectation that stated income and In December, the FFIEC agencies pub- reduced documentation would be ac- lished guidance on planning for the pur- cepted only if there are documented fac- pose of minimizing the potential adverse tors that clearly minimize the need for effects of an influenza pandemic. The verification of the borrower’s repayment guidance emphasizes the importance of capacity. Consumer protection standards (1) a preventive program to reduce the include clear and balanced product dis- likelihood that the institution’s opera- closures for customers and limits on pre- tions will be significantly affected by a payment penalties so that customers pandemic, (2) a documented strategy have a reasonable period to refinance that scales the response to the particular without penalty, typically at least sixty stages of an outbreak, (3) a comprehen- days before expiration of the initial fixed sive framework of facilities, systems, or interest rate period. procedures needed to continue critical operations, (4) a testing program, and (5) an oversight program. In September Statement on and October, the Federal Reserve par- Loss-Mitigation Strategies ticipated with the other FFIEC agencies In September the Federal Reserve, in a Treasury-sponsored, industrywide FDIC, NCUA, OCC, OTS, and Confer- business continuity exercise to test the ence of State Bank Supervisors issued a financial sector’s ability to respond to a statement encouraging federally regu- pandemic crisis. The Federal Reserve lated financial institutions and state- helped develop the after-exercise report, supervised entities that service securi- which was published in January 2008. tized residential mortgages to review their authority under pooling and servic- Banks’ Securities Activities ing agreements to identify borrowers at risk of default and to pursue appropriate In September, the Federal Reserve and loss-mitigation strategies designed to the SEC adopted joint final rules defin- preserve sustainable home ownership. ing the scope of securities activities a Banking Supervision and Regulation 103 bank may conduct without registering needed, to recommend and implement with the SEC as a securities broker. The appropriate and timely revisions to the Gramm-Leach-Bliley Act eliminated the reporting forms and the attendant blanket “broker” exception for banks instructions. that had been contained in section 3(a)(4) of the Securities Exchange Act Bank Holding Company of 1934, but it granted exceptions de- Regulatory Reports signed to allow banks to continue to engage in securities transactions for cus- The Federal Reserve requires that U.S. tomers in connection with their normal bank holding companies periodically trust, fiduciary, custodial, and other submit reports providing financial and banking operations. The rules imple- structure information. The information ment the most important “broker” ex- is essential in supervising the companies ceptions for trust and fiduciary activi- and in formulating regulations and su- ties, custodial and deposit “sweep” pervisory policies. It is also used in re- functions, and third-party networking sponding to requests from Congress and arrangements. the public for information about bank holding companies and their nonbank Economic Growth and Regulatory subsidiaries. Foreign banking organiza- Paperwork Reduction Act of 1996 tions also are required to periodically submit reports to the Federal Reserve. The Economic Growth and Regulatory Reports in the FR Y-9 series— Paperwork Reduction Act of 1996 FR Y-9C, FR Y-9LP, and FR Y-9SP— (EGRPRA) requires that the federal provide standardized financial state- banking agencies review their regula- ments for bank holding companies on tions every ten years to identify and both a consolidated and a parent-only eliminate any unnecessary requirements basis. The reports are used to detect imposed on insured depository institu- emerging financial problems, to review tions. (In addition, the Board periodi- performance and conduct pre-inspection cally reviews each of its regulations.) analysis, to monitor and evaluate risk During 2007, the Federal Reserve, OCC, profiles and capital adequacy, to evalu- FDIC, and OTS completed the required ate proposals for bank holding company review and issued a joint report to mergers and acquisitions, and to analyze Congress, which is available on the the holding company’s overall financial EGRPRA website at www.egrpra.gov. condition. Nonbank subsidiary reports— FR Y-11, FR 2314, and FR Y-7N—help Regulatory Reports the Federal Reserve determine the condition of bank holding companies that The supervisory policy function is re- are engaged in nonbank activities and sponsible for developing, coordinating, also aid in monitoring the number, na- and implementing regulatory reporting ture, and condition of the companies’ requirements for various financial re- nonbank subsidiaries. porting forms filed by domestic and for- In March, several revisions to the eign financial institutions subject to Fed- FR Y-9C report were approved for eral Reserve supervision. Federal implementation during 2007: (1) collec- Reserve staff members interact with ap- tion of certain data on the sources of fair propriate federal and state supervisors, value measurements from all institutions including foreign bank supervisors as that choose, under GAAP, to apply a fair 104 94th Annual Report, 2007 value option to one or more financial and Income (Call Report) as described instruments and one or more classes of in the next section. In addition, the Fed- servicing assets and liabilities, and from eral Reserve proposed to collect certain certain institutions that report trading as- data on the FR Y-9LP, FR Y-9SP, sets and liabilities; (2) collection of in- FR Y-11, FR 2314, FR Y-7, and formation on the cumulative change in FR 2886b forms from all institutions the fair value of liabilities accounted for that choose to apply a fair value option under the fair value option that is attrib- to financial instruments and servicing utable to changes in the bank holding assets and liabilities, and also proposed company’s own creditworthiness, for to collect other information on sources purposes of determining regulatory capi- of income for supervisory purposes. tal; (3) collection of certain data on one- to four-family residential mortgage Commercial Bank loans that have terms allowing for nega- Regulatory Financial Reports tive amortization; and (4) revision of instructions for reporting time deposits As the federal supervisor of state mem- and brokered deposits. ber banks, the Federal Reserve, along Effective March 2007, four new items with the other banking agencies through were added to the quarterly FR Y-11 the FFIEC, requires banks to submit and FR 2314 reporting forms to facili- quarterly Call Reports. Call Reports are tate monitoring of the extension of nega- the primary source of data for the super- tively amortizing residential mortgage vision and regulation of banks and the loans. Also, a new section concerning ongoing assessment of the overall notes to the financial statements was soundness of the nation’s banking sys- added to the FR 2314. tem. Call Report data, which also serve Effective June 2007, reporting forms as benchmarks for the financial informa- used to collect information on changes tion required by many other Federal Re- in organizational structure and the status serve regulatory financial reports, are of a foreign branch (FR Y-10, widely used by state and local govern- FR Y-10F, FR Y-10S, and FR 2058) ments, state banking supervisors, the were combined into one event-generated banking industry, securities analysts, form called the FR Y-10. Also, a supple- and the academic community. mental form was created (FR Y-10E) to For the 2007 reporting period, the collect additional structure information FFIEC implemented various revisions to that the Federal Reserve deems to be the Call Report to address new safety critical and is needed in an expedited and soundness considerations and to fa- manner in order to meet new legislative cilitate supervision. Among these revi- requirements, answer congressional in- sions were changes related to the report- quiries, or respond to market events. ing of data for deposit insurance Effective December 2007, a require- assessments; changes to provide for the ment that an institution verify its list of reporting of data on nontraditional mort- domestic branches was added to the gage products; and changes to provide FR Y-6. for the reporting of data related to cer- In November, the Federal Reserve tain financial instruments measured at proposed a number of revisions to the fair value. FR Y-9 for the 2008 reporting period In September, the FFIEC proposed a comparable to those proposed for the number of revisions to the Call Report bank Consolidated Reports of Condition for the 2008 reporting period. The pro- Banking Supervision and Regulation 105 posed revisions include collecting addi- with business needs; (2) identification tional information related to one- to and implementation of improvements to four-family residential mortgage loans; make technology more accessible to modifying the definition of trading ac- staff working in the field; (3) strengthen- count in response to the creation of a ing of compliance with data-privacy fair value option in generally accepted regulations; (4) identification of oppor- accounting principles; revising certain tunities to converge and streamline IT schedules to enhance the reporting of applications, including key administra- information available under the fair tive systems, to provide consistent and value option; revising the instructions seamless information; (5) evaluation and for reporting daily average deposit data implementation of collaboration and by newly insured institutions to conform analysis technologies (such as commu- with the FDIC’s assessment regulations; nities of practice and business intelli- and clarifying the instructions for report- gence tools) to integrate supervisory and ing credit derivatives data in the risk- management information systems that based capital schedule. support both office-based and field staff; In 2007, Federal Reserve staff led a (6) with the other federal regulatory review of the Call Report by the federal agencies, modernization of the Shared banking agencies to determine which National Credit system; and (7) en- data requirements are no longer neces- hancement of the information security sary or appropriate. The review, re- framework for the supervisory function, quired by the Financial Regulatory Re- improving both overall security and lief Act of 2006 to be conducted every compliance with best-practices and five years, documented the safety and regulatory requirements (security en- soundness and other public policy uses hancements included the encryption of of each Call Report item and will serve data on all laptop computers and distri- as a reference for future changes to the bution of encrypted portable drives). In Call Report. addition, new, advanced security measures were pilot-tested prior to expected Supervisory Information implementation in 2008. Technology National Information Center Information technology supporting Fed- eral Reserve supervisory activities is The National Information Center (NIC) managed within the System supervisory is the Federal Reserve’s comprehensive information technology (SSIT) function repository for supervisory, financial, and in the Board’s Division of Banking Su- banking structure data and supervisory pervision and Regulation. SSIT works documents. NIC includes data on bank- through assigned staff at the Board and ing structure throughout the United the Reserve Banks, as well as through States; the National Examination Data- System committees, to ensure that key base (NED), which enables supervisory staff members throughout the System personnel as well as federal and state participate in identifying requirements banking authorities to access NIC data; and setting priorities for information the Banking Organization National technology initiatives. Desktop (BOND), an application that fa- In 2007, the SSIT function worked on cilitates secure, real-time electronic several strategic projects and initiatives: information-sharing and collaboration (1) alignment of technology investments among federal and state banking regula- 106 94th Annual Report, 2007 tors for the supervision of banking orga- ence of State Bank Supervisors—on a nizations; and the Central Document and variety of technology-related initiatives Text Repository (CDTR), which con- and projects supporting the supervision tains documents supporting the supervi- business function. sory processes. Within the NIC, the supporting sys- Staff Development tems have been modified over time to extend their useful lives and improve The System Staff Development Program business workflow efficiency. During trains staff members at the Board, the 2007 work continued on upgrading the Reserve Banks, and state banking de- entire NIC infrastructure in order to pro- partments. Training is offered at the ba- vide easier access to information, a con- sic, intermediate, and advanced levels in sistent Federal Reserve enterprise infor- several disciplines within bank supervi- mation layer, a comprehensive metadata sion: safety and soundness, information repository, and uniform security across technology, foreign banking organiza- the Federal Reserve. Implementation is tions, and consumer affairs. Classes are expected to be phased in beginning mid- conducted in Washington, D.C., as well year 2008, with a completion target of as at Reserve Banks and other locations. 2010. Also in 2007, the NED system The Federal Reserve also participates in was modified to enhance the collection training offered by the FFIEC and by and reporting of Bank Secrecy Act in- certain other regulatory agencies. The formation. In addition, the BOND and System’s involvement includes develop- CDTR systems were enhanced to pro- ing and implementing basic and ad- vide the document storage facility for vanced training in relation to various the new national Federal Reserve Con- emerging issues as well as in specialized sumer Help call center. Key summary areas such as international banking, in- documentation regarding consumer formation technology, anti–money laun- complaints and inquiries is posted into dering, capital markets, payment sys- the CDTR and made available to Sys- tems risk, and real estate appraisal (see tem staff and staff at the other federal table). banking agencies via the BOND system. In 2007, the Federal Reserve trained The BOND and CDTR systems were 2,588 students in Federal Reserve Sys- also enhanced to provide an automated, tem schools, 894 in schools sponsored electronic means for passing examina- by the FFIEC, and 26 in other schools, tion and inspection reports to the records for a total of 3,508. The number of train- management system of the Board’s Of- ing days in 2007 totaled 16,791. fice of the Secretary. This new elec- The System provides scholarship as- tronic process has allowed the Reserve sistance to the states for training their Banks to discontinue the long-standing examiners in Federal Reserve and practice of sending hard-copy reports to FFIEC schools. Through this program, the Board for records management pur- 659 state examiners were trained—347 poses. in Federal Reserve courses, 309 in Finally, during 2007 the Federal Re- FFIEC programs, and 3 in other courses. serve continued to work closely with A staff member seeking an examin- other federal and state banking er’s commission is required to take a agencies—including federal agency first proficiency examination as well as chief information officers, FFIEC task a second proficiency examination in one forces and subgroups, and the Confer- of two specialty areas, safety and sound- Banking Supervision and Regulation 107

Training Programs for Banking Supervision and Regulation, 2007

Number of sessions conducted Program Total Regional

Schools or seminars conducted by the Federal Reserve Core schools Banking and supervision elements ...... 9 8 Financial analysis and risk management ...... 9 8 Bank management ...... 3 1 Report writing ...... 17 17 Team dynamics and negotiation ...... 9 9 Conducting meetings with management ...... 15 15 Other schools Credit risk analysis ...... 7 7 Examination management ...... 6 5 Real estate lending seminar ...... 2 1 Senior forum for current banking and regulatory issues ...... 1 1 Basel II corporate activities ...... 1 1 Basel II operational risk ...... 2 1 Basel II retail activities ...... 2 2 Principles of fiduciary supervision ...... 1 1 Commercial lending essentials for consumer affairs ...... 1 1 Consumer compliance examinations I ...... 2 0 Consumer compliance examinations II ...... 2 2 CRA examination techniques ...... 2 2 CA risk-focused examination techniques ...... 2 2 Fair lending examination techniques ...... 2 2 Foreign banking organizations seminar ...... 1 1 Information systems continuing education ...... 8 8 Asset liability management (ALM1) ...... 2 2 Fundamentals of interest rate risk management ...... 6 6 Technology risk integration ...... 4 4 Trading risk management ...... 2 2 Leadership and influence ...... 4 4 Fundamentals of fraud ...... 7 7 Information technology seminars1 ...... 21 21

Self-study or online learning2 Orientation (core and specialty) ...... 0 0 Self-study programs 1, 2, and 3 ...... 3 0 Self-study modules ...... 0 0

Other agencies conducting courses3 Federal Financial Institutions Examination Council ...... 71 1 The Options Institute ...... 1 1

1. Held at the IT Lab at the Chicago Federal Reserve 2. Self-study programs do not involve group sessions. Bank. 3. Open to Federal Reserve employees. ness or consumer affairs. In 2007, 161 Regulation of the examiners passed the first proficiency U.S. Banking Structure examination and 73 passed the second proficiency examination, 53 examiners The Federal Reserve administers several in safety and soundness and 20 in federal statutes that apply to bank hold- consumer affairs. An information ing companies, financial holding com- technology specialty is also offered; it panies, member banks, and foreign requires passing a proficiency examina- banking organizations—the Bank Hold- tion and an examination administered ing Company Act, the Bank Merger Act, by an information technology industry the Change in Bank Control Act, the association. Federal Reserve Act, and the Interna- 108 94th Annual Report, 2007 tional Banking Act. In administering plicable law. In the case of a foreign these statutes, the Federal Reserve acts banking organization seeking to acquire on a variety of proposals that directly or control of a U.S. bank, the Federal Re- indirectly affect the structure of the U.S. serve also considers whether the foreign banking system at the local, regional, bank is subject to comprehensive super- and national levels; the international op- vision or regulation on a consolidated erations of domestic banking organiza- basis by its home-country supervisor. In tions; or the U.S. banking operations of 2007, the Federal Reserve acted on 603 foreign banks. The proposals concern applications and notices filed by bank bank holding company formations and holding companies to acquire a bank or acquisitions, bank mergers, and other a nonbank firm, or to otherwise expand transactions involving bank or nonbank their activities. firms. In 2007, the Federal Reserve acted Bank holding companies generally on 1,365 proposals, which represented may engage in only those nonbanking 2,661 individual applications filed under activities that the Board has previously the five administered statutes. determined to be closely related to banking under section 4(c)(8) of the Bank Bank Holding Company Act Holding Company Act. Since 1996, the act has provided an expedited prior no- Under the Bank Holding Company Act, tice procedure for certain permissible a corporation or similar legal entity must nonbank activities and for acquisitions obtain the Federal Reserve’s approval of small banks and nonbank entities. before forming a bank holding company Since that time the act has also permit- through the acquisition of one or more ted well-run bank holding companies banks in the United States. Once that satisfy certain criteria to commence formed, a bank holding company must certain other nonbank activities on a de receive Federal Reserve approval before novo basis without first obtaining Fed- acquiring or establishing additional eral Reserve approval. banks. The act also identifies the non- A bank holding company may repur- banking activities permissible for bank chase its own shares from its sharehold- holding companies. Depending on the ers. When the company borrows money circumstances, these activities may or to buy the shares, the transaction in- may not require Federal Reserve ap- creases the company’s debt and de- proval in advance of their commence- creases its equity. The Federal Reserve ment. may object to stock repurchases by hold- When reviewing a bank holding coming companies that fail to meet certain pany application or notice that requires standards, including the Board’s capital prior approval, the Federal Reserve may adequacy guidelines. In 2007, the consider the financial and managerial re- Federal Reserve reviewed 11 stock resources of the applicant, the future pros- purchase proposals by bank holding pects of both the applicant and the firm companies. to be acquired, the convenience and The Federal Reserve also reviews needs of the community to be served, elections from bank holding companies the potential public benefits, the com- seeking financial holding company sta- petitive effects of the proposal, and the tus under the authority granted by the applicant’s ability to make available to Gramm-Leach-Bliley Act. Bank holding the Federal Reserve information deemed companies seeking financial holding necessary to ensure compliance with ap- company status must file a written dec- Banking Supervision and Regulation 109 laration with the Federal Reserve. In ture prospects of the institution to be 2007, 37 domestic financial holding acquired; the effect of the proposed company declarations and 2 foreign change on competition in any relevant bank declarations were approved. market; the completeness of the information submitted by the acquiring per- Bank Merger Act son; and whether the proposed change would have an adverse effect on the fed- The Bank Merger Act requires that all eral deposit insurance fund. A proposed proposals involving the merger of in- transaction should not jeopardize the sured depository institutions be acted on stability of the institution or the interests by the appropriate federal banking of depositors. During its review of a pro- agency. The Federal Reserve has pri- posed transaction, the Federal Reserve mary jurisdiction if the institution sur- may contact other regulatory or law en- viving the merger is a state member forcement agencies for information bank. Before acting on a merger pro- about relevant individuals. posal, the Federal Reserve considers the In 2007, the Federal Reserve financial and managerial resources of approved 106 changes in control of state the applicant, the future prospects of the member banks and bank holding existing and combined organizations, companies. the convenience and needs of the community(ies) to be served, and the com- Federal Reserve Act petitive effects of the proposed merger. The Federal Reserve also must consider Under the Federal Reserve Act, a mem- the views of the U.S. Department of Jus- ber bank may be required to seek Fed- tice regarding the competitive aspects of eral Reserve approval before expanding any proposed bank merger involving un- its operations domestically or interna- affiliated insured depository institutions. tionally. State member banks must ob- In 2007, the Federal Reserve approved tain Federal Reserve approval to estab- 68 merger applications under the act. lish domestic branches, and all member banks (including national banks) must Change in Bank Control Act obtain Federal Reserve approval to establish foreign branches. When review- The Change in Bank Control Act re- ing proposals to establish domestic quires individuals and certain other par- branches, the Federal Reserve consid- ties that seek control of a U.S. bank or ers, among other things, the scope and bank holding company to obtain ap- nature of the banking activities to be proval from the appropriate federal conducted. When reviewing proposals banking agency before completing the for foreign branches, the Federal Re- transaction. The Federal Reserve is reserve considers, among other things, the sponsible for reviewing changes in the condition of the bank and the bank’s control of state member banks and bank experience in international banking. In holding companies. In its review, the 2007, the Federal Reserve acted on new Federal Reserve considers the financial and merger-related branch proposals for position, competence, experience, and 1,520 domestic branches and granted integrity of the acquiring person; the ef- prior approval for the establishment of fect of the proposed change on the fi- 20 new foreign branches. nancial condition of the bank or bank State member banks must also obtain holding company being acquired; the fu- Federal Reserve approval to establish fi- 110 94th Annual Report, 2007 nancial subsidiaries. These subsidiaries operations; the managerial resources of may engage in activities that are finan- the foreign bank; whether the home- cial in nature or incidental to financial country supervisor shares information activities, including securities and insur- regarding the operations of the foreign ance agency-related activities. In 2007, bank with other supervisory authorities; no financial subsidiary applications whether the foreign bank has provided were filed. adequate assurances that information concerning its operations and activities Overseas Investments by will be made available to the Federal U.S. Banking Organizations Reserve, if deemed necessary to determine and enforce compliance with ap- U.S. banking organizations may engage plicable law; whether the foreign bank in a broad range of activities overseas. has adopted and implemented proce- Many of the activities are conducted in- dures to combat money laundering and directly through Edge Act and agree- whether the home country of the foreign ment corporation subsidiaries. Although bank is developing a legal regime to ad- most foreign investments are made un- dress money laundering or is participat- der general consent procedures that in- ing in multilateral efforts to combat volve only after-the-fact notification to money laundering; and the record of the the Federal Reserve, large and other sig- foreign bank with respect to compliance nificant investments require prior ap- with U.S. law. In 2007, the Federal Re- proval. In 2007, the Federal Reserve ap- serve approved 18 applications by for- proved 69 proposals for overseas eign banks to establish branches, agen- investments by U.S. banking organiza- cies, or representative offices in the tions, many of which represented invest- United States. ments through an Edge Act or agreement corporation. Public Notice of Federal Reserve Decisions International Banking Act Certain decisions by the Federal Reserve The International Banking Act, as that involve an acquisition by a bank amended by the Foreign Bank Supervi- holding company, a bank merger, a sion Enhancement Act of 1991, requires change in control, or the establishment foreign banks to obtain Federal Reserve of a new U.S. banking presence by a approval before establishing branches, foreign bank are made known to the agencies, commercial lending company public by an order or an announcement. subsidiaries, or representative offices in Orders state the decision, the essential the United States. facts of the application or notice, and In reviewing proposals, the Federal the basis for the decision; announce- Reserve generally considers whether the ments state only the decision. All orders foreign bank is subject to comprehen- and announcements are made public im- sive supervision or regulation on a con- mediately; they are subsequently re- solidated basis by its home-country su- ported in the Board’s weekly H.2 statis- pervisor. It also considers whether the tical release. The H.2 release also home-country supervisor has consented contains announcements of applications to the establishment of the U.S. office; and notices received by the Federal Re- the financial condition and resources of serve upon which action has not yet the foreign bank and its existing U.S. been taken. For each pending applica- Banking Supervision and Regulation 111 tion and notice, the related H.2 contains the credit is used to purchase debt and the deadline for comments. The Board’s equity securities. The Board’s Regula- website (www.federalreserve.gov) pro- tion U limits the amount of credit that vides information on orders and an- may be provided by lenders other than nouncements as well as a guide for U.S. brokers and dealers when the credit is and foreign banking organizations that used to purchase or carry publicly held wish to submit applications or notices to equity securities if the loan is secured by the Federal Reserve. those or other publicly held equity securities. The Board’s Regulation X applies Enforcement of these credit limitations, or margin re- Other Laws and Regulations quirements, to certain borrowers and to certain credit extensions, such as credit The Federal Reserve’s enforcement re- obtained from foreign lenders by U.S. sponsibilities also extend to the disclo- citizens. sure of financial information by state Several regulatory agencies enforce member banks and the use of credit to the Board’s securities credit regulations. purchase and carry securities. The SEC, the Financial Industry Regula- tory Authority (formed through the com- Financial Disclosures by bination of the National Association of State Member Banks Securities Dealers and the regulation, enforcement, and arbitration functions State member banks that issue securities of the New York Stock Exchange), and registered under the Securities Exchange the Chicago Board Options Exchange Act of 1934 must disclose certain infor- examine brokers and dealers for compli- mation of interest to investors, including ance with Regulation T. With respect to annual and quarterly financial reports compliance with Regulation U, the fed- and proxy statements. By statute, the eral banking agencies examine banks Board’s financial disclosure rules must under their respective jurisdictions; the be substantially similar to those of the FCA, the NCUA, and the OTS examine SEC. At the end of 2007, 12 state mem- lenders under their respective jurisdic- ber banks were registered with the tions; and the Federal Reserve examines Board under the Securities Exchange other Regulation U lenders. Act of 1934.

Securities Credit Federal Reserve Membership Under the Securities Exchange Act, the At the end of 2007, 2,489 banks were Board is responsible for regulating members of the Federal Reserve System credit in certain transactions involving and were operating 55,603 branches. the purchase or carrying of securities. These banks accounted for 36 percent of The Board’s Regulation T limits the all commercial banks in the United amount of credit that may be provided States and for 71 percent of all commer- by securities brokers and dealers when cial banking offices. Á

113

Consumer and Community Affairs

Among the Federal Reserve’s responsi- creasing competition and consumer bilities in the areas of consumer and choice. However, the number and types community affairs are of consumer financing products and pro- • viders now available means consumers writing and interpreting regulations to have to become more vigilant and well- implement federal laws that protect informed as they shop for financial and inform consumers; products and manage their personal fi- • supervising state member banks to en- nances. The Federal Reserve has strate- sure compliance with the regulations; gically used its regulatory and supervisory authorities to address consumer • investigating complaints from the protection issues in today’s complex public about state member banks’ consumer financial services marketplace compliance with regulations; and to promote consumer education and • promoting community development community development. in historically underserved markets; and Mortgage Credit • conducting research and promoting consumer education. Homeownership has long been a highly valued goal of both policymakers and These responsibilities are carried out by consumers. In response to the demand the members of the Board of Governors, for home loans, the mortgage industry the Board’s Division of Consumer and has introduced innovative and creative Community Affairs, and the consumer loan products into the consumer finan- and community affairs staff of the Fed- cial services market. As a result, con- eral Reserve Banks. sumers’ access to home mortgage credit The Federal Reserve System’s vari- has expanded considerably over the last ous consumer protection and commu- decade. Market opportunities and tech- nity development roles were the subject nological advancements have contrib- of great interest in 2007. Consumer pro- uted to the growth of the mortgage in- tection concerns moved to the forefront dustry. As the mortgage market grew, of public dialogue as lawmakers, regula- some lenders employed nontraditional tors, the media, and consumers scruti- underwriting and risk-layering strategies nized various practices being used in the in order to capture new market seg- financial services marketplace, particu- ments, particularly consumers who may larly in the markets for subprime mort- not have been able to qualify for gages and credit cards. Intense examina- credit under more-traditional mortgage- tion of the policies and practices at issue underwriting criteria. Although innova- has revealed the complexity of the cur- tion in the mortgage market has made rent financial services marketplace. De- access to mortgage credit possible for regulation and technological and finan- increasing numbers of households, loan cial innovation over the last two decades products have become increasingly fueled the growth of this market, in- complex—and underwriting standards 114 94th Annual Report, 2007

An Overview of the Subprime Mortgage Market

At $11 trillion, the depth and breadth of ability of lenders to sell many mortgages the U.S. home mortgage market is unique. to “securitizers” that pooled large numbers Its sheer capacity has enabled many of mortgages and sold the rights to the families to become homeowners, facilitat- resulting cash flows to investors. Previ- ing a long-standing goal of consumers and ously, lenders tended to hold mortgages on policymakers. Over the past two decades, their books until the loans were repaid. the mortgage industry has expanded as a The increasingly popular “originate-to- result of financial innovation, technologi- distribute” lending model gave lenders cal advancements, and deregulation. Lend- (and mortgage borrowers) greater access to ers have been able to provide more capital markets and allowed risk to be consumers with access to mortgage credit. shared more widely. Increased access to In particular, advances in credit scoring mortgage credit was further fueled by the technology and risk-based pricing strate- rise of both mortgage brokers who gies opened up the mortgage market to expanded the sales and distribution chan- consumers considered to be higher-risk nels of mortgage lending and independent because of their limited or negative credit mortgage originators not directly affiliated histories, income limitations, or other with a federally supervised depository financial issues. Lenders charged these institution. borrowers, known as subprime borrowers, The expanding field of nonbank higher rates to reflect the higher level of mortgage lenders was particularly notable risk they presented. The subprime in the subprime mortgage market. Data mortgage market began to expand mark- from 2006 reported under the Home edly in the mid-1990s and peaked in 2006. Mortgage Disclosure Act indicate that The growth of the subprime mortgage 45 percent of high-cost first mortgages market was fueled by expansive develop- were originated by independent mortgage ments across the financial industry that companies, institutions that are not significantly changed every aspect of the regulated by the federal banking agencies mortgage industry, from how mortgages and that typically sell nearly all of the were marketed and underwritten to how mortgages they originate. These non- they were funded. The use of credit scor- depository institutions fund mortgage lending models to price for risk enabled lending through the capital markets rather than ers to more efficiently evaluate a customer deposits, the traditional source of consumer’s creditworthiness, reducing loan funding for banks. transaction costs for lenders. In addition, All of these mortgage market develop- changes to and the ongoing growth of the ments increased the supply of mortgage secondary mortgage market increased the credit, which in turn likely contributed to have loosened in recent years, particu- mortgage loans.1 In recent years and larly in the subprime market. (See re- throughout 2007, Federal Reserve staff lated box “An Overview of the have undertaken various initiatives to Subprime Mortgage Market.”) (1) scrutinize potentially risky practices Aware of the changing conditions in within the mortgage industry and (2) ad- the mortgage market, the Federal Re- serve Board has responded to the con- 1. See the testimony of Chairman Ben S. Ber- sumer protection and supervisory con- nanke, September 20, 2007 (www.federalreserve.gov/ cerns of nontraditional and subprime newsevents/testimony/bernanke20070920a.htm). Consumer and Community Affairs 115

the rise in the national homeownership rate As the subprime mortgage crisis ex- from 64 percent in 1994 to about 68 per- panded throughout the last quarter of 2007, cent in 2007. But the broadening of access the Federal Reserve actively used its to mortgage credit also had negative as- policy, supervisory, and regulatory tools to pects. Given their weaker credit histories respond to the needs of markets, lenders, and financial conditions, subprime borrow- consumers, and communities. These activi- ers tend to default on their loans more fre- ties were discussed in detail by Federal quently than prime borrowers. A higher in- Reserve Board governors and other offi- cidence of weaker underwriting standards cials who testified before Congress and risk-layering practices, such as failing throughout the year, offering lawmakers to document income and lending nearly to and the public an in-depth discussion about the full value of the home, further increased the issues and actions undertaken by the a subprime borrower’s vulnerability for Federal Reserve in response to concerns default. about the subprime market.1 In addition, In 2007, the problems in the subprime staff at Federal Reserve Banks across the market, deceleration of the housing market, country worked with regulators, govern- decreased house-price appreciation, and the ment officials, lenders, servicers, consumer weakening of the overall economy contrib- advocates, and community leaders to im- uted to a significant number of subprime prove their understanding of the complex mortgage defaults. As a result, the sub- issues that contribute to, as well as the ef- prime mortgage market experienced sig- fects of, widespread mortgage delinquen- nificant setbacks: several independent cies and foreclosures. (For a detailed dis- mortgage lenders declared bankruptcy, and cussion of the Federal Reserve’s efforts, some large financial organizations experi- see the “Mortgage Credit” section of this enced multimillion dollar losses in their chapter.) The Federal Reserve has a strong portfolios. For consumers, the conse- interest in supporting consumers and com- quences of defaulting on a mortgage can be munities. Its activities during 2007 have severe, such as the loss of accumulated laid the foundation for continued efforts to home equity, reduced access to credit, and help stabilize the mortgage industry and foreclosure. And the negative effects can assist consumers to make sound financial spread beyond subprime customers. Clus- decisions. ters of foreclosures in one community can cause the value of nearby properties to decline and lead to an increase in vacant and abandoned properties, thereby inflicting 1. See www.federalreserve.gov/newsevents/ economic harm on entire neighborhoods. testimony/2007testimony.htm) dress issues through regulatory, sup- of the hearing was to gather information ervisory, or community engagement on how the Board might use its rulemak- activities. ing authority to curb abusive lending practices in the home mortgage market, Regulatory Actions particularly the subprime sector.2 The

In June, the Board held a public hearing 2. In 1994, HOEPA was enacted in response to under the Home Ownership and Equity reports of predatory home equity lending practices Protection Act (HOEPA). The purpose in underserved markets. HOEPA amended the 116 94th Annual Report, 2007 meeting, moderated by Governor Ran- tives supported improving the disclo- dall Kroszner, was the last in a series of sures provided to consumers during the five hearings held under HOEPA; the mortgage process. other four hearings were held through- Conversely, consumer advocates and out the nation during the summer of state and local officials urged the Board 2006.3 Representatives from the finan- to adopt robust regulations under cial services industry, consumer and HOEPA. They acknowledged a useful community groups, and state agencies role for supervisory guidance but con- participated in the June hearing and tended that recent problems in the mort- shared their perspectives on certain gage market indicated a need for stron- lending practices, such as prepayment ger requirements that can be enforced penalties, the underwriting of “stated in- through civil actions—actions that come” loans, and the failure to provide would only be possible under regula- escrow accounts for taxes and insur- tions, not supervisory guidance. Con- ance.4 Representatives from the finan- sumer advocates and others welcomed cial services industry acknowledged that efforts to improve mortgage disclosures some recent lending practices merited but insisted that disclosures alone would concern, but these participants urged the not prevent abusive loans. They argued Board to address most of the concerns that independent mortgage lenders are by issuing supervisory guidance rather not subject to the federal regulators’ guid- than regulations under HOEPA. They ance, and enforcement of the existing suggested that recent supervisory guid- laws governing these entities is limited. ance on nontraditional mortgages and In addition to the series of hearings, subprime lending, as well as corrective the Board received information and ad- measures initiated within the mortgage vice from its Consumer Advisory Coun- market, had reduced the need for new cil (see “Advice from the Consumer Ad- regulations. Industry participants said visory Council”) and from outreach that if the Board issues regulations, they meetings to gain insight into industry must be clear enough to eliminate uncer- practices. These efforts informed the tainty and avoid unduly restricting Board’s release of proposed amend- credit. To help consumers avoid abusive ments to Regulation Z (Truth in Lend- lending practices, industry representa- ing) at a public meeting in December.5 The goals of these proposed amendments are to Truth in Lending Act by imposing additional disclosure requirements and other limits on certain • protect consumers in the mortgage high-cost, home-secured loans. Under HOEPA, the market from unfair, abusive, or decep- Board is authorized to issue rules that prohibit tive lending and servicing practices, certain acts or practices in connection with home while preserving responsible lending mortgage loans. HOEPA also directs the Board to periodically hold public hearings to examine the and sustainable homeownership; home equity lending market and the adequacy of • existing regulatory and legislative provisions for ensure that advertisements for mort- protecting the interests of consumers, particularly gage loans provide accurate and bal- low-income consumers. anced information and do not contain 3. For Governor Kroszner’s opening com- misleading or deceptive representa- ments, see www.federalreserve.gov/newsevents/ tions; and speech/kroszner20070614a.htm. 4. For a list of panelists and the agenda, see www.federalreserve.gov/newsevents/press/bcreg/ 5. See www.federalreserve.gov/newsevents/ 20070612a.htm. press/bcreg/20071218a.htm. Consumer and Community Affairs 117

• provide additional consumer protec- For closed-end loans, the proposed rules tions on “higher-priced mortgages,” would prohibit seven misleading or de- mortgages whose annual percentage ceptive advertising practices, for ex- rate (APR) exceeds the yield on com- ample, using the term “fixed” to de- parable Treasury securities by at least scribe a rate that is not fixed. The public three percentage points for first-lien comment period ends in early April loans, or five percentage points for 2008. subordinate-lien loans. Supervisory Activities The proposed rules are comprehensive both in their reach and aim: they would Throughout 2007, concerns about the apply to all mortgage lenders, not just mortgage industry continued to grow. depository institutions, and they seek to The Board undertook various supervi- improve transparency and enhance con- sory activities in collaboration with sumer protection in mortgage lending. other agencies to provide guidance to The proposal directly addresses those lenders and support to consumers. A practices raising the most significant comprehensive overview of the Federal concerns. For higher-priced loans, the Reserve Board’s ongoing efforts to ad- proposed rule would prohibit lenders dress supervisory concerns in the from engaging in a pattern or practice of subprime mortgage market was outlined making mortgage loans on the basis of in congressional testimony delivered in March by the director of the Division of collateral alone, without considering a 6 borrower’s ability to repay the loan; re- Consumer and Community Affairs. In quire lenders to verify the income or April, the federal financial regulatory assets they rely upon in making the loan; agencies jointly issued the “Statement and require lenders to establish escrow on Working with Mortgage Borrowers” accounts for taxes and insurance. Pre- that encouraged institutions to work payment penalties would be permitted constructively with residential borrow- on higher-cost loans only under certain ers who are, or who are reasonably expected to be, unable to make payments conditions. For higher-cost loans and 7 most other mortgage loans secured by a on their home loans. The statement em- principal dwelling, the proposed rules phasizes that loan-workout arrange- would prohibit lenders from paying ments are generally in the long-term best yield-spread premiums to brokers, un- interest of both financial institutions and less a written agreement between the borrowers, provided the arrangement is consumer and broker disclosed the bro- consistent with safe and sound lending ker’s total compensation and other im- practices. The statement cites examples portant information; prohibit lenders and of constructive workout arrangements; brokers from coercing appraisers to mis- for instance, an institution might modify state a home’s value; and require that a borrower’s loan terms or move a bor- servicers credit loan payments on the rower from a variable-rate to a fixed- date of receipt and refrain from charging consumers multiple late fees. 6. See the testimony of Sandra F. Braunstein, With respect to the marketing of March 27, 2007 (www.federalreserve.gov/ home loans, the proposed rules would newsevents/testimony/braunstein20070327a.htm). 7. See www.federalreserve.gov/newsevents/ require lenders to disclose applicable press/bcreg/20070417a.htm (press release) and rates or payments in advertisements as www.federalreserve.gov/boarddocs/srletters/2007/ prominently as advertised teaser rates. sr0706.htm (Consumer Affairs letter). 118 94th Annual Report, 2007 rate loan. In addition, bank and thrift titled the “Statement on Subprime Mort- programs that transition low- or gage Lending” in June.10 This guidance moderate-income homeowners from describes prudent safety-and-soundness higher-cost loans to lower-cost loans in and consumer protection standards that a safe and sound manner may receive institutions should follow when originat- favorable consideration under the Com- ing certain ARMs that are typically of- munity Reinvestment Act.8 fered to subprime borrowers. These In May, the federal bank, thrift, and ARMs offer low initial payments that credit union regulatory agencies issued are based on a short-term fixed introduc- final illustrations of the information on tory rate that is significantly discounted nontraditional mortgage products that from the fully indexed rate (the sum of lenders should provide to consumers. the current index and the margin). The The sample illustrations are intended to statement emphasizes the importance of help institutions implement consumer evaluating a borrower’s repayment ca- protections in the “Interagency Guid- pacity and ability to make payments un- ance on Nontraditional Mortgage Prod- der the fully indexed rate, assuming a uct Risks” that the agencies adopted in fully amortizing repayment schedule. October 2006.9 The consumer protec- The guidance also stresses the need for tions described in the guidance aim to institutions to consider a borrower’s to- ensure that consumers receive clear and tal monthly housing-related payments balanced information about nontradi- (that is, principal, interest, taxes, and in- tional mortgages—before they choose a surance) when assessing the borrower’s mortgage product or select a payment repayment capacity, using the borrow- option for an existing mortgage. Ac- er’s debt-to-income ratio. Finally, the cordingly, the illustrations consist of a guidance instructs lenders to provide narrative explanation of nontraditional consumers with clear and balanced in- mortgage products, a chart compar- formation on the benefits and risks of ing interest-only and payment-option this type of ARM. adjustable-rate mortgages (ARMs) with In September, the federal financial a traditional fixed-rate loan, and a table regulatory agencies and the Conference showing the impact of various payment of State Banking Supervisors issued the options on the loan balance of a “Statement on Loss Mitigation Strate- payment-option ARM (such a table gies for Servicers of Residential Mort- could be included in monthly loan state- gages.”11 The guidance encourages ser- ments). Institutions are not required to vicers of residential mortgages to pursue use the sample illustrations, but the strategies to mitigate their losses and guidance sets forth information that seek to preserve homeownership among lenders should provide to consumers to their borrowers. The statement outlines allow them to evaluate a nontraditional steps that servicers may pursue to deter- mortgage loan. mine if a borrower is at an increased risk The federal financial regulatory agencies jointly issued additional guidance 10. See www.federalreserve.gov/newsevents/ press/bcreg/20070629a.htm (press release) and www.federalreserve.gov/boarddocs/srletters/2007/ 8. For more information, see Q&A §__.22(a)-1 sr0712.htm (Consumer Affairs letter). (Interagency Questions and Answers Regarding 11. See www.federalreserve.gov/newsevents/ Community Reinvestment, July 11, 2001). press/bcreg/20070904a.htm (press release) and 9. See www.federalreserve.gov/newsevents/ www.federalreserve.gov/boarddocs/srletters/2007/ press/bcreg/20070531b.htm. sr0716.htm (Consumer Affairs letter). Consumer and Community Affairs 119 of mortgage default. Steps include iden- standards, as well as senior manage- tifying borrowers who have a height- ment’s oversight of the risk-manage- ened risk of delinquency, contacting ment practices the companies used to those borrowers to assess their ability to ensure compliance with state and fed- repay, and determining whether default eral consumer protection regulations and is reasonably foreseeable. The guidance laws, including the Home Mortgage also presents many possible loss- Disclosure Act, the Equal Credit Oppor- mitigation techniques that a servicer tunity Act, the Truth in Lending Act, the may initiate with a troubled borrower. Real Estate Settlement Procedures Act, In addition to issuing industry guid- the Federal Trade Commission Act, and ance, the Board entered a multiagency the Home Ownership and Equity Protec- partnership to conduct targeted con- tion Act. The agencies will share infor- sumer compliance reviews of selected mation about the reviews and invest- nondepository lenders that have signifi- igations; take supervisory action, as cant subprime mortgage operations.12 appropriate; collaborate on lessons The joint effort, announced in July, is learned; and seek ways to better cooper- the first time multiple agencies have col- ate in ensuring effective and consistent laborated to plan and conduct consumer reviews of these institutions. By jointly compliance reviews of independent developing and applying a coordinated mortgage lenders and nondepository review program, the regulatory agencies subsidiaries of bank and thrift holding will be better positioned to evaluate and companies, as well as mortgage brokers more consistently assess subprime mort- doing business with, or working for, gage practices across a broad range of these entities. mortgage lenders and other participants The agencies involved—the Federal within the industry. On-site reviews are Reserve, the Office of Thrift Supervi- scheduled to begin in February 2008. sion (OTS), the Federal Trade Commis- sion (FTC), state agencies represented Community Outreach Efforts by the Conference of State Bank Super- visors, and the American Association of To augment the Board’s regulatory and Residential Mortgage Regulators—have supervisory activities, System commu- begun developing plans for the targeted nity affairs staff engaged in numerous consumer compliance reviews. Federal efforts to address the personal, eco- Reserve System examiners, assisted by nomic, and social distress of homeown- representatives from the FTC and the ers and communities that have been states, will lead reviews of entities su- negatively affected by the sharp in- pervised by the Federal Reserve System. creases in subprime mortgage loan de- At the same time, state regulators will linquencies and foreclosures. Commu- conduct a coordinated review of an inde- nity affairs analysts and outreach pendent state-licensed subprime lender specialists used their long-standing net- and associated mortgage brokers, and works of industry and community rela- the OTS will conduct a review of a se- tionships to convene local community lected mortgage subsidiary of a thrift and business leaders, investors, lenders, holding company. These reviews will servicers, rating agency representatives, evaluate the companies’ underwriting government officials, consumer and community groups, and others across 12. See www.federalreserve.gov/newsevents/ the country. To complement these dis- press/bcreg/20070717a.htm. cussions, System research staff collected 120 94th Annual Report, 2007 and analyzed data on real estate and the need to modernize the foreclosure subprime mortgage conditions and on system, and the differences in state fore- the impact of homeowner counseling closure laws. The Reserve Banks also programs. The Federal Reserve Bank of organized several public workshops and Philadelphia began collecting data for a participated in outreach events to high- longitudinal study of the effectiveness light innovative intervention programs. of homeownership counseling. In a For example, the San Francisco and Dal- similar but smaller-scale study, the Dal- las Reserve Banks cosponsored a series las Reserve Bank began measuring the of mortgage-streamlining workshops to impact of a local mortgage assistance leverage participants’ broader knowl- program. The New York Reserve Bank edge of community development sub- collected zip code−level data on the in- jects and apply this knowledge to home- cidence of Alt-A and subprime mort- ownership initiatives for Native gage products in its District. Several Americans. other researchers focused on loan work- During the past year, Board and Sys- outs and modifications throughout the tem staff strengthened partnerships with country. Other key initiatives for the re- two prominent national homeownership search functions included providing re- preservation organizations, Neighbor- gional foreclosure projections and in- Works America and the Hope Now Alli- depth analyses of the incidence of ance. Both groups have mobilized their defaults within a particular region. national networks of affiliates and part- The Board and the Reserve Banks ners in order to advance efforts to hosted a number of events, conferences, streamline the mortgage-refinancing and meetings on foreclosure-related process and modify subprime mort- matters in 2007. Many events focused gages. In 2007, Governor Kroszner con- on encouraging lenders and servicers to tinued to serve on the NeighborWorks develop systematic loss-mitigation tech- America board of directors. Members of niques and to promote coordinated out- the Board’s staff remain involved with reach to distressed borrowers. In the that organization’s Center for Home- twelfth District, the San Francisco Re- ownership Education and Counseling, serve Bank and its partners conducted a which establishes education standards series of six forums to explore foreclo- for counseling intermediaries. System sure issues and identify strategies for community affairs staff collaborated preserving homeownership among mi- with NeighborWorks America by par- norities and low-income borrowers.13 ticipating in several foreclosure- The Federal Reserve Bank of Chicago prevention training workshops for home- sponsored symposiums in Chicago, In- ownership counselors; staff also helped dianapolis, and Detroit that featured dis- promote the 1-888-995-HOPE hotline cussions on the regional impact of fore- that links borrowers in financial distress closures. The Cleveland Reserve Bank with mortgage counseling. The Atlanta cosponsored a conference on vacant and Reserve Bank produced an educational abandoned properties, and the Federal DVD in partnership with Neighbor- Reserve Bank of Minneapolis hosted Works America that addressed the grow- several events in the Twin Cities area ing foreclosure challenges in its region. focused on mortgage broker licensing, Several Reserve Banks also supported the Hope Now Alliance, a collaboration 13. See www.sf.frb.org/community/issues/assets/ of counselors, servicers, investors, and preservation/index.html. other mortgage market participants. Sys- Consumer and Community Affairs 121 tem community affairs staff worked with viously, lenders had relied almost solely local Hope Now partners and commu- on interest from their customers’ ac- nity stakeholders to identify cross- count balances for revenue.) These in- industry technology solutions that would dustry developments have significantly enable servicers and counselors to con- elevated concerns about consumer pro- tact at-risk borrowers and better serve tection; the transparency of credit card homeowners. pricing; and the adequacy of consumer Substantial consumer protection and disclosures in credit card marketing ma- community development concerns con- terials, contracts, and periodic state- tinue to be raised about mortgage lend- ments.15 ing practices. The Federal Reserve will Credit card disclosures are intended continue its regulatory, supervisory, and to provide consumers with the informa- community development efforts to seek tion they need to shop for the product ways to protect and support consumers’ that best meets their needs and to enable interests in mortgage credit. The Federal them to make well-informed decisions Reserve will also work collaboratively regarding usage of their cards. However, with a broad spectrum of partners to de- as credit products became more com- velop strategies and programs that will plex, the Board recognized the need to help troubled homeowners address their evaluate its existing regulations govern- mortgage credit difficulties.14 ing the content and presentation of information on credit card disclosures. This undertaking required an in-depth under- Credit Cards standing of the credit card industry, con- The credit card market is another area of sumers’ information needs, and the way consumer finance that has grown rap- consumers shop for credit cards. Before idly, spurred by technological advances, engaging in rule-writing, the Board un- new products, and other innovations. In- dertook extensive consumer testing. creasingly, electronic payments are ac- Working with a consultant, the Board cepted for a wide range of transactions, developed a testing methodology that in- and consumers now use credit cards to volved several stages. First, two sets of facilitate everyday purchases, such as focus-group meetings were held with groceries, gasoline, and even a cup of credit card customers. The focus groups coffee. In 2007, the total level of revolv- offered insight on ing debt held by consumers increased by • what credit terms consumers usually nearly 8 percent from 2006, to nearly consider when shopping for a credit $944 billion. card, Competition in the credit card market • what information consumers find use- has intensified over the last decade. As a ful when they receive a new card in result, lenders have undertaken aggres- the mail, and sive marketing and product development campaigns and also pursued strategies • what information consumers find use- to rely more on fee-based income. (Pre- ful on periodic statements.

14. See the testimony of Governor Randall S. Kroszner, December 6, 2007 (www.federalreserve. gov/newsevents/testimony/kroszner20071206a.htm), 15. See the testimony of Governor Frederic S. and October 24, 2007 (www.federalreserve.gov/ Mishkin, June 7, 2007 (www.federalreserve.gov/ newsevents/testimony/kroszner20071024a.htm). newsevents/testimony/mishkin20070607a.htm). 122 94th Annual Report, 2007

The second stage of the consumer test- ments. The proposal is intended to im- ing focused on current credit card dis- prove the effectiveness of the disclo- closures. In one-on-one interviews, sures consumers receive in connection credit card customers were presented with credit card accounts and other re- with mock disclosures. Participants were volving credit plans; specifically, the asked to evaluate the information pre- proposal seeks to ensure that such infor- sented, and an interviewer asked them mation is provided in a timely manner follow-up questions in order to evaluate and in a form that is readily understand- the usability of the disclosures and con- able. The proposed amendments would sumers’ understanding of them. require changes to the format, timing, Feedback from the second stage was and content requirements of the five used to develop revised sample disclo- main types of open-end credit disclosures for the third phase of testing. sures: (1) credit and charge card applica- These sample disclosures were tested tion and solicitation disclosures; (2) ac- and refined during multiple interviews count-opening disclosures; (3) periodic- with consumers. This process allowed statement disclosures; (4) change-in- staff to learn more about what informa- terms notices; and (5) advertising tion consumers read on current credit provisions. The proposed amendments card disclosures; to observe how easily largely reflect the results of the con- consumers can find various pieces of sumer testing described above. information in these disclosures; and to The proposal generated a great deal test consumers’ understanding of the ter- of interest, yielding more than 2,500 minology used in the disclosures. comments during the comment period The consumer testing process pro- that ended in October. A large number vided important insights into the way of these comments were submitted by consumers shop for credit cards and the individual consumers. Additional in- information they need to make informed sights were provided by consumer advo- decisions. In particular, staff found that cates and industry representatives serv- consumers tend to notice numbers rather ing on the Board’s Consumer Advisory than narrative text. Consumers fre- Council. (See “Advice from the Con- quently reviewed the summary table of sumer Advisory Council.”) rates and terms that they receive with Applications and Solicitations credit card solicitations but paid little attention to densely worded account- The proposal contains changes to make opening disclosures and change-in- the disclosures provided with credit and terms notifications. Likewise, on peri- charge card applications and solicita- odic statements, consumers generally tions more meaningful and easier for focused on numbers, such as fee and consumers to use. Proposed changes in- interest charge information. The Board clude adopting new format requirements took these findings into account as it for the summary table, including rules began drafting proposed amendments to regarding type size and the use of bold- Regulation Z. face type for certain key terms; placement of information; and use of cross- Proposed Amendments references. The proposed rules address a to Regulation Z number of issues regarding the penalties credit and charge card companies may In May, the Board issued for public charge customers. For example, applica- comment proposed Regulation Z amend- tions and solicitations would have to Consumer and Community Affairs 123 state how long penalty rates may be in (for example, an increase in the interest effect, provide a modified disclosure rate) applicable to their accounts, and it about variable rates, describe the effect increases the amount of time these no- of creditors’ payment-allocation practices must be sent before the change be- tices, and reference consumer education comes effective. Generally, the proposed materials on the Board’s website. rules would increase advance notice before a changed term can be imposed Account-Opening Disclosures from 15 to 45 days, to better allow con- The proposal contains revisions to make sumers to obtain alternative financing or the cost disclosures provided to consum- change their account usage. The pro- ers at account opening more conspicu- posed rules would also require a creditor ous and easier to read. The proposed to provide 45 days’ prior notice before changes would require that certain key increasing a rate as a result of a consum- terms be disclosed in a summary table at er’s delinquency or default. account opening; this table would sum- marize the key information consumers Advertising Provisions need to make informed decisions about The proposal revises the rules governing how they use credit cards. The proposed the advertising of open-end credit, to changes would also adopt a different ap- help consumers better understand the proach to disclosing fees, in order to credit terms being offered. Under the make it easier for consumers to identify proposed revisions, advertisements that the costs associated with using the card. state a minimum monthly payment on a Periodic-Statement Disclosures plan offered to finance the purchase of goods or services would be required to The proposal contains revisions to make disclose, in equal prominence to the the disclosures on periodic statements minimum payment, the time period re- more understandable, primarily by quired to pay off the balance and the changing the format requirements for total of payments if only minimum pay- these disclosures—for example, by ments were made. Furthermore, adver- grouping fees, interest charges, and tisements would be able to refer to a rate transactions together by type. Other for- as “fixed” only if the advertisement mat changes include itemizing the inter- specified the time period for which the est charges for different types of transac- rate was fixed and that the rate would tions, such as purchases and cash not increase for any reason during that advances, and providing aggregate to- time. If a time period is not specified, tals of fees and interest for the month the term “fixed” may be used only if the and year-to-date. In addition, creditors rate will not increase for any reason would have to disclose to consumers the while the plan is open. effect of making only the minimum required payments on their account balances. Other Regulatory Actions Change in Consumer’s Interest Rate In addition to proposed rules related to and Other Account Terms mortgages and credit cards, the Board The proposal expands the circumstances issued regulatory amendments in 2007 under which consumers will receive related to the electronic delivery of written notice of changes in the terms consumer disclosures, electronic fund 124 94th Annual Report, 2007 transfers, and the privacy of financial banking and commerce and that were information. unnecessary for consumer protection. The November final rules also included Electronic Disclosures guidance on the use of electronic disclosures, including provisions to clarify the In November, the Board published circumstances under which consumers amendments to five consumer financial conducting transactions online may ob- services and fair lending regulations tain electronic disclosures without re- (Regulations B, E, M, Z, and DD). The gard to the consent requirements of the amendments clarify the requirements for E-Sign Act. The mandatory compliance providing consumer disclosures in elec- date for the final rules is October 1, tronic form under the Electronic Signa- 2008.16 tures in Global and National Commerce Act (the E-Sign Act). Enacted in 2000, Regulation E the E-Sign Act provides that electronic documents and electronic signatures The Electronic Fund Transfer Act have the same validity as paper docu- (EFTA) provides a basic framework of ments and handwritten signatures. The rights, liabilities, and responsibilities for E-Sign Act also contains special rules participants in electronic fund transfer for the use of electronic disclosures in systems. The EFTA is implemented by consumer transactions. Under the act, the Board’s Regulation E (12 CFR 205). consumer disclosures that are required In July, the Board published a final rule by other laws or regulations to be pro- that exempts transactions of $15 or less vided in writing may be provided in from Regulation E’s requirement that re- electronic form if the consumer affirma- ceipts be made available to consumers tively consents after receiving the notice for transactions initiated at an electronic specified in the statute and if certain terminal. For this purpose, electronic other conditions are met. terminals include automated teller ma- In March 2001, the Board published chines and point-of-sale terminals. This interim final rules under Regulations B, exception is intended to facilitate the E, M, Z, and DD that established uni- ability of consumers to use debit cards form standards for the timing and deliv- in retail settings where it may not be ery of electronic disclosures, consistent practical or cost-effective to provide re- with the requirements of the E-Sign Act. ceipts. The rule was effective August 6, The Board later lifted the mandatory 2007.17 compliance date for these rules. As a result, institutions could provide disclo- Fair Credit Reporting Act sures electronically pursuant to the In November, the Board published two E-Sign Act but were not required to final rules under Regulation V to imple- comply with the 2001 interim rules. ment provisions of the Fair and Accu- In November, the Board withdrew rate Credit Transactions Act of 2003 certain portions of the 2001 interim rules (the FACT Act), which amended the from the Code of Federal Regulations in order to reduce confusion about their status and simplify the regulations. The 16. See www.federalreserve.gov/newsevents/ Board also withdrew other provisions of press/bcreg/20071101a.htm. the 2001 interim rules that might have 17. See www.federalreserve.gov/newsevents/ imposed undue burdens on electronic press/bcreg/20070628a.htm. Consumer and Community Affairs 125

Fair Credit Reporting Act (FCRA). theft red flags and address discrepancies First, the Board published final rules to were developed on an interagency basis implement the affiliate-marketing-notice with the other federal banking agencies and opt-out requirements of section 214 and the FTC.19 of the FACT Act. The final rules give In December, the Board published consumers the ability to limit the use of proposed rules to implement the provi- certain information for marketing pur- sions of section 312 of the FACT Act, poses by affiliates of companies with which apply to those who furnish infor- which consumers have done business. mation to consumer reporting agencies The final rules also incorporate certain (furnishers). That section requires the statutory exceptions to the notice and Board to issue guidelines to ensure the opt-out requirement, including excep- accuracy and integrity of information tions for when an affiliate has a pre- being furnished to consumer reporting existing business relationship with a agencies. Section 312 also requires the consumer or when the marketing is in Board to issue rules identifying the cir- response to a consumer-initiated com- cumstances under which furnishers must munication. The mandatory compliance investigate disputes about the accuracy date for the final rule is October 1, 2008. of information contained in consumer The affiliate-marketing rules were de- reports based on a direct request from a veloped on an interagency basis with the consumer. The comment period for the other federal banking agencies, the Fed- proposal will close in February 2008. eral Trade Commission (FTC), and the The furnisher accuracy-and-integrity Securities and Exchange Commission.18 guidelines and the direct-dispute rules Second, the Board published final were developed on an interagency basis rules to implement the identity theft “red with the other federal banking agencies flag” provisions of section 114 of the and the FTC.20 FACT Act and the address-discrepancy provisions of section 315 of the act. The final rules require financial institutions Other Supervisory Activities and creditors to develop and implement Related to Compliance with an identity theft protection program that Consumer Protection and is designed to detect, prevent, and miti- Community Reinvestment Laws gate identity theft. The final rules also The Division of Consumer and Commu- require users of consumer reports to (1) nity Affairs supports and oversees the adopt reasonable policies and proce- supervisory efforts of the Reserve Banks dures for verifying the identity of a con- to ensure that consumer protection laws sumer upon receipt of a notice of ad- and regulations are fully and fairly en- dress discrepancy from a consumer forced. (See “Mortgage Credit” earlier reporting agency and (2) reconcile the in this chapter for a description of the discrepancy when the user opens an ac- division’s supervisory activities related count despite the discrepancy and regu- to mortgage lending.) Division staff larly furnishes information to the con- members provide guidance and exper- sumer reporting agency. The mandatory tise to the Reserve Banks on consumer compliance date for the final rule is No- vember 1, 2008. The rules for identity 19. See www.federalreserve.gov/newsevents/ press/bcreg/20071031a.htm. 18. See www.federalreserve.gov/newsevents/ 20. See www.federalreserve.gov/newsevents/ press/bcreg/20071025a.htm. press/bcreg/20071129a.htm. 126 94th Annual Report, 2007 protection regulations, examination and are enforced consistently and rigorously enforcement techniques, examiner train- throughout the Federal Reserve ing, and emerging issues. Routinely, System.23 staff members develop and update ex- The Federal Reserve enforces the amination policies, procedures, and ECOA and the provisions of the Fair guidelines; review Reserve Bank super- Housing Act that apply to lending insti- visory reports and work products; and tutions. The ECOA prohibits creditors participate in interagency activities that from discriminating against any appli- promote uniformity in examination prin- cant, in any aspect of a credit transac- ciples and standards. tion, on the basis of race, color, religion, Examinations are the System’s pri- national origin, sex, marital status, or mary means of enforcing compliance age. In addition, creditors may not dis- with consumer protection laws. During criminate against an applicant because the 2007 reporting period,21 the Reserve the applicant receives income from a Banks conducted 324 consumer compli- public assistance program or has exer- ance examinations—312 of state mem- cised, in good faith, any right under the ber banks and 12 of foreign banking Consumer Credit Protection Act. The organizations.22 Fair Housing Act prohibits discrimination in residential real estate−related Fair Lending transactions, including the making and purchasing of mortgage loans, on the The Federal Reserve is committed to en- basis of race, color, religion, national suring that the institutions it supervises origin, handicap, familial status, or sex. comply fully with the federal fair lend- Pursuant to the ECOA, if the Board ing laws—the Equal Credit Opportunity has reason to believe that a creditor has Act (ECOA) and the Fair Housing Act. engaged in a pattern or practice of dis- Fair lending reviews are conducted crimination in violation of the ECOA, regularly within the supervisory cycle. the matter will be referred to the Depart- Additionally, examiners may conduct ment of Justice (DOJ) The DOJ reviews fair lending reviews outside of the usual the referral and decides if further inves- supervisory cycle, if warranted. When tigation is warranted. A DOJ investiga- examiners find evidence of potential dis- tion may result in a public civil enforce- crimination, they work closely with the ment action or settlement. The DOJ may division’s Fair Lending Enforcement decide instead to return the matter to the Section, which brings additional legal Federal Reserve for administrative en- and statistical expertise to the examina- forcement. When a matter is returned to tion and ensures that fair lending laws the Federal Reserve, staff ensures that the institution corrects the problems and 21. The 2007 reporting period for examination makes amends to the victims. data was July 1, 2006, through June 30, 2007. During 2007, the Board referred the 22. The foreign banking organizations exam- following eight matters to the DOJ: ined by the Federal Reserve are organizations operating under section 25 or 25A of the Federal Reserve Act (Edge Act and agreement corporations) and state-chartered commercial lending companies owned or controlled by foreign banks. These institutions are not subject to the Commu- 23. See the testimony of Sandra F. Braunstein, nity Reinvestment Act and typically engage in director, Division of Consumer and Community relatively few activities that are covered by con- Affairs, July 25, 2007 (www.federalreserve.gov/ sumer protection laws. newsevents/testimony/braunstein20070725a.htm). Consumer and Community Affairs 127

• Two referrals involved ethnic and soon as they become aware of a prob- racial discrimination in mortgage lem. Thus, the Federal Reserve gener- pricing by nationwide lenders. These ally uses informal supervisory tools referrals are discussed in more detail (such as memoranda of understanding below. (See “Evaluating Pricing- between the bank’s board of directors Discrimination Risk by Ana- and the Reserve Bank) or board resolu- lyzing HMDA Data and Other tions to ensure that violations are cor- Information.”) rected. If necessary to protect consumers, however, the Board can and does • One referral involved racial discrimi- bring public enforcement actions. nation in the pricing of automobile loans. The institution purchased loans in which auto dealers had charged Evaluating Pricing-Discrimination Risk higher interest rates, through the use by Analyzing HMDA Data and of markups, that were based on the Other Information race of the borrowers. This pricing The two previously mentioned referrals was permitted by the lender, who re- involving mortgage-pricing discrimina- ceived a share of the markups. tion resulted from a process of targeted pricing reviews that the Federal Reserve • One referral involved an institution initiated when Home Mortgage Disclo- with two loan policies that were found sure Act (HMDA) pricing data first be- to be discriminatory. One policy pro- came available in 2005. (See “Reporting hibited lending on Native American on Home Mortgage Disclosure Act lands. The other policy restricted Data.”) Board staff developed, and con- lending on row houses, which resulted tinue to refine, HMDA screens that in discrimination against African identify institutions that may warrant Americans. further review on the basis of an analy- • Four referrals involved discrimination sis of HMDA pricing data. Because against unmarried people. In one mat- HMDA data lack many factors that ter, an institution combined incomes lenders routinely use to make credit for married applicants, but not for co- decisions and set loan prices, such as applicants who were unmarried, when information about a borrower’s credit- underwriting consumer loans. In an- worthiness and loan-to-value ratios, other matter, an institution only per- HMDA data alone cannot be used to mitted spousal co-applicants for con- determine whether a lender dis- sumer loans. The institution also criminates. Thus, the Federal Reserve improperly required non-applicant staff analyzes HMDA data in conjunc- spouses to sign mortgage notes. The tion with other supervisory information remaining two referrals involved im- to evaluate a lender’s risk for engaging proper spousal guarantees. in discrimination. For the 2006 HMDA pricing data— If a fair lending violation does not the most recent year for which the data constitute a pattern or practice that is are publicly available—Federal Reserve referred to the DOJ, the Federal Reserve examiners performed a pricing- acts on its own to ensure that the bank discrimination risk assessment for each remedies it. Most lenders readily agree institution that was identified through to correct fair lending violations. In fact, the HMDA screening process. These lenders often take corrective steps as risk assessments incorporated not just 128 94th Annual Report, 2007 the institution’s HMDA data but also uncommon for a lender to offer many the strength of the institution’s fair lend- different products, each with its own ing compliance program; past supervi- pricing based on the borrower’s credit sory experience with the institution; risk. consumer complaints against the institu- To effectively detect discrimination in tion; and the presence of fair lending the expanding range of products and risk factors, such as discretionary pric- credit-risk categories, the Federal Re- ing. On the basis of these comprehen- serve increasingly uses statistical tech- sive assessments, Federal Reserve staff niques. When performing a pricing re- determined which institutions would review, staff typically obtain extensive ceive a targeted pricing review. Depend- proprietary loan-level data on all mort- ing on the examination schedule, the tar- gage loans originated by the lender, in- geted pricing review could occur as part cluding prime loans (that is, not just the of the institution’s next examination or higher-priced loans reported under outside the usual supervisory cycle. HMDA). To determine how to analyze Even if an institution is not identified these data, the Federal Reserve studies through HMDA screening, examiners the lender’s specific business model, may still conclude that the institution is pricing policies, and product offerings. at risk for engaging in pricing discrimi- On the basis of the review of the lend- nation and may perform a pricing re- er’s policies, staff determine which fac- view. The Federal Reserve supervises tors from the lender’s data should be many institutions that are not required to considered. A statistical model is then report data under HMDA. Also, many developed that takes those factors into of the HMDA-reporting institutions su- account and is then tailored to that spe- pervised by the Federal Reserve origi- cific lender. Typically, a test for dis- nate few higher-priced loans and, there- crimination in particular geographic fore, report very little pricing data. For markets, such as metropolitan statistical these institutions, examiners analyze areas (MSAs), is performed. Looking at other available information to assess specific markets is important, as rela- pricing-discrimination risk and, when tively small unexplained pricing dispari- appropriate, perform a pricing review. ties at the national level can mask much During a targeted pricing review, staff larger disparities in individual markets. analyze additional information, includ- On the basis of the results of pricing ing potential pricing factors that are not reviews conducted, Federal Reserve available in the HMDA data, to deter- staff had reason to believe that two na- mine whether any pricing disparity by tionwide lenders had engaged in a pat- race or ethnicity is fully attributable to tern or practice of discrimination and legitimate factors, or whether any por- referred these cases to the DOJ. After tion of the pricing disparity may be at- accounting for legitimate factors re- tributable to illegal discrimination. To flected in the lenders’ specific pricing perform these reviews, staff use analyti- policies, staff found that minorities still cal techniques that account for the in- paid more for their mortgages than non- creasing complexity of the mortgage Hispanic white borrowers in multiple market. Two industry changes in MSAs. The first referral involved two of particular—the proliferation of product the fair lending risk factors that the offerings and the increased use of risk- agencies have identified and used for based pricing—have increased the com- some time: (1) broad discretion in pric- plexity of fair lending reviews. It is not ing by loan officers or brokers and (2) fi- Consumer and Community Affairs 129 nancial incentives for loan officers or implementing regulation) in 2002. The brokers to charge borrowers higher revisions, which became effective in prices. The lending institution gave its 2004, require lenders to collect price in- loan officers discretion to charge over- formation for loans they originated in ages and underages, that is, to set loan the higher-priced segment of the home- prices higher or lower than its standard loan market. When applicable, lenders rates. The institution also paid loan of- report the number of percentage points ficers more if they charged overages. by which a loan’s annual percentage rate The Federal Reserve found evidence exceeds the threshold that defines that, in multiple MSAs, African Ameri- “higher-priced loans.” The threshold is can and Hispanic borrowers paid higher 3 percentage points or more above the overages than comparable non-Hispanic yield on comparable Treasury securities whites. for first-lien loans, and 5 percentage The second referral involved loans points or more above that yield for originated through mortgage brokers at junior-lien loans. The HMDA data col- which the institution also permitted pric- lected in 2004 and released to the public ing discretion. In multiple MSAs, Afri- in 2005 provided the first publicly avail- can Americans and Hispanics paid able loan-level data about loan prices. higher annual percentage rates than The FFIEC released the 2006 HMDA comparable non-Hispanic whites. Pric- data to the public in September 2007. ing discretion and financial incentives to A December 2007 article published charge borrowers more do not always by Federal Reserve staff in the Federal result in fair lending violations; how- Reserve Bulletin uses the 2006 data to ever, these referrals underscore that it is describe the market for higher-priced critical for lenders that permit these loans and patterns of lending across loan practices to have clear policies about products, geographic markets, and bor- their use and to monitor their use rowers and neighborhoods of different effectively. races and incomes.24 The article also analyzed several of the items included Reporting on Home Mortgage in the HMDA data in order to determine Disclosure Act Data their usefulness in predicting mortgage- loan delinquency across metropolitan- The Home Mortgage Disclosure Act area counties. The analysis resulted in (HMDA), enacted by Congress in 1975, several findings, including that the inci- requires most mortgage lenders located dence of higher-priced lending and the in metropolitan areas to collect data share of non-owner-occupied loans in a about their housing-related lending ac- county were both related to higher lev- tivity, report the data annually to the els of default in the future. government, and make the data publicly As in 2004 and 2005, most reporting available. In 1989, Congress expanded institutions reported extending few if the data required by HMDA to include any higher-priced loans in 2006; 61 per- information about loan applications that cent of the lenders originated less than did not result in a loan origination, as well as information about the race, sex, and income of applicants and borrowers. 24. Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, “The 2006 HMDA Data,” In response to the growth of the Federal Reserve Bulletin, December 2007 subprime loan market, the Federal Re- (www.federalreserve.gov/pubs/bulletin/2007/pdf/ serve updated Regulation C (HMDA’s hmda06final.pdf). 130 94th Annual Report, 2007

10 higher-priced loans that year. The ern region of the country. Several metro- data also indicate that relatively few politan areas on the West Coast also had lenders accounted for most of the an elevated incidence of higher-priced higher-priced loan originations in 2006. lending in 2006. In many metropolitan Of the nearly 8,900 home lenders report- areas in the South, Southwest, and West, ing HMDA data, 928 of them made 100 30 percent to 40 percent of the home- or more higher-priced loans. The 10 buyers who obtained conventional loans home lenders that had the largest vol- in 2006 received higher-priced loans. ume of higher-priced loans accounted Third, the incidence of higher-priced for about 38 percent of all such loans in lending varies greatly among borrowers 2006. Also as in 2004 and 2005, the of different races and ethnicities. In majority of all loan originations were 2006, as in 2004 and 2005, African not higher priced in 2006; however, the Americans and Hispanics were much incidence of higher-priced lending did more likely than non-Hispanic whites increase from 26.2 percent in 2005 to and Asians to receive higher-priced 28.7 percent in 2006. Some of the in- loans. For example, in 2006, 54 percent crease in the incidence of higher-priced of African American borrowers, and lending is attributed to changes in the 47 percent of Hispanic borrowers, re- interest rate environment from 2005 to ceived higher-priced conventional home 2006, as well as to changes in borrower purchase loans, compared with 18 per- profiles and lender practices. cent of non-Hispanic white and 17 per- Loan pricing is a complex process cent of Asian borrowers. Because that may reflect a wide variety of factors HMDA data lack information about about the level of risk a particular loan credit risk and other legitimate pricing or borrower presents to the lender. As a factors, it is not possible to determine result, the prevalence of higher-priced from HMDA data alone whether the ob- lending varies widely. First, the inci- served pricing disparities and market dence of higher-priced lending varies by segmentation reflect discrimination. product type. For example, manu- When analyzed in conjunction with other factured-home loans show the greatest fair lending risk factors and supervisory incidence of higher-priced lending information, however, the HMDA data (more than half of these loans are higher can facilitate fair lending supervision priced), because these loans are consid- and enforcement. (See “Fair Lending.”) ered higher risk. In addition, first-lien mortgages are generally less risky than comparable junior-lien loans, and the Examinations and Activities pricing for these loans reflects their risk Related to the Community profiles: 25.3 percent of first-lien con- Reinvestment Act ventional home purchase loans were reported as higher-priced in 2006, com- The Community Reinvestment Act pared with 45.7 percent of comparable (CRA) requires that the Federal Reserve junior-lien loans. and other banking agencies encourage Second, higher-priced lending varies financial institutions to help meet the widely by geography. As in 2004 and credit needs of the local communities in 2005, many of the metropolitan areas which they do business, consistent with that reported the greatest incidence of safe and sound operations. To carry out higher-priced lending were in the south- this mandate, the Federal Reserve Consumer and Community Affairs 131

• examines state member banks to as- cies had received numerous consumer sess their compliance with the CRA,25 complaints and inquiries about this type • of solicitation, and the alert warned that analyzes applications for mergers and the solicitation appears to be a deceptive acquisitions by state member banks effort to encourage consumers to apply and bank holding companies in rela- 26 for a mortgage loan secured by their tion to CRA performance, and home. A statement that the agencies do • disseminates information on commu- not sponsor or endorse such programs nity development techniques to bank- and that the CRA does not require such ers and the public through community programs was also included in the alert, affairs offices at the Reserve Banks. along with a warning for consumers to be suspicious about conducting business The Federal Reserve assesses and rates with lenders who make deceptive the performance of state member banks claims. under the CRA in the course of examinations conducted by staff at the twelve Proposed Interagency Questions Reserve Banks. During the 2007 report- and Answers on the CRA ing period, the Reserve Banks conducted 271 CRA examinations of banks: In July, the federal bank and thrift regu- 33 were rated Outstanding, 237 were latory agencies released for comment a rated Satisfactory, none was rated Needs series of new and revised interagency to Improve, and one was rated Substan- questions and answers on CRA. The tial Noncompliance.27 agencies are proposing new questions and answers, as well as making substan- Consumer Alert on Solicitations tive and technical revisions to the exist- for CRA Programs ing material. Some of the proposed revisions are intended to encourage In February, the Board, the Federal De- institutions to work with homeowners posit Insurance Corporation, the Office who are unable to make their mortgage of the Comptroller of the Currency, and payments; the questions and answers the Office of Thrift Supervision jointly emphasize that institutions can receive released a consumer alert about CRA- CRA consideration for foreclosure- 28 related solicitations from lenders. This prevention programs for low- and alert cautioned the public about loan so- moderate-income homeowners, consis- licitations or other offers from lenders or tent with the April 2007 interagency mortgage brokers that offer consumers “Statement on Working with Mortgage cash as part of a “Community Reinvest- Borrowers.”29 In addition, several tech- ment Act (CRA) Program.” The agen- nical changes are being proposed to clarify, update, and improve the read- 25. See the testimony of Sandra F. Braunstein, ability of existing guidance. A few of director, Division of Consumer and Community Affairs, October 24, 2007 (www.federalreserve.gov/ the more substantive changes include newsevents/testimony/braunstein20071024a.htm). • allowing CRA consideration for in- 26. See the testimony of Sandra F. Braunstein, director, Division of Consumer and Community vestments made by banks to minority- Affairs, May 21, 2007 (www.federalreserve.gov/ or women-owned financial institu- newsevents/testimony/braunstein20070521a.htm). tions when that investment benefits 27. The 2007 reporting period for examination data was July 1, 2006, through June 30, 2007. 28. See www.federalreserve.gov/newsevents/ 29. See www.federalreserve.gov/newsevents/ press/other/20070216a.htm. press/bcreg/20070417a.htm. 132 94th Annual Report, 2007

the minority or women-owned finan- • An application by Huntington Banc- cial institution’s local community, shares, Inc., Columbus, Ohio, to ac- even if the investment does not ben- quire Sky Financial Group, Inc., efit the bank’s own assessment area; Bowling Green, Ohio, was approved • providing flexibility to certain inter- in June. mediate small banks in the evaluation • An application by Wells Fargo & of their home mortgage, small busi- Company, San Francisco, California, ness, and small farm loans; and to acquire Greater Bay Bancorp, East • clarifying that an institution that Palo Alto, California, was approved makes a loan or investment in a na- in August. tional or regional community development fund should be able to dem- The public submitted comments on nine onstrate that the fund will benefit the applications, including those mentioned institution’s assessment area(s) or the above. Many of the commenters refer- broader statewide or regional area that enced pricing information on residential includes the bank’s assessment area(s) mortgage loans and concerns that mi- as contemplated by the regulation, nority applicants were more likely than provided the fund meets certain defi- nonminority applicants to receive nition and geographic requirements. higher-priced mortgages. These concerns were largely based on observa- Analysis of Applications for tions of lenders’ 2005 and 2006 HMDA Mergers and Acquisitions pricing data. Other issues raised by com- in Relation to the CRA menters involved minority applicants During 2007, the Board considered ap- being denied mortgage loans more fre- plications for several significant bank- quently than nonminority applicants; po- ing mergers. The Board approved two tentially predatory lending practices by applications by Bank of America Corpo- subprime and payday lenders; the poten- ration, Charlotte, North Carolina, the tial adverse effects of branch closings; second largest depository institution in and lenders’ failure to address the the United States. The company’s acqui- convenience and needs of low- and sition of U.S. Trust Corporation, New moderate-income communities. In addi- York, New York, was approved by the tion, the Board also received comments Board in March and its application to about the adverse effects of increased acquire ABN AMRO North America foreclosures, especially in low- and Holding Company, Chicago, Illinois, moderate-income communities. was approved in September. The merger The Board considered forty-two of two historic bank holding companies, applications with outstanding issues in- The Bank of New York, New York, New volving compliance with consumer pro- York, and Mellon Financial Corporation, tection statutes and regulations, includ- 30 Pittsburgh, Pennsylvania, was approved ing fair lending laws, and the CRA. by the Board in June. Several other sig- Thirty-seven of those applications were nificant applications are listed below. approved and five were withdrawn, including one with an adverse CRA • An application by PNC Financial Ser- rating. vices Group, Inc., Pittsburgh, Penn- sylvania, to acquire Mercantile Bank- shares Corporation, Baltimore, 30. The forty-two applications do not include Maryland, was approved in February. the nine protested applications. Consumer and Community Affairs 133

Initiatives for Minority-Owned Bank Examiner Guidance Financial Institutions and Training

The Federal Reserve is committed to en- Examiner Guidance on Unfair and suring the provision of financial services Deceptive Acts and Practices to all consumers and communities. One of the many ways the Board achieves Periodically, the Board issues guidance this goal is by promoting the safety and on consumer protection laws and regula- soundness of all the institutions subject tions to Reserve Bank examiners. Some to System supervision, including those guidance is developed and updated in that are minority owned. Through its concert with the other federal financial regulatory, supervisory, and community institution regulatory agencies, and development functions, the Board con- some is issued solely by the Board. In sistently addresses the unique challenges 2007, the Board issued examination pro- and needs of minority-owned banks. At cedures designed to help examiners de- the same time, the Board holds these termine whether specific acts or prac- institutions to the supervisory standards tices conducted by state-chartered banks that are applied to all state member are unfair or deceptive. These proce- banks. The Board views this strategy as dures incorporate general guidance pro- integral to its efforts to promote a safe, vided in the March 11, 2004, “Statement sound, and competitive banking system on Unfair or Deceptive Acts or Practices that also protects consumer interests. (UDAP) by State-Chartered Banks” is- To enhance its support of minority- sued jointly by the Board and the Fed- owned institutions, the Federal Reserve eral Deposit Insurance Corporation. The has been developing an innovative and Board’s guidance helps examiners ana- comprehensive training and technical lyze potential UDAP issues during a assistance program for minority-owned consumer compliance examination or a depository institutions. Designed to ad- complaint investigation. dress issues that might inhibit or limit the financial and operating performance Training for Bank Examiners of minority-owned institutions, the program includes outreach and technical as- Ensuring that financial institutions com- sistance for institution directors. It also ply with laws that protect consumers and fosters relationship-building between in- encourage community reinvestment is stitutions and supervisory staff, and an important part of the bank examina- raises supervisory awareness of the tion and supervision process. As the unique challenges faced by minority- number and complexity of consumer fi- owned institutions. The program is nancial transactions grow, training for scheduled to be fully operational in staff that review and examine the organi- 2008.31 zations under the Federal Reserve’s supervisory responsibility becomes even more important. The consumer compli- 31. See the speech by Governor Randall S. ance examiner training curriculum con- Kroszner, August 1, 2007 (www.federalreserve.gov/ sists of six courses focused on various newsevents/speech/kroszner20070801a.htm). See consumer protection laws, regulations, also the testimony of Sandra F. Braunstein, director, Division of Consumer and Community Af- and examination concepts. In 2007, fairs, October 30, 2007 (www.federalreserve.gov/ these courses were offered in eleven ses- newsevents/testimony/braunstein20071030a.htm). sions to more than 193 consumer com- 134 94th Annual Report, 2007 pliance examiners and System staff determined to have special flood haz- members. ards. Under the Federal Reserve’s Regu- Board and Reserve Bank staff regulation H, which implements the act, state larly review the core curriculum for ex- member banks are generally prohibited aminer training, updating subject matter from making, extending, increasing, or and adding new elements as appropriate. renewing any such loan unless the build- During 2007, staff conducted a curricu- ing or mobile home and any personal lum review of the Introduction to Con- property securing the loan are covered sumer Compliance Examinations I by flood insurance for the term of the (CA I) course to incorporate technical loan. Moreover, the act requires the changes in policy and laws, along with Board and other federal financial institu- changes in instructional delivery tech- tion regulatory agencies to impose civil niques. This course, designed for assis- money penalties when it finds a pattern tant examiners, focuses on the (1) con- or practice of violations of the regula- sumer laws and regulations that govern tion. The civil money penalties are pay- operations and non−real estate lending able to the Federal Emergency Manage- and (2) regulations affecting deposit and ment Agency for deposit into the non−real estate lending operations. The National Flood Mitigation Fund. course emphasizes examination tech- During 2007, the Board imposed civil niques and procedures that demonstrate money penalties against eight state the practical application of these laws member banks. The penalties, which and regulations. were assessed via consent orders, to- When appropriate, courses are deliv- taled $246,050. ered via alternative methods, such as the Internet or other distance-learning tech- Agency Reports on Compliance nologies. The CA I course uses a with Consumer Protection Laws combination of instructional methods: (1) classroom instruction focused on The Board reports annually on compli- case studies and (2) specially developed ance with consumer protection laws by computer-based instruction that includes entities supervised by federal agencies. interactive self-check exercises. This section summarizes data collected In addition to providing core training, from the twelve Federal Reserve Banks the examiner curriculum emphasizes the and the FFIEC member agencies (col- importance of continuing professional lectively, the FFIEC agencies), as well development. Opportunities for continu- as other federal enforcement agencies.32 ing development include special projects and assignments, self-study programs, Regulation B rotational assignments, the opportunity (Equal Credit Opportunity) to instruct at System schools, mentoring The FFIEC agencies reported that programs, and an annual senior exam- 85 percent of the institutions examined iner forum. during the 2007 reporting period were in compliance with Regulation B, com- Flood Insurance The National Flood Insurance Act im- 32. Because the agencies use different methods to compile the data, the information presented here poses certain requirements on loans se- supports only general conclusions. The 2007 re- cured by buildings or mobile homes lo- porting period was July 1, 2006, through June 30, cated in, or to be located in, areas 2007. Consumer and Community Affairs 135 pared with 87 percent for the 2006 re- the entities they supervise. The FCA’s porting period. The most frequently examination activities revealed Regula- cited violations involved tion B violations involving the improper collection of government monitoring • the failure to properly collect informa- information. tion for monitoring purposes, including the race, ethnicity, sex, marital Regulation E status, and age of applicants seeking (Electronic Fund Transfers) credit primarily for the purchase or refinancing of a principal residence The FFIEC agencies reported that approximately 94 percent of the institu- • the improper collection of informa- tions examined during the 2007 report- tion on an applicant’s race, color, reli- ing period were in compliance with gion, national origin, or sex when not Regulation E, compared with 95 percent permitted by regulation in the 2006 reporting period. The most frequently cited violations involved the • the improper requirement of the sig- failure to take one or more of the follow- nature of an applicant’s spouse or ing actions: other person, other than a joint applicant, when the applicant qualified un- • determine whether an error occurred, der the creditor’s standards of credit- within ten business days of receiving worthiness for the amount and terms a notice of error from a consumer of the credit requested • • give the consumer provisional credit the failure to provide a written notice for the amount of an alleged error of denial or other adverse action to a when an investigation into the alleged credit applicant that contains the spe- error cannot be completed within ten cific reason for the adverse action, business days along with other required information • During this reporting period, the OTS provide initial disclosures that contain issued two supervisory agreements and required information, including limi- one cease-and-desist order to a savings tations on the types of transfers per- association for alleged violations of the mitted and error-resolution proce- Equal Credit Opportunity Act (ECOA) dures, at the time a consumer and Regulation B, as well as other con- contracts for an electronic fund trans- sumer regulations. The other FFIEC fer service agencies did not issue any formal en- • when a determination is made that no forcement actions specific to Regulation error has occurred, provide a written B during the reporting period. explanation and note the consumer’s The other agencies that enforce the right to request documentation sup- ECOA—the Farm Credit Administration porting the institution’s findings (FCA), the Department of Transporta- tion, the Securities and Exchange Com- The FFIEC agencies did not issue any mission (SEC), the Small Business Ad- formal enforcement actions relating to ministration, and the Grain Inspection, Regulation E during the period. Packers and Stockyards Administration The Federal Trade Commission of the Department of Agriculture— (FTC) settled charges against one corpo- reported substantial compliance among ration that falsely marketed products and 136 94th Annual Report, 2007 debited consumer accounts without ob- The FFIEC agencies did not issue any taining consumers’ authorization for formal enforcement actions relating to preauthorized electronic fund transfers, Regulation P during the reporting in violation of Regulation E. The FTC period. also continued litigation against a group of defendants for allegedly enrolling Regulation Z (Truth in Lending) consumers in a program and automati- cally billing them for charges without The FFIEC agencies reported that obtaining authorization for the recurring 82 percent of the institutions examined debits. during the 2007 reporting period were in compliance with Regulation Z, compared with 85 percent for the 2006 re- Regulation M (Consumer Leasing) porting period. The most frequently The FFIEC agencies reported that more cited violations involved the failure to than 99 percent of the institutions exam- take one or more of the following ined during the 2007 reporting period actions: were in compliance with Regulation M, • accurately disclose the finance charge which equals the level of compliance for in closed-end credit transactions the 2006 reporting period. The FFIEC agencies did not issue any formal en- • accurately disclose the amount forcement actions relating to Regulation financed, by subtracting any prepaid M during the period. finance charge from the amount financed Regulation P (Privacy of Consumer • accurately disclose the payment Financial Information) schedule, including the number, The FFIEC agencies reported that amounts, and timing of payments 97 percent of the institutions examined scheduled to repay the obligation during the 2007 reporting period were in • ensure that disclosures reflect the compliance with Regulation P, com- terms of the legal obligation between pared with 98 percent for the 2006 re- the parties porting period. The most frequently cited violations involved the failure to In addition, 185 banks supervised by the take one or more of the following Federal Reserve, FDIC, OCC, and OTS actions: were required, under the Interagency Enforcement Policy on Regulation Z, to • provide a clear and conspicuous an- reimburse a total of approximately nual privacy notice to customers $2.75 million to consumers for under- • disclose the institution’s information- stating the annual percentage rate or the sharing practices in initial, annual, finance charge in their consumer loan and revised privacy notices disclosures. The OTS issued two supervisory • provide customers with a clear and agreements and two cease-and-desist or- conspicuous initial privacy notice that ders for violations of a number of con- accurately reflects the institution’s sumer regulations, including Regulation privacy policies and practices, not Z, during the reporting period. The other later than when the customer relation- FFIEC agencies did not issue any for- ship is established mal enforcement actions specific to Consumer and Community Affairs 137

Regulation Z during the reporting that are not subject to next-day period. availability The Department of Transportation • continued to prosecute one air carrier follow procedures when invoking the for its improper handling of credit card exception for large-dollar deposits refund requests and other Federal Avia- • provide required information when tion Act violations. placing an exception hold on an The FCA identified creditors that account were using incorrect templates, resulting • in violations of Regulation Z. While all make funds from local and certain required disclosures were made, the for- other checks available for withdrawal mat of the disclosures was not consis- within the times prescribed by tent with regulatory requirements. regulation The FTC continued litigation in fed- The OTS issued one supervisory agree- eral district court against a mortgage ment for violations of a number of con- broker for alleged violations of Regula- sumer regulations, which included tion Z; the alleged violations involved Regulation CC. The other FFIEC agen- the broker’s advertisements and finance- cies did not issue any formal enforce- charge disclosures. ment actions specific to Regulation CC during the reporting period. Regulation AA (Unfair or Deceptive Acts or Practices) Regulation DD (Truth in Savings) The FFIEC agencies reported that more The FFIEC agencies reported that than 99 percent of the institutions exam- 88 percent of institutions examined dur- ined during the 2007 reporting period ing the 2007 reporting period were in were in compliance with Regulation compliance with Regulation DD, AA, which equals the level of compli- compared with 91 percent for the 2006 ance for the 2006 reporting period. No reporting period. The most frequently formal enforcement actions relating to cited violations involved the failure to Regulation AA were issued during the take one or more of the following reporting period. actions: • provide a statement that fees could Regulation CC (Availability of Funds reduce the earnings on an account, and Collection of Checks) when the term “annual percentage The FFIEC agencies reported that yield” is used in an advertisement 90 percent of institutions examined dur- • use the term “annual percentage ing the 2007 reporting period were in yield” if an advertisement states a rate compliance with Regulation CC, com- of return pared with 92 percent for the 2006 re- • porting period. The most frequently provide initial account disclosures cited violations involved the failure to containing all required information take one or more of the following • provide adequate subsequent account actions: disclosures for time accounts that have maturities greater than one year • make available on the next business day the lesser of $100 or the aggre- The OTS issued one supervisory agree- gate amount of checks deposited ment and one cease-and-desist order for 138 94th Annual Report, 2007 violations of a number of consumer Complaints Against State Member regulations, including Regulation DD. Banks The other FFIEC agencies did not issue The majority (61 percent) of complaints any formal enforcement actions specific about regulated practices involved credit to Regulation DD during the reporting cards. The most common credit card period. problem fell into the complaint category called “other rates/terms/fees” (35 per- Consumer Complaints cent), followed by problems with The Federal Reserve investigates com- billing-error resolution (19 percent) and plaints against state member banks and banks’ providing inaccurate account in- forwards those that involve other credi- formation (8 percent).34 tors and businesses to the appropriate Complaints about checking accounts enforcement agency. Each Reserve were the next largest category (19 per- Bank investigates complaints against cent) of complaints about regulated state member banks in its District. In practices. The most common checking 2007, the Federal Reserve received account concerns were insufficient- 1,540 consumer complaints concerning funds or overdraft charges and proce- regulated practices by state member banks. dures (30 percent), funds availability In November, the Federal Reserve (14 percent), and disputed withdrawals System launched Federal Reserve Con- of funds by banks (13 percent). sumer Help (FRCH), an initiative that Real estate−related complaints made consolidates and streamlines the Federal up 5 percent of complaints involving Reserve’s process for handling con- regulated practices.35 Of those, only sumer complaints and inquiries. FRCH 4 percent (or three complaints) con- improves consumers’ access to the Fed- cerned adjustable-rate mortgages. The eral Reserve by providing a convenient, most common real estate−related loan one-stop website and a toll-free number problems concerned escrow accounts where consumers can get assistance with (15 percent); other rates, terms, or fees their banking problems or questions. (11 percent); and errors or delays in (See related box “The Federal Reserve crediting loan payments (10 percent). Of Consumer Help Center.”) all complaints involving regulated prac- Under the direction of the Federal Fi- tices, 13 (0.8 percent) alleged discrimi- nancial Institutions Examination Coun- nation on a basis prohibited by law cil (FFIEC), an interagency working (race, color, religion, national origin, group was formed in late 2007 to explore ways to improve consumers’ expe- riences with contacting a banking the Comptroller of the Currency, the Federal De- posit Insurance Corporation, the Office of Thrift agency and with submitting a complaint Supervision, and the National Credit Union Ad- or inquiry to the appropriate regulator. A ministration. Representatives from the Conference third-party contractor may be used to of State Bank Supervisors are also participating. examine best practices and recommend 34. Includes complaints about interest rates, improvements to the process consumers terms, or fees other than late fees, overlimit fees, prepayment fees, fees related to credit insurance, use to file a complaint or inquiry with or the calculation of the finance charge. one of the FFIEC agencies.33 35. Includes adjustable-rate mortgages; residential construction loans, open-end home equity lines of credit, home improvement loans, home 33. FFIEC agencies represented on the working purchase loans, home refinance or closed-end group are the Federal Reserve Board, the Office of loans; and reverse mortgages. Consumer and Community Affairs 139 sex, marital status, handicap, age, the Consumer Complaints against State fact that the applicant’s income comes Member Banks That Involve Regulated from a public assistance program, or the Practices, by Classification, 2007 fact that the applicant has exercised a right under the Consumer Credit Protec- Classification Number tion Act). Regulation AA (Unfair or Deceptive Complaint investigations determined Acts or Practices) ...... 85 Regulation B (Equal Credit Opportunity) ..... 62 that banks had handled customers’ ac- Regulation C (Home Mortgage Disclosure) . . . 1 counts in accordance with Federal Re- Regulation E (Electronic Fund Transfers) .... 98 Regulation H (Bank Sales of Insurance) ...... 2 serve regulations in the majority (96 per- Regulation M (Consumer Leasing) ...... 3 Regulation P (Privacy of Consumer cent) of the complaints reviewed. Financial Information) ...... 35 Investigations for the remaining 4 per- Regulation Q (Payment of Interest) ...... 3 Regulation Z (Truth in Lending) ...... 761 cent determined that the bank had vio- Regulation BB (Community Reinvestment) . . . 6 lated a consumer protection regulation. Regulation CC (Expedited Funds Availability) ...... 123 The most common violations involved Regulation DD (Truth in Savings) ...... 124 Regulations T, U, and X ...... 0 credit cards and checking accounts. (See Regulation V (Fair and Accurate tables.) Credit Transactions) ...... 13 Fair Credit Reporting Act ...... 138 Fair Debt Collection Practices Act ...... 64 Unregulated Practices Fair Housing Act ...... 1 Flood Insurance ...... 1 Homeownership Counseling ...... 2 As required by section 18(f) of the Fed- HOPA (Homeowners Protection Act) ...... 1 Real Estate Settlement Procedures Act ...... 15 eral Trade Commission Act, the Board Right to Financial Privacy Act ...... 2 continued to monitor complaints about banking practices that are not subject to Total ...... 1,540 existing regulations and to focus on those that concern possible unfair or de- sumers most frequently complained ceptive practices. In 2007, the Board re- about fraud, forgery, or theft (216 com- ceived more than 2,000 complaints plaints); problems with opening or clos- against state member banks that in- ing an account (196 complaints); issues volved unregulated practices. The prod- involving insufficient-funds or overdraft uct categories that contained the most charges and procedures (190 com- complaints were credit cards and check- plaints); and certain credit card interest ing accounts. In those categories, con- rates, terms, and fees (129 complaints).

Complaints against State Member Banks That Involve Regulated Practices, 2007

All complaints Complaints involving violations Subject of complaint Number Percent Number Percent

Total ...... 1,540 100 53 3 Discrimination alleged ...... 13 Real estate loans ...... 1 .1 0 0 Credit cards ...... 8 .5 0 0 Other loans ...... 4 .3 0 0

Nondiscrimination complaints, total1 ...... 1,5271 Credit cards ...... 939 61 39 3 Checking accounts ...... 295 19 13 .8 Real estate loans ...... 80 5 0 0

1. Only the top three product categories of nondiscrimination complaints are listed here. 140 94th Annual Report, 2007

The Federal Reserve Consumer Help Center: A New Resource for Expert, Immediate Help

Credit cards, mortgages, and electronic Consumer complaints are an important funds transfers are just a few of the source of information for the Federal services and products consumers use to Reserve Board. Regardless of their conduct their financial business. The use outcome, complaints often identify areas of these products and services has become of concern that the Board considers when widespread, and it can be easy to lose sight writing regulations or guidance for bank of their complexity—until a consumer has examiners. Complaints can also reveal a question or something goes wrong. emerging consumer-protection issues and Consumers often need help navigating the trends in banking practices. The Federal maze of terminology, regulations, and poli- Reserve established its program for receiv- cies that governs financial products, ing consumer complaints and inquiries in services, and institutions. For more than 30 1976. Drawing on the resources of the years, the Federal Reserve System has Federal Reserve System’s twelve Reserve provided professional help to consumers Bank Districts, the program answers who have complaints against a financial consumers’ questions, investigates com- institution. In 2007, the Federal Reserve plaints against state member banks launched the Federal Reserve Consumer (those institutions under the Federal Help (FRCH) center, a centralized Reserve’s supervisory authority), or refers consumer complaint center that improves consumers to the appropriate agency for a consumers’ access to information and response. In addition, the Board responds services. The FRCH website (www. to issues raised by congressional rep- federalreserveconsumerhelp.gov) provides resentatives on behalf of their con- comprehensive information on consumer stituents. Over the last decade, the financial issues, as well as contact informa- consumer financial services marketplace tion. Consumers can use the site to has dramatically changed. Technological research their issue, or they may contact developments and increased access to the Federal Reserve to ask a question or technology have also changed both the file a complaint via e-mail, a toll-free way institutions operate and how consum- number, fax, or mail. ers want to communicate with financial

Complaint Referrals to HUD Responding to Community Economic Development Needs in In 2007, the Federal Reserve received Historically Underserved one housing-related discrimination com- Markets plaint and forwarded it to HUD in accordance with a memorandum of under- The mission of the community affairs standing between HUD and the federal function within the Federal Reserve Sys- bank regulatory agencies regarding tem is to promote community economic complaints alleging a violation of the development and fair access to credit for Fair Housing Act. The Federal Re- low- and moderate-income communities serve’s investigation of this complaint and populations. As a decentralized revealed no evidence of illegal credit function, the Community Affairs Offices discrimination. (CAOs) at each of the twelve Reserve Consumer and Community Affairs 141

institutions and others. In 2007, the Federal analyze the data so that they can identify Reserve responded to these forces by shared issues, develop best practices for launching FRCH, while continuing to tap customer service and complaint investiga- staff expertise and knowledge of regional tion, and develop consumer education banking markets. materials. Such collaboration is critical to The Federal Reserve is committed to addressing consumer protection issues in providing superior service to consumers. the broader financial services marketplace The call center is staffed by highly trained and developing consumer information professionals; 80 percent of incoming calls materials to educate consumers about or e-mail inquiries are answered by a trends in banking products and their rights. representative within 60 seconds or less. In addition, FRCH is establishing a Complaints against banking institutions mechanism for tracking customer satisfac- supervised by the Federal Reserve continue tion, that is, whether consumers feel the to be investigated by the Reserve Bank center helped them with their financial responsible for examining the institution in services issues. question. This approach ensures that Early reviews of available data on complaints are investigated by examiners FRCH call volume and website visits who are knowledgeable about an institu- indicate that consumers are contacting the tion and its regional banking market—and the Federal Reserve in record numbers. who can leverage the bank-supervisor The Federal Reserve is dedicated to relationship to resolve an issue. If a providing superior access to consumers consumer has a complaint against an who need assistance and will continue to institution not supervised by the Federal monitor the performance of FRCH, with Reserve, FRCH can seamlessly connect the goal of identifying further opportuni- him or her with the appropriate agency. ties to help consumers exercise their rights FRCH tracks all incoming questions and and work through their financial services requests for assistance, by issue and challenges. The Federal Reserve plans to volume. Data will be shared with the other launch a Spanish-language version of the federal banking regulatory agencies. The website in the first quarter of 2008. Federal Reserve and other agencies

Banks design activities in response to high-priority efforts; in particular, Board the needs of communities in the Dis- community affairs staff focus on issues tricts they serve, with oversight from that have public policy implications.36 Board staff. The CAOs focus on provid- In 2007, disruptions in the housing ing information and promoting aware- market made collaboration among the ness of investment opportunities to financial services community, the financial institutions, government agen- Board, and the Reserve Banks impera- cies, and organizations that serve low- and moderate-income communities and populations. Similarly, the Board’s CAO 36. See www.federalreserve.gov/communitydev/ promotes and coordinates Systemwide default.htm. 142 94th Annual Report, 2007 tive. The CAOs worked diligently to System Research Conference, “Financ- identify solutions that would help miti- ing Community Development: Learning gate the adverse consequences of the in- from the Past, Looking to the Future,” creasing numbers of mortgage defaults cosponsored by the Board and the Fed- and foreclosures in many Districts. (See eral Reserve Bank of Philadelphia. The “Mortgage Credit.”) System staff also conference brought together a diverse continued work on a number of impor- audience from academia, financial insti- tant topics: improving the sustainability tutions, community organizations, foun- and financial capacity of community de- dations, and the government. Approxi- velopment organizations, creating asset- mately 400 participants learned about building opportunities for low- and and discussed original studies on the op- moderate-income populations, and de- portunities and obstacles to helping low- veloping programs to promote commu- and moderate-income communities and nity development and consumer educa- people build wealth by using home tion. Activities included conducting loans, small business loans, or other fi- research, sponsoring conferences and nancial services. System community af- seminars, publishing newsletters and ar- fairs staff were actively involved in the ticles, and supporting the dissemination planning and execution of the confer- of information to both general and tar- ence: staff reviewed papers, developed geted audiences. the agenda, presented research, and served as moderators and participants in System Collaborative Efforts formal discussion groups. The Board’s Community Affairs officer delivered a The Reserve Banks and the Board con- keynote address during the conference, tinued their work on two substantial col- and Chairman Ben Bernanke provided laborative efforts over the past year. The remarks on the history, evolution, and first effort, an initiative undertaken by new challenges of the Community Rein- System Community Affairs staff and the vestment Act.37 Brookings Institution, analyzes and compares communities that have high Identifying Strategies to Enhance concentrations of poverty. Using sixteen Access to Community case studies from selected communities, Development Financing and the project employs both quantitative Asset-Building and qualitative analyses to explore the dynamics of the communities, their resi- In 2007, Community Affairs staff from dents, their economies, and programs around the System continued working that are helping or hindering a commu- on several initiatives to not only en- nity’s integration into the economic hance access to affordable credit in cur- mainstream. The data generated by this rently underserved markets but also to ongoing initiative help Reserve Banks, provide information and promote aware- local financial institutions, business ness of investment opportunities to fi- leaders, service providers, and philan- nancial institutions, government agen- thropic organizations better understand cies, and organizations. The St. Louis their regional economies and the capital Reserve Bank hosted “Exploring Inno- and credit needs of the communities vation: A Conference on Community they serve. The second major collaborative effort 37. See www.federalreserve.gov/newsevents/ in 2007 was the Community Affairs speech/bernanke20070330a.htm. Consumer and Community Affairs 143

Development Finance” to explore how Kansas City Reserve Bank cosponsored organizational creativity, learning, and a major conference on entrepreneurship innovation can improve community with the Association for Enterprise Op- development projects, increase their portunity. Together with the San Fran- access to capital, and help projects cisco and Minneapolis Reserve Banks, achieve scale and sustainability. The the Kansas City Reserve Bank also con- San Francisco Reserve Bank’s Center tinued work on several Indian country for Community Investments hosted two initiatives focused on improving the fi- conferences focused on community nancial literacy and housing options of development investment. One confer- Native Americans. The three Banks con- ence, which was cosponsored with the tinued to promote the adoption of uni- Board, focused on the availability of ru- form commercial codes to facilitate ral venture capital; the other, cospon- tribes’ efforts to borrow from off- sored with the New York Reserve Bank, reservation partners or other tribes. The discussed issues related to the creation Federal Reserve Bank of Dallas engaged of a secondary market for community in efforts to promote financial education development loans. Other Reserve in the workplace, including sponsorship Banks hosted symposiums on this topic of a highly successful seminar for hu- as well, such as the Federal Reserve man resource professionals attended by Bank of Richmond’s Community Devel- approximately 80 employers, who in opment Financial Institution (CDFI) turn represented 380,000 employees. workshops that gathered community de- The Richmond Reserve Bank released velopment lenders, local bankers, and two issues of its journal MarketWise, representatives from the CDFI Fund to one which featured an article on the discuss capitalizing and certifying po- earned-income tax credit (EITC). The tential CDFIs. The Federal Reserve New York Reserve Bank cosponsored a Bank of Boston and the Aspen Institute, conference with the New York City Of- a national research and leadership devel- fice of Financial Empowerment that pro- opment organization, cohosted a confer- moted the EITC. As a result of the con- ence on socially responsible investment ference, a statewide coalition of EITC and the role of subsidy dollars in public practitioners was created, and several investment. In a related initiative, the statewide asset-building strategies for Boston Reserve Bank collaborated with low- and moderate-income communities the Massachusetts Small Business As- were adopted. sistance Advisory Council on the launch of a loan program for small businesses. Advice from the Asset-building and financial educa- Consumer Advisory Council tion remained major areas of focus for the Community Affairs Offices in 2007. The Board’s Consumer Advisory System staff continued to collaborate Council—whose members represent with constituent organizations on efforts consumer and community organizations, to provide advisory services and con- the financial services industry, academic duct outreach to low- and moderate- institutions, and state agencies—advises income communities. The Federal Re- the Board of Governors on matters con- serve Bank of Atlanta worked with the cerning laws and regulations that the Federal Deposit Insurance Corporation Board administers and on other issues to create MoneySmart curriculum mod- related to consumer financial services. ules on low-income investment. The Council meetings are held three times a 144 94th Annual Report, 2007 year, in March, June, and October, and just federally supervised institutions. are open to the public. (For a list of Consumer representatives noted that members of the council, see the section rules would also provide consumers “Federal Reserve System Organiza- with a private right of action. Several tion.”) Among other issues, council dis- members stated that rulemaking may be cussions in 2007 focused on two signifi- appropriate for areas in which the Board cant topics: can establish clear, bright lines for regu- • latory supervision but that guidance is various issues related to mortgage the best way to ensure that institutions lending, specifically the Board’s rule- have appropriate flexibility to meet con- making authority under the Home sumers’ needs. Ownership and Equity Protection Act In considering whether proposed rules (HOEPA) to address concerns about on mortgage lending should apply to the abusive lending practices in the home subprime mortgage market, council mortgage market, and concerns about members generally urged the Board to foreclosures and the subprime lending define “subprime” not by borrower char- market acteristics but according to the type of • proposed amendments to Regulation loan or its terms, such as a loan’s annual Z that would revise the disclosure re- percentage rate. An industry member quirements for credit card accounts endorsed the definition of “subprime” and other open-end (revolving) credit that the Board used in earlier guidance plans that are not secured by a bor- and cautioned against using Home Mort- rower’s home gage Disclosure Act (HMDA) standards as a pricing criterion for subprime loans, because the HMDA standards may not Mortgage Lending Issues capture all subprime loans. HOEPA Several members urged the Board to ban prepayment penalties, particularly In its June and October meetings, the for subprime loans. They expressed con- council addressed several issues related cerns that, for subprime borrowers, pre- to the Board’s rulemaking authority un- payment penalties are not balanced by der HOEPA: whether the Board should lower interest rates and often prevent issue rules or guidance, the possibility borrowers from graduating into prime of prohibiting or restricting certain loan loans. Other members acknowledged terms or practices in subprime loans, the problems with using prepayment penal- definition of “subprime,” and the role ties in the subprime market but said the and timing of the disclosures provided penalties can be a useful tool and yield to consumers during the loan-making lower interest rates for consumers. process. These members urged the Board to Several consumer representatives regulate prepayment penalties to ensure strongly supported issuing rules under that borrowers receive a choice about HOEPA rather than guidance. Consumer whether to have a prepayment penalty, representatives expressed the view that which may result in a lower interest rate guidance puts supervised institutions at for them. A consumer representative a competitive disadvantage to other suggested that prepayment penalties for mortgage lenders that do not have to adjustable-rate mortgages should expire comply with guidance. Rules, however, 60 days before the first interest-rate re- would apply to all mortgage lenders, not set on such a loan. Consumer and Community Affairs 145

Council members generally agreed the loan to the fully indexed rate. Some that it is a sound underwriting practice members commented that such a stan- to require borrowers to make monthly dard would also benefit investors by giv- payments to escrow accounts for taxes ing them greater assurance about the and insurance, as loans that include es- quality of the loans they are purchasing. crow payments generally perform better. Members disagreed about the length of There was also consensus on the impor- time for which ability to repay should be tance of clearly disclosing whether an considered. Some industry representa- advertised payment amount includes a tives cautioned that setting too strict a borrower’s taxes and insurance. Recog- standard could inappropriately restrict nizing the financial vulnerability of access to credit. subprime borrowers, members generally Members agreed on the importance of agreed that the Board should mandate providing consumers with simplified, that escrow accounts be established for plain-language disclosures for mortgage subprime loans. Some members sug- products. Several members identified gested that escrow accounts should not key terms that should be clearly and be required for borrowers who take out concisely disclosed. Some members ex- prime loans. Members had a variety of pressed concern, however, that simpli- views about initially mandated escrow fied disclosures may not sufficiently in- accounts that borrowers could later opt form borrowers about the more complex out of. Both consumer and industry rep- or exotic mortgage products being of- resentatives generally agreed that any fered; they suggested such products may opt-out decision should not be made at require a different type of disclosure. loan closing and that clear disclosure of Some members supported a requirement any escrow requirement and opt-out pro- that Truth in Lending Act (TILA) dis- vision is paramount. closures be provided earlier in the loan- Several council members commented making process for nonpurchase mort- on the need for stated-income loans, es- gage loans. They also emphasized that pecially in immigrant communities and TILA disclosures should accurately re- for borrowers who engage in cash trans- flect the terms of the transaction. actions or are otherwise not connected In a discussion of yield-spread premi- with mainstream financial institutions. ums (YSPs), several members stated The members emphasized the impor- that many consumers do not know about tance of sound, responsible underwrit- YSPs or understand how they work. ing for stated-income loans and urged Members agreed on the importance of that lenders be given flexibility to use providing borrowers with transparent nontraditional, third-party forms of in- YSP disclosures. Several consumer rep- come documentation. Some members resentatives expressed concern about highlighted the importance of providing abusive practices related to YSPs; for borrowers with clear disclosures for example, a consumer may receive a stated-income loans to ensure that these higher interest rate because his or her borrowers are aware they may not be mortgage broker has an agreement to receiving the lowest rate for which they receive a YSP from a certain lender, or qualify. some lenders may combine YSPs and Council members generally agreed discount points, resulting in higher fees that the Board should require lenders to for borrowers. An industry member ex- ensure borrowers’ ability to repay a loan pressed the view that banning YSPs for a reasonable term by underwriting would hurt small broker businesses by 146 94th Annual Report, 2007 eliminating a key source of their com- adjustable-rate mortgage loans and (2) pensation and would put small loan these products may pose an elevated risk originators at a competitive disadvan- to financial institutions. Most members tage to large lenders, thereby leaving supported the guidance. Several mem- consumers with fewer choices in the bers voiced approval for the provision marketplace. recommending that lenders underwrite a loan at its fully indexed rate. They were Foreclosures and also supportive of the recommendation Subprime Lending Issues that a loan’s underwriting include an escrow component for taxes and insur- At its March meeting, the council dis- ance. Some members supported extend- cussed the recent increase in home fore- ing the principles of the guidance to closures in a number of markets across prime mortgage lending, but others the country. Several members described noted possible difficulties to segmenting the impact of defaults and foreclosures the mortgage market in this way. Sev- on their communities: large concentra- eral members shared concerns that ap- tions of abandoned and vacant proper- plying the guidance to prime loans ties and the associated need to enhance might reduce the variety of loan prod- policing efforts and other city services, a ucts available to consumers. Members rise in homelessness, decreasing prop- representing the financial services in- erty values, and declining tax revenues dustry questioned whether the guidance for local governments. Some members might lead to the creation of a loan- noted a disproportionate concentration suitability standard, that is, a require- of foreclosures in communities that are ment that lenders gauge the suitability predominately Latino or African Ameri- can; members also shared concerns of a loan product for certain borrowers. about foreclosure “rescue” scams and Industry members generally thought the “flipping” of previously foreclosed such a standard could limit the array of homes, and they stressed the importance loan products available to consumers. of having community-based organiza- Several members emphasized the need tions coordinate and manage rescue for a new Federal Housing Administra- funds for homeowners facing foreclo- tion loan product that could meet the sure. Members discussed possible ways needs of subprime borrowers. to assist households facing default or foreclosure. Several consumer represen- Credit Cards tatives described the difficulty credit counselors face when they try to contact In May, the Board issued proposed servicers on behalf of borrowers. Mem- amendments to Regulation Z, which bers also noted the challenges associ- implements the Truth in Lending Act, ated with restructuring mortgages that that would affect the content, format, have been securitized. and timing of credit card disclosures. Members commented on the proposed The council’s discussions in June and statement on subprime mortgage lend- October focused on several dimensions ing issued by the federal financial regu- of the proposal: the summary table, or latory agencies in March. The proposal “Schumer box,” for application and so- addressed concerns that (1) subprime licitation disclosures; account-opening borrowers may not fully understand the disclosures; periodic statements; and risks and consequences of products like change-in-terms notices. Consumer and Community Affairs 147

Several members commended the Members generally approved of the Board for proposed revisions to the new format for periodic statements, par- Schumer box. By highlighting key infor- ticularly the clear grouping of fees and mation on credit card terms, the revi- the year-to-date totals for interest sions would facilitate consumers’ ability charges and fees. They noted the impor- to compare different credit cards, mem- tance of highlighting the late-payment bers said. Several consumer representa- notice by requiring its placement on the tives urged the Board to include a “typi- front of the statement and emphasized cal APR” in the Schumer box. This APR the importance of clearly disclosing day would include the fees that consumers and time deadlines for payments (that is, typically pay during a billing cycle and the cutoff before late-payment charges could alert them to the potential costs of apply). Several consumer representa- using the credit card. A typical APR tives stated that the effective APR dis- would also allow consumers to compare closure should be retained because it the fees different cards charge. Several more accurately accounts for the total industry members objected to the idea cost of credit. Industry representatives, of a typical APR, however, expressing however, expressed their preference for concerns that such a rate would be mis- eliminating the effective APR disclosure leading and unhelpful, as many fees are on the basis that, even with the change not necessarily incurred by every con- in labeling, the figure is confusing to sumer. Industry representatives sup- consumers. The industry members stated ported the disclosure of fees in dollar that the proposed year-to-date totals for amounts rather than as a percentage of interest and fees represent the most the balance, noting that the Board’s con- meaningful disclosure to consumers of sumer testing found that consumers the total cost. Several members com- more readily understand dollar amounts mended the Board on its use of con- than percentages. Several consumer rep- sumer testing to develop the credit card resentatives commended the Board for disclosures and urged the Board to con- proposing a disclosure to inform continue using both qualitative and quanti- sumers about the amount of available tative testing as it determines how best credit if the account-opening fees are to communicate complicated financial 25 percent or more of the credit limit, as terms to consumers. is sometimes the case with subprime For change-in-terms notices, several credit cards. consumer representatives expressed For account-opening disclosures, support for requiring 45 days’ advance members generally supported the notice for rate increases triggered by a Board’s proposal to require a summary consumer’s default or delinquency. table similar to the Schumer box. They They emphasized that advance notice noted that a summary would make it will give consumers the opportunity to easy for consumers to compare the ac- pursue other credit options. Industry tual account terms with those they were representatives disagreed with provid- originally offered. Some industry and ing a 45-day advance notice of in- consumer representatives disagreed creased rates when the increase is about the proposal to allow the verbal prompted by consumer default. They disclosure of some fees at the time a noted that default pricing is properly consumer incurs a charge, instead of re- disclosed to consumers at account open- lying on account-opening disclosures to ing and that the triggering of a default disclose all fees. rate by a consumer’s action does not 148 94th Annual Report, 2007 constitute a change in terms. Industry Other Issues representatives expressed support for 45 days’ advance notice of charges or At their March meeting, council mem- changes in terms that have not been bers discussed additional topics, includ- previously disclosed. Several industry ing model privacy notices, proposed representatives opposed having an opt- amendments to Regulation E, and sev- out when a rate increase is prompted by eral aspects of Regulation CC. default or delinquency, but they sup- To comply with their disclosure obli- ported a consumer’s right to opt out in gations on the sharing of consumer in- other cases. formation under the Gramm-Leach- The council also discussed credit card Bliley Act, financial institutions may issuers’ practice of offering a 0 percent use the model privacy form developed APR for consumers’ balance transfers jointly by the federal financial regula- from other credit cards and a higher tory agencies and the Federal Trade APR for purchases. Typically, issuers Commission. Members generally com- then typically allocate consumers’ pay- mended the agencies for the proposed ments to balances that have the lowest form, noting that the prototype was a APR—allowing high-APR balances to marked improvement over current pri- remain high. Several consumer repre- vacy notices because it is clearer and sentatives urged the Board to prohibit easier to navigate—and thus makes it policies that apply all payments to the easier for consumers to compare differ- lowest-rate balance first, noting that ent privacy policies. Some industry rep- many consumers do not understand how resentatives expressed concerns that the such low-APR products work. Several form did not sufficiently address addi- industry representatives expressed the tional notice and opt-out requirements view that such payment-allocation meth- that may exist under state laws; they ods are appropriate business practices urged the agencies to preempt state pri- and that consumers benefit from low- vacy law requirements. Institutions may APR cards because they receive an not use the form if they lack confidence interest-free loan for a certain period that doing so would satisfy their obliga- of time. Industry representatives did tions under state laws, industry repre- acknowledge the need for better sentatives said. disclosures. The council provided feedback on There was consensus among council proposed amendments to Regulation E, members on what they consider to be which implements the Electronic Fund best practices for due dates on credit Transfer Act, that would eliminate the card payments: if creditors do not re- receipt requirement at point-of-sale and ceive mail or post payments on week- other electronic terminals for debit card ends or holidays, then payments that ar- transactions of $15 or less. Members ac- rive on those days should be posted on knowledged that consumers increasingly the next business day and should be use credit and debit cards for small- credited as on time if the due date fell dollar transactions but disagreed about on that weekend or holiday. Similarly, a whether receiving a receipt helps con- payment that has a weekend or holiday sumers manage their finances. Industry due date should be credited as on time if members generally expressed the view it is received on the next business day. that consumers receive minimal benefit Consumer and Community Affairs 149 from receipts for small-dollar transac- accounts and the collection and return of tions. They noted that consumers would checks. They focused particularly on continue to receive information about scams involving fraudulent checks and each of their transactions on periodic on the exception-hold practices that fi- statements. Several consumer represen- nancial institutions can use to protect tatives opposed the Board’s proposal, themselves and their customers from stating that receipts are an important tool these scams. Members expressed con- to help consumers accurately track their cern that the brief hold periods permit- transactions, obtain reimbursements, ted under Regulation CC for certain and provide documentation in a dispute. checks may impede financial institu- Several industry representatives ex- tions’ ability to conduct appropriate due pressed concern that the costs associated diligence. Several industry representa- with providing terminal receipts for tives emphasized the importance of co- debit card transactions are burdensome operation and information-sharing and impede industry efforts to create among financial institutions when an in- cashless payment options in certain re- stitution has concerns that a check may tail settings. Consumer representatives be fraudulent. Some members suggested generally regarded the proposed $15 that enhanced enforcement to require a threshold as too high. Industry represen- paying institution to return a check item tatives, however, suggested that the promptly could be helpful in this pro- threshold should be increased to $25, cess. Others recommended that the fed- consistent with current credit card rules eral financial regulatory agencies stan- that waive requirements for authoriza- dardize and coordinate fraudulent-check tion by signature or personal identifica- alerts rather than issue separate alerts. tion number for transactions less than Members highlighted the importance of this amount. education to increase awareness of Members discussed several aspects of fraudulent-check issues among both Regulation CC, which governs the avail- financial institution employees and ability of funds deposited in checking consumers. Á

151

Federal Reserve Banks

In addition to contributing to setting na- ment factor (PSAF).2 Over the past ten tional monetary policy and supervising years, the Reserve Banks have recov- and regulating banks and other financial ered 99.1 percent of their priced services entities (discussed in preceding chap- costs, including the PSAF (table).3 ters), the Federal Reserve Banks provide In 2007, the Reserve Banks recovered payment services to depository and cer- 101.9 percent of total costs of tain other institutions, distribute the na- $993.7 million, including the PSAF.4 tion’s currency and coin, and serve as Revenue from priced services amounted fiscal agents and depositories for the to $878.4 million, other income was United States. $133.8 million, and costs were $913.3 million, resulting in net income from priced services of $98.9 million. Developments in Federal Reserve Priced Services The Federal Reserve Banks provide a range of payment and related services to depository institutions, including col- 2. In addition to income taxes and the return on equity, the PSAF is made up of three imputed lecting checks, operating an automated costs: interest on debt, sales taxes, and assess- clearinghouse service, transferring funds ments for deposit insurance by the Federal Deposit and securities, and providing a multilat- Insurance Corporation (FDIC). Board of Gover- eral settlement service. The Reserve nors assets and costs that are related to priced services are allocated to priced services; in the pro Banks charge fees for providing these forma financial statements at the end of this chap- “priced services.” ter, Board assets are part of long-term assets, and The Monetary Control Act of 1980 Board expenses are included in operating ex- requires that the Federal Reserve estab- penses. lish fees for priced services provided to 3. Effective December 31, 2006, the Reserve Banks implemented the Financial Accounting depository institutions so as to recover, Standards Board’s Statement of Financial Ac- over the long run, all direct and indirect counting Standards (SFAS) No. 158, Employers’ costs actually incurred as well as the Accounting for Defined Benefit Pension and Other imputed costs that would have been in- Postretirement Plans, which has resulted in the recognition of a $237.9 million reduction in equity curred, including financing costs, taxes, related to the priced services’ benefit plans and certain other expenses, and the re- through 2007. Including this reduction in equity, turn on equity (profit) that would have which represents a decline in economic value, re- been earned if a private business firm sults in cost recovery of 96.7 percent for the ten- had provided the services.1 The imputed year period. For details on how implementing SFAS No. 158 affected the pro forma financial costs and imputed profit are collectively statements, refer to notes 2, 3, and 5 at the end of referred to as the private-sector adjust- this chapter. 4. Other income is revenue from investment of clearing balances net of earnings credits, an 1. Financial data reported throughout this amount termed net income on clearing balances. chapter—revenue, other income, cost, income be- Total cost is the sum of operating expenses, im- fore taxes, and net income—can be linked to the puted costs (interest on debt, interest on float, sales pro forma financial statements at the end of this taxes, and the FDIC assessment), imputed income chapter. taxes, and the targeted return on equity. 152 94th Annual Report, 2007

Priced Services Cost Recovery, 1998–2007 Millions of dollars except as noted

Revenue from Operating Targeted return Total Cost recovery Year expenses and services1 on equity costs (percent) 3, 4 imputed costs2

1998 ...... 839.8 743.2 66.8 809.9 103.7 1999 ...... 867.6 775.7 57.2 832.9 104.2 2000 ...... 922.8 818.2 98.4 916.6 100.7 2001 ...... 960.4 901.9 109.2 1,011.1 95.0 2002 ...... 918.3 891.7 92.5 984.3 93.3 2003 ...... 881.7 931.3 104.7 1,036.1 85.1 2004 ...... 914.6 842.6 112.4 955.0 95.8 2005 ...... 994.7 834.7 103.0 937.7 106.1 2006 ...... 1,031.2 875.5 72.0 947.5 108.8 2007 ...... 1,012.3 913.3 80.4 993.7 101.9

1998–2007 ...... 9,343.4 8,528.0 896.6 9,424.8 99.1

Note: Here and elsewhere in this chapter, totals and of $7,938.1 million, imputed costs of $227.2 million, and percentages may not reflect components shown because imputed income taxes of $362.8 million. of rounding. 3. Revenue from services divided by total costs. 1. For the ten-year period, includes revenue from ser- 4. For the ten-year period, cost recovery is 96.7 per- vices of $8,816.8 million and other income and expense cent, including the net reduction in equity related to (net) of $526.6 million. FAS 158 reported by the priced services in 2007. 2. For the ten-year period, includes operating expenses

Commercial Check-Collection 9.8 percent from 2006 (table). The de- Service cline in Reserve Bank check volume is consistent with nationwide trends away In 2007, the Reserve Banks recovered from the use of checks and toward 100.7 percent of the total costs of their greater use of electronic payment meth- commercial check-collection service, in- ods.5 Of all the checks presented by the cluding the PSAF. The Reserve Banks’ Reserve Banks to paying banks in 2007, operating expenses and imputed costs 42.2 percent were deposited and 24.6 totaled $743.3 million, of which $26.1 percent were presented using Check 21 million was attributable to the transpor- products, compared with 14.0 percent tation of commercial checks between and 4.3 percent, respectively, in 2006.6 Reserve Bank check-processing centers. By the end of 2007, this growth resulted Revenue amounted to $705.0 million, of in 57.5 percent of the Reserve Bank which $23.1 million was attributable to estimated revenues derived from the transportation of commercial checks be- 5. The Federal Reserve System’s retail pay- tween Reserve Bank check-processing ments research suggests that the number of checks centers, and other income was written in the United States has been declining $106.9 million. The resulting net income since the mid-1990s. For details, see Federal Re- was $68.6 million. Check-service rev- serve System, “The 2007 Federal Reserve Pay- ments Study: Noncash Payment Trends in the enue in 2007 decreased $40.0 million United States, 2003-2006” (December 2007). from 2006, largely because of a drop in (www.frbservices.org/files/communications/pdf/ paper-check fee revenue; this drop was research/2007_payments_study.pdf). partially offset by an increase in Check 6. The Reserve Banks also offer non−Check 21 electronic-presentment products. In 2007, 21 fee revenue. 19.2 percent of the Reserve Banks’ deposit vol- The Reserve Banks handled 10.0 bil- ume was presented to paying banks using these lion checks in 2007, a decrease of products. Federal Reserve Banks 153

Activity in Federal Reserve Priced Services, 2005–2007 Thousands of items

Percent change Service 2007 2006 2005 2006 to 2007 2005 to 2006

Commercial check ...... 10,001,289 11,083,122 12,227,718 –9.8 –9.4 Commercial ACH ...... 9,363,429 8,230,782 7,338,950 13.8 12.2 Funds transfer ...... 137,555 136,399 135,227 0.9 0.9 Multilateral settlement ...... 505 470 440 7.4 6.8 Securities transfer ...... 10,110 9,053 9,235 11.7 –2.0

Note: Activity in commercial check is the total num- securities transfer, the number of transactions originated ber of commercial checks collected, including processed online and offline; and in multilateral settlement, the and fine-sort items; in commercial ACH, the total number number of settlement entries processed. of commercial items processed; in funds transfer and check deposits and 39.0 percent of Re- The Reserve Banks’ operating expenses serve Bank check presentments being and imputed costs totaled $85.9 million. made through Check 21 products. Revenue from ACH operations totaled In 2007, the Reserve Banks continued $88.3 million and other income totaled efforts to reduce check-service operat- $13.7 million, resulting in net income of ing costs in response to the ongoing de- $16.0 million. The Banks processed cline in check volume. These efforts in- 9.4 billion commercial ACH transac- cluded the consolidation of some check- tions, an increase of 13.8 percent from processing sites. Check processing at 2006. Nashville has now been consolidated to In 2007, nationwide ACH volumes Atlanta; San Francisco operations to Los continued to grow at double-digit rates. Angeles; and Helena (Montana) opera- This growth is largely attributable to tions to Denver. As part of a longer- volume increases associated with elec- range strategy, the Reserve Banks have tronic check conversion applications— selected Philadelphia, Cleveland, At- including checks converted at lockbox lanta, and Dallas as regional check- locations or at the point of purchase. processing sites, which will provide a ACH rule changes that took effect in full range of check-processing services. early 2007 permitted checks to be con- The transition to this new structure is verted in processing centers or back of- expected to begin in 2008. The Reserve fices, spurring further growth in the vol- Banks will continue to review their ume of ACH check conversions. check infrastructure regularly to respond to further changes within the nation’s payments system and to meet statutory Fedwire Funds and requirements for long-term cost National Settlement Services recovery. In 2007, the Reserve Banks recovered Commercial Automated 107.3 percent of the costs of their Fed- Clearinghouse Services wire Funds and National Settlement Ser- vices, including the PSAF. The Reserve In 2007, the Reserve Banks recovered Banks’ operating expenses and imputed 107.6 percent of the total costs of their costs totaled $63.1 million in 2007. Rev- commercial automated clearinghouse enue from these operations totaled (ACH) services, including the PSAF. $64.4 million and other income 154 94th Annual Report, 2007 amounted to $10.1 million, resulting in government-sponsored enterprises, and net income of $11.4 million. certain international organizations to other participants in the service.7 In Fedwire Funds Service 2007, the number of non-Treasury securities transfers processed by the service The Fedwire Funds Service allows par- increased 11.7 percent from 2006, to ap- ticipants to use their reserve or clearing proximately 10.1 million. balances at the Reserve Banks to trans- In 2007, the Board published an as- fer funds to other participants. In 2007, sessment of the compliance of the Fed- the number of Fedwire funds transfers wire Securities Service with the Recom- originated by depository institutions in- mendations for Securities Settlement creased 0.9 percent from 2006, to ap- Systems that are included in the Federal proximately 137.6 million. The average Reserve Policy on Payments System daily value of Fedwire funds transfers in Risk.8 The Fedwire Securities Service 2007 was $2.7 trillion. mostly complied with the recommendations’ applicable standards.9 Both the National Settlement Service Fedwire Funds Service and the Fedwire The National Settlement Service is a Securities Service assessments will be multilateral settlement system that al- reviewed periodically to ensure that they lows participants in private-sector clear- remain accurate. ing arrangements to exchange and settle transactions on a net basis using reserve or clearing balances. In 2007, the ser- Float vice processed settlement files for ap- The Federal Reserve had daily average proximately fifty-four local and national credit float of $604.9 million in 2007, private arrangements, primarily check clearinghouse associations. The Reserve Banks processed slightly more than 17,000 files that contained almost 7. The expenses, revenues, volumes, and fees 505,000 settlement entries for these ar- reported here are for transfers of securities issued rangements in 2007. by federal government agencies, government- sponsored enterprises, and certain international organizations. The Reserve Banks provide Treasury Fedwire Securities Service securities services in their role as the U.S. Trea- sury’s fiscal agent. These services are not consid- In 2007, the Reserve Banks recovered ered priced services. For details, see the section 103.7 percent of the total costs of their “Debt Services” later in this chapter. 8. The Recommendations are a set of nineteen Fedwire Securities Service, including minimum standards, developed by the Committee the PSAF. The Reserve Banks’ operat- on Payment and Settlement Systems (CPSS) and ing expenses and imputed costs for pro- the Technical Committee of the International Or- viding this service totaled $21.0 million ganization of Securities Commissions (IOSCO), to in 2007. Revenue from the service to- address legal, presettlement, settlement, operational, and custody risks, among other issues, in taled $20.6 million, and other income securities settlement systems. See www. totaled $3.2 million, resulting in net in- federalreserve.gov/paymentsystems/fedwiresecsvs/ come of $2.9 million. fedwiresecsvs.pdf. The Fedwire Securities Service al- 9. In 2006, the Board published an assessment of the compliance of the Fedwire Funds Service lows participants to electronically trans- with the Core Principles for Systemically Impor- fer securities issued by the U.S. Trea- tantPaymentSystems.Seewww.federalreserve.gov/ sury, federal government agencies, paymentsystems/coreprinciples/coreprinciples.pdf. Federal Reserve Banks 155 compared with credit float of $85.9 mil- the Reserve Banks’ Currency Technol- lion in 2006.10 ogy Office to develop more-secure de- signs for the $5 Federal Reserve note. The Reserve Banks issued the rede- Developments in signed $5 note in March 2008. Currency and Coin Board staff worked with the Reserve The Federal Reserve Banks issue the na- Banks and the United States Mint to tion’s currency (in the form of Federal implement the distribution strategy for Reserve notes) and distribute coin the Presidential $1 Coin Program. Con- through depository institutions. The Re- sistent with the requirements of the serve Banks also receive currency and Presidential $1 Coin Act, the Federal coin from circulation through these in- Reserve and the Mint conducted addi- stitutions. The Reserve Banks received tional outreach to depository institutions 38.0 billion Federal Reserve notes from and coin users to gauge demand for the circulation in 2007, a 0.8 percent de- coins and to anticipate and eliminate ob- crease from 2006, and made payments stacles to the efficient circulation of $1 of 38.5 billion notes into circulation in coins. 2007, a 1.5 percent decrease from 2006. The Reserve Banks began implement- They received 63.3 billion coins from ing a program to extend to 2017 the circulation in 2007, a 5.9 percent in- useful life of the System’s BPS 3000 crease from 2006, and made payments high-speed currency-processing ma- of 75.7 billion coins into circulation, a chines. The program will replace the op- 2.2 percent increase from 2006. erating systems of the current equip- In July, the Reserve Banks implement but retain the machines’ frames, mented the fee component of the Fed- note-transport mechanisms, and large eral Reserve currency recirculation mechanical parts. Software problems policy. The intent of the policy is to and development delays have extended reduce the overuse of Federal Reserve the schedule for completion of the pro- currency-processing services by deposi- gram to the fourth quarter of 2009. tory institutions. Under the policy, the The Reserve Banks selected a vendor Reserve Banks assess fees to institutions to design software to replace the current that, within a one-week period, deposit standard cash application. The multiyear fit $10 or $20 notes and reorder cur- project will begin in 2008; the target rency of the same denomination, above implementation date for the new auto- a de minimis amount, within the same mation system is 2010. Reserve Bank office’s service area. At the end of the first two billing quarters, the Developments in Reserve Banks had collected $5.5 million Fiscal Agency and in recirculation fees from institutions. Government Depository Services Board staff worked with the Treasury Department, the U.S. Secret Service, and As fiscal agents and depositories for the federal government, the Federal Reserve Banks provide services related to the 10. Credit float occurs when the Reserve Banks federal debt, help the Treasury collect present items for collection to the paying bank funds owed to the federal government, prior to providing credit to the depositing bank, and debit float occurs when the Reserve Banks process electronic and check payments credit the depositing bank prior to presenting items for the Treasury, maintain the Trea- for collection to the paying bank. sury’s bank account, and invest excess 156 94th Annual Report, 2007

Expenses of the Federal Reserve Banks for Fiscal Agency and Depository Services, 2005–2007 Thousands of dollars

Agency and service 2007 2006 2005

Department of the Treasury

Bureau of the Public Debt Treasury retail securities ...... 74,149.2 73,931.4 86,503.2 Treasury securities safekeeping and transfer ...... 8,687.7 7,535.2 6,055.8 Treasury auction ...... 41,372.0 23,594.9 17,553.5 Computer infrastructure development and support ...... 3,558.7 3,853.1 2,575.5 Other services ...... 724.5 1,578.7 1,806.5 Total ...... 128,492.1 110,493.2 114,494.5 Financial Management Service Payment services Government check processing ...... 17,522.7 20,918.6 20,988.0 Automated clearinghouse ...... 6,050.3 5,823.1 5,709.5 Fedwire funds transfers ...... 116.8 123.1 109.4 Other payment programs ...... 81,636.9 69,696.8 49,366.0 Collection services Tax and other revenue collections ...... 38,254.5 37,095.5 39,736.0 Other collection programs ...... 12,483.6 14,122.6 14,354.2 Cash-management services ...... 46,093.6 48,320.2 40,496.7 Computer infrastructure development and support ...... 70,999.9 67,046.4 67,703.3 Other services ...... 7,507.2 7,414.8 2,332.2 Total ...... 280,665.7 270,561.2 240,795.4 Other Treasury Total ...... 17,997.1 16,786.3 15,726.7 Total, Treasury ...... 427,154.9 397,840.7 371,016.6 Other Federal Agencies Department of Agriculture Food coupons ...... 2,706.0 2,929.8 2,642.4 United States Postal Service Postal money orders ...... 8,913.2 9,334.4 7,647.8 Other agencies Other services ...... 19,412.0 15,977.1 14,870.2 Total, other agencies ...... 31,031.1 28,241.4 25,160.4 Total reimbursable expenses ...... 458,186.0 426,082.1 396,177.0

Treasury balances. The Reserve Banks reimbursed the Reserve Banks for the also provide limited fiscal agency and costs of providing these services. depository services to other entities. The total cost of providing fiscal Debt Services agency and depository services to the Treasury and other entities in 2007 The Reserve Banks auction, provide amounted to $458.2 million, compared safekeeping for, and transfer Treasury with $426.1 million in 2006 (table). securities. Reserve Bank operating ex- Treasury-related costs were $427.2 mil- penses for these activities totaled $50.1 lion in 2007, compared with $397.8 mil- million in 2007, compared with $31.1 lion in 2006, an increase of 7.4 percent. million in 2006. The Banks processed The cost of providing services to other 104,000 commercial tenders for Trea- entities was $31.0 million, compared sury securities in 2007 through the Fed- with $28.2 million in 2006. In 2007, as wire Securities Service, compared with in 2006, the Treasury and other entities 148,000 in 2006. They originated Federal Reserve Banks 157

13.7 million transfers of Treasury secu- taled $105.3 million in 2007, compared rities in 2007, a 6.4 percent increase with $96.6 million in 2006. The Banks from 2006. The Reserve Banks are de- processed 1,027 million ACH payments veloping a new Treasury auction appli- for the Treasury, an increase of 3.6 per- cation and infrastructure that will cent from 2007, and more than 618,000 provide increased functionality and se- Fedwire funds transfers. They also pro- curity. The application will be opera- cessed 214 million government checks, tional in early 2008. a decline of 3.6 percent from 2006. The The Reserve Banks also operate com- proportion of government checks being puter applications and provide customer processed as paper checks has been de- service and back-office support for the clining as an increasing number of Treasury’s retail securities programs. checks are being presented by deposi- Reserve Bank operating expenses for tory institutions in image form. Of all these activities were $74.1 million in the government checks processed by the 2007, compared with $73.9 million in Banks in 2007, 54 percent of the checks 2006. The Reserve Banks operate were presented as paper and 46 percent Legacy Treasury Direct, a program that were presented as images, compared allows investors to purchase and hold with 87 percent and 13 percent, respec- Treasury securities directly with the tively, in 2006. In addition, the Banks Treasury through the Reserve Banks in- issued more than 131,000 fiscal agency stead of through a broker. The program checks, a decrease of 22.6 percent from held $70.3 billion (par value) of Trea- 2006. sury securities as of December 31. Be- cause the program was designed for investors who plan to hold their securities Collection Services to maturity, it does not provide transfer services. Investors may, however, sell The Reserve Banks support several their securities for a fee through Sell Treasury programs to collect funds Direct, a program operated by one of the owed the federal government. Reserve Reserve Banks. Approximately 13,000 Bank operating expenses related to these securities worth $642.4 million were programs totaled $50.7 million in 2007, sold through Sell Direct in 2007, com- compared with $51.2 million in 2006. pared with 13,000 securities worth The Banks operate the Federal Reserve $678.9 million in 2006. The Banks Electronic Tax Application (FR-ETA) as printed and mailed more than 25.1 mil- an adjunct to the Treasury’s Electronic lion savings bonds in 2007, a 13.2 per- Federal Tax Payment System (EFTPS). cent decrease from 2006. They issued EFTPS allows businesses and individual more than 4.2 million Series I (inflation- taxpayers to pay their taxes electroni- indexed) bonds and 20.6 million Series cally. It uses the automated clearing- EE bonds. house (ACH) to collect funds, so tax payments must be scheduled at least one Payments Services day in advance. Some business taxpayers, however, do not know their tax li- The Reserve Banks process both elec- ability until the tax due date. FR-ETA tronic and check payments for the Trea- allows these taxpayers to use EFTPS by sury. Reserve Bank operating expenses providing a same-day electronic federal for processing government payments tax payment alternative. FR-ETA col- and for payments-related programs to- lected $519.8 billion for the Treasury in 158 94th Annual Report, 2007

2007, compared with $456.3 billion in vides the Repurchase Agreement Pro- 2006. gram on a limited basis, which allows In addition, the Reserve Banks oper- the Treasury to place a portion of its ate Pay.gov, a Treasury program that al- excess operating funds directly with lows members of the public to use the TT&L depositaries through a repurchase Internet to pay for goods and services transaction for a set period at an offered by the federal government. They agreed-on interest rate. In 2007, the Re- also operate the Treasury’s Paper Check serve Banks placed a total of $499 bil- Conversion and Electronic Check Pro- lion of investments through repurchase cessing programs, whereby checks writ- agreements. ten to government agencies are con- In 2007, the Treasury announced the verted into ACH transactions at the Collections and Cash Management point of sale or at lockbox locations. In Modernization (CCMM) initiative, 2007, the Reserve Banks originated which is a multiyear effort to streamline, more than 10.1 million ACH transac- modernize, and improve the process and tions through these programs, a signifi- systems supporting the Treasury’s col- cant increase from 2006 due to growth lections and cash-management pro- in the electronic check processing grams. Several Federal Reserve Banks program. have been selected to work on the CCMM initiative. Treasury Cash-Management Services Services Provided to Other Entities The Treasury maintains its bank account The Reserve Banks provide fiscal at the Reserve Banks and invests the agency and depository services to other funds it does not need for current pay- domestic and international entities when ments with qualified depository institu- required to do so by the Secretary of the tions through the Treasury Tax and Loan Treasury or when required or permitted (TT&L) program, which the Reserve to do so by federal statute. The majority Banks operate. Reserve Bank operating of the work is securities-related. expenses related to this program and other cash-management initiatives to- Electronic Access to taled $46.1 million in 2007, compared Reserve Bank Services with $48.3 million in 2006. The investments either are callable on demand or In 2007, the Federal Reserve Banks con- are for a set term. In 2007, the Reserve tinued to migrate their computer inter- Banks placed a total of $308.4 billion in face customers to FedLine Direct and immediately callable investments, which FedLine Command. This migration, includes funds invested through retained typically for high-volume depository in- tax deposits and direct, special direct, stitutions, comes after the Reserve and dynamic investments, and $687 bil- Banks completed the FedLine Advan- lion in term investments. The rate for tage migration, typically for low- to term investments is set by auction; the moderate-volume depository institu- Reserve Banks held 126 such auctions tions, in 2006. FedLine Direct is an in 2007, roughly the same number of internet-protocol-based computer-to- auctions as in 2006. In 2007, the Trea- computer electronic access channel used sury’s income from the TT&L program to access critical payment services, such was $1.15 billion. The Treasury pro- as Fedwire Funds, Fedwire Securities, Federal Reserve Banks 159

National Settlement, and FedACH Ser- tem has decided not to make any further vices. FedLine Command is a lower- significant investments in the mainframe cost internet-protocol-based computer- platform. System business owners are to-computer electronic access channel looking at alternative platforms for web- for file delivery services, including the based access to applications and data, FedACH Service. The Reserve Banks partly because of concerns about the began the migration to FedLine Direct continued availability of technical re- and FedLine Command in 2006 and ex- sources to support mainframe platforms. pect to complete the conversion in 2008. In 2007, the Federal Reserve continued to implement the Information Secu- Information Technology rity Architecture Framework (ISAF), a large program scheduled to be com- In 2007, the Federal Reserve Banks en- pleted in 2008. ISAF is intended to re- hanced their information technology spond to the continuing and increasingly (IT) governance framework to better sophisticated security threats facing in- align IT management authority and ac- formation technology systems and to countability with the business models improve information security at all used in the System. A System chief in- points in the Federal Reserve by raising formation officer (CIO) position and two the level of enterprise-wide assurance. advisory councils were established. The Major accomplishments in 2007 include Business Technology Council represents improving the separation of sensitive in- the technology needs of the Federal Re- frastructure, limiting access to sensitive serve’s business lines, and the Technol- desktop functions, and strengthening ogy Services Council represents the desktop-access protections. Federal Reserve’s IT providers. The CIO leads System efforts to develop and Examinations of the implement the Federal Reserve’s overall Federal Reserve Banks IT strategy at the Reserve Banks, man- ages national information-security risk, Section 21 of the Federal Reserve Act and analyzes and coordinates the Sys- requires the Board of Governors to or- tem’s IT investments. der an examination of each Federal Re- The System continued to develop the serve Bank at least once a year. The National Information Security Assur- Board performs its own reviews and en- ance function as a central point of gov- gages a public accounting firm. The ernance for enterprise-level information public accounting firm performs an an- security. Associated roles and responsi- nual audit of the combined financial bilities within the function were clari- statements of the Reserve Banks (see fied. Efforts to improve the function will the section “Federal Reserve Banks continue as the Federal Reserve’s infor- Combined Financial Statements”) and mation security environment continues audits the annual financial statements of to evolve. each of the twelve Banks. The Reserve To address the business implications Banks use the framework established by of reduced demand for mainframe ser- the Committee of Sponsoring Organiza- vices, Federal Reserve Information tions of the Treadway Commission Technology in mid-2007 implemented a (COSO) to assess their internal controls multiyear strategic plan for mainframe over financial reporting, including the technologies. These technologies are no safeguarding of assets. The Reserve longer considered strategic, and the Sys- Banks have further enhanced their as- 160 94th Annual Report, 2007 sessments under the COSO framework System Open Market Account at the to strengthen the key control assertion Federal Reserve Bank of New York and process and in 2007 met the require- the foreign currency operations con- ments of the Sarbanes-Oxley Act of ducted by that Bank. In addition, D&T 2002. Within this framework, manage- audits the schedule of participated asset ment of each Reserve Bank provides an and liability accounts and the related assertion letter to its board of directors schedule of participated income ac- annually confirming adherence to counts at year-end. The FOMC receives COSO standards, and a public account- the external audit reports and the report ing firm confirms management’s asser- on the division’s examination. tion and issues an attestation report to each Bank’s board of directors and to the Board of Governors. Income and Expenses In 2007, the Board engaged Deloitte & Touche LLP (D&T) for the audits of The accompanying table summarizes the the individual and combined financial income, expenses, and distributions of statements of the Reserve Banks. Previ- net earnings of the Federal Reserve ously, PricewaterhouseCoopers LLP per- Banks for 2006 and 2007. Income in formed the audits. Fees for D&T’s ser- 2007 was $42,576 million, compared vices totaled $4.7 million. To ensure with $38,410 million in 2006. auditor independence, the Board requires Expenses totaled $4,382 million that D&T be independent in all matters ($3,270 million in operating expenses, relating to the audit. Specifically, D&T $240 million in earnings credits granted may not perform services for the Re- to depository institutions, $296 million serve Banks or others that would place it in assessments for expenditures by the in a position of auditing its own work, Board of Governors, and $576 million making management decisions on behalf for the cost of new currency). Revenue of Reserve Banks, or in any other way from priced services was $878.4 mil- impairing its audit independence. In lion. Net additions to and deductions 2007, the Reserve Banks did not engage from current net income showed a net D&T for nonaudit services. profit of $198 million. The profit was The Board’s annual examination of due primarily to unrealized gains on as- the Reserve Banks includes a wide range sets denominated in foreign currencies of off-site and on-site oversight activi- revalued to reflect current market ex- ties conducted primarily by the Division change rates offset, in part, by interest of Reserve Bank Operations and Pay- expense on reverse repurchase agreement Systems. Division personnel moni- ments. Statutory dividends paid to mem- tor the activities of each Reserve Bank ber banks totaled $992 million, on an ongoing basis and conduct on-site $121 million more than in 2006; the in- reviews based on the division’s risk- crease reflects an increase in the capital assessment methodology. The examina- and surplus of member banks and a con- tions also include assessing the effi- sequent increase in the paid-in capital ciency and effectiveness of the internal stock of the Reserve Banks. audit function. To assess compliance Payments to the U.S. Treasury in the with the policies established by the Fed- form of interest on Federal Reserve eral Reserve’s Federal Open Market notes totaled $34,598 million in 2007, Committee (FOMC), the division also up from $29,052 million in 2006; the reviews the accounts and holdings of the payments equal net income after the de- Federal Reserve Banks 161

Income, Expenses, and Distribution of Net Earnings of the Federal Reserve Banks, 2007 and 2006 Millions of dollars

Item 2007 2006

Current income ...... 42,576 38,410 Current expenses ...... 3,510 3,264 Operating expenses1 ...... 3,270 2,987 Earnings credits granted ...... 240 276 Current net income ...... 39,066 35,147 Net additions to (deductions from, − ) current net income ...... 198 –159 Assessments by the Board of Governors ...... 872 793 For expenditures of Board ...... 296 301 For cost of currency ...... 576 492 Change in funded status of benefit plans2 ...... 324 ... Net income before payments to Treasury ...... 38,716 34,195 Dividends paid ...... 992 871 Transferred to (from) surplus and change in accumulated other comprehensive income ...... 3,126 4,272

Payments to Treasury3 ...... 34,598 29,052

1. Includes a net periodic pension expense of funded status of benefit plans as an element of other $110 million in 2007 and $53 million in 2006. comprehensive income. 2. Subsequent to the adoption of SFAS 158 in 2006, 3. Interest on Federal Reserve notes. the Reserve Banks began to recognize the change in . . . Not applicable. duction of dividends paid and of the lion, an increase of $28,243 million amount necessary to equate the Reserve from 2006 (table). U.S. government se- Banks’ surplus to paid-in capital. curities holdings increased $26,124 mil- In the “Statistical Tables” section of lion, and loans increased $1,297 million. this report, table 10 details the income In December 2007, the Federal Reserve and expenses of each Reserve Bank for established a Term Auction Facility 2007 and table 11 shows a condensed (TAF) under which the Reserve Banks statement for each Bank for the years conduct auctions for a fixed amount of 1914 through 2007; table 9 is a state- funds for a fixed term, with the interest ment of condition for each Bank, and rate determined by the auction process, table 13 gives the number and annual subject to a minimum bid rate. All ad- salaries of officers and employees for vances under the TAF must be fully col- each Bank. A detailed account of the lateralized. In 2007, average daily hold- assessments and expenditures of the ings of Term Auction Credit (TAC) under Board of Governors appears in the sec- the TAF amounted to $822 million. tion “Board of Governors Financial The average rate of interest earned on Statements.” the Reserve Banks’ holdings of government securities increased to 4.95 per- Holdings of Securities and Loans cent, from 4.63 percent in 2006, and the average rate of interest earned on loans The Federal Reserve Banks’ average decreased to 2.18 percent, from daily holdings of securities and loans 5.36 percent. The average interest rate during 2007 amounted to $816,115 mil- on TAC was 4.66 percent. 162 94th Annual Report, 2007

Securities and Loans of the Federal Reserve Banks, 2005–2007 Millions of dollars except as noted

U.S. Term Item and year Total government Loans 2 Auction securities1 Credit3

Average daily holdings 4 20055 ...... 753,748 753,549 199 ... 20065 ...... 787,872 787,648 224 ... 2007 ...... 816,115 813,772 1,521 822

Earnings 6 2005 ...... 28,966 28,959 7 . . . 2006 ...... 36,464 36,452 12 . . . 2007 ...... 40,369 40,298 33 38 Average interest rate (percent) 20055 ...... 3.84 3.84 3.52 ... 20065 ...... 4.63 4.63 5.36 ... 2007 ...... 4.95 4.95 2.18 4.66

1. Includes federal agency obligations. 5. Amounts in bold are restatements due to changes in 2. Does not include indebtedness assumed by the Fed- previously reported data. eral Deposit Insurance Corporation. 6. Earnings have not been netted with the interest ex- 3. Reflects temporary Term Auction Facility activity pense on securities sold under agreements to repurchase. beginning in 2007. . . . Not applicable. 4. Based on holdings at opening of business.

Volume of Operations law enforcement officers (FRLEOs). The 240-hour program covers a variety Table 12 in the “Statistical Tables” sec- of topics related to the mission of an tion shows the volume of operations in FRLEO. The Federal Reserve was the principal departments of the Federal granted federal law enforcement author- Reserve Banks for the years 2004 ity by the USA Patriot Act to protect through 2007. and safeguard Board and Federal Re- serve Bank premises, grounds, property, Federal Reserve personnel, and operations. Law Enforcement In November, the Federal Reserve Sys- Federal Reserve Bank Premises tem became the eleventh federal law enforcement agency to be awarded ac- In 2007, construction was largely com- creditation from the Federal Law pleted on the Kansas City Bank’s new Enforcement Training Accreditation headquarters building and the San Fran- board of directors for its Basic Law En- cisco Bank’s new Seattle Branch build- forcement Course (BLEC). The primary ing. The multiyear renovation program benefit of accreditation is increased pub- at the New York Bank’s headquarters lic confidence in the integrity, profes- building continued. The St. Louis Bank sionalism, and accountability of the law continued a long-term facility redevel- enforcement agencies. Accreditation is opment program that includes the ongo- considered a “best practice” for federal ing construction of an addition to the law enforcement agencies and signifies Bank’s headquarters building. compliance with 63 stringent standards. Security enhancement programs con- All law enforcement candidates com- tinued at several facilities. Construction plete the Federal Reserve’s BLEC prior of security improvements to the Rich- to their designation as Federal Reserve mond Bank’s headquarters building is Federal Reserve Banks 163 ongoing. The Philadelphia Bank com- final design of a new parking garage to pleted the purchase of property behind be constructed adjacent to the Richmond its headquarters building for the con- Bank’s headquarters building. Efforts to struction of a remote vehicle-screening sell the St. Louis Bank’s Little Rock facility and is developing the facility’s Branch building continued. design. Design development of a similar Table 14 in the “Statistical Tables” screening facility for the Dallas Bank section of this report details the acquisi- also continued. tion costs and net book value of the Fed- During 2007, the Board approved the eral Reserve Banks and Branches. Á 164 94th Annual Report, 2007

Pro Forma Financial Statements for Federal Reserve Priced Services

Pro Forma Balance Sheet for Priced Services, December 31, 2007 and 2006 Millions of dollars

Item 2007 2006

Short-term assets (Note 1) Imputed reserve requirements on clearing balances ...... 755.7 821.7 Imputed investments ...... 6,465.7 7,207.5 Receivables ...... 66.7 73.6 Materials and supplies ...... 1.8 0.9 Prepaid expenses ...... 28.5 24.2 Items in process of collection ...... 1,769.6 3,391.0 Total short-term assets ...... 9,088.0 11,518.9 Long-term assets (Note 2) Premises ...... 453.5 424.9 Furniture and equipment ...... 130.2 127.9 Leases, leasehold improvements, and long-term prepayments ...... 64.2 83.3 Prepaid pension costs ...... 484.6 453.0 Deferred tax asset ...... 109.4 130.0 Total long-term assets ...... 1,242.0 1,219.0 Total assets ...... 10,330.0 12,737.9 Short-term liabilities Clearing balances and balances arising from early credit of uncollected items ...... 7,641.1 8,015.6 Deferred-availability items ...... 1,685.1 3,592.5 Short-term debt ...... 0.0 0.0 Short-term payables ...... 102.4 100.4 Total short-term liabilities ..... 9,428.5 11,708.4 Long-term liabilities Long-term debt ...... 0.0 0.0 Postretirement/postemployment benefits obligation ...... 385.0 392.6 Total long-term liabilities ..... 385.0 392.6 Total liabilities ...... 9,813.5 12,101.0 Equity (including accumulated other comprehensive loss of $237.9 million and $306.1 million at December 31, 2007 and 2006, respectively) ...... 516.5 636.9 Total liabilities and equity (Note 3) . . . 10,330.0 12,737.9

Note: Components may not sum to totals because of The accompanying notes are an integral part of these rounding. Amounts in bold are restated due to changes in pro forma priced services financial statements. previously reported data. Federal Reserve Banks 165

Pro Forma Income Statement for Federal Reserve Priced Services, 2007 and 2006 Millions of dollars

Item 2007 2006

Revenue from services provided to depository institutions (Note 4) ...... 878.4 908.4 Operating expenses (Note 5) ...... 888.2 803.5 Income from operations ...... −9.8 104.8 Imputed costs (Note 6) Interest on float ...... −32.0 –4.9 Interest on debt ...... 0.0 0.0 Sales taxes ...... 11.6 10.8 FDIC insurance ...... 0.0 −20.4 0.0 5.9 Income from operations after imputed costs ...... 10.6 98.9 Other income and expenses (Note 7) Investment income ...... 362.3 383.6 Earnings credits ...... −228.5 133.8 –260.8 122.8 Income before income taxes ...... 144.5 221.8 Imputed income taxes (Note 6) ...... 45.5 66.1 Net income ...... 98.9 155.7 Memo: Targeted return on equity (Note 6) . . . 80.4 72.0

Note: Components may not sum to totals because of The accompanying notes are an integral part of these rounding. pro forma priced services financial statements.

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2007 Millions of dollars

Commercial Item Total check Commercial Fedwire Fedwire collection ACH funds securities

Revenue from services (Note 4) ...... 878.4 705.0 88.3 64.4 20.6 Operating expenses (Note 5) ...... 888.2 733.6 78.3 56.9 19.3

Income from operations ...... −9.8 −28.6 10.0 7.5 1.3 Imputed costs (Note 6) ...... −20.4 −21.8 0.2 0.9 0.3

Income from operations after imputed costs ...... 10.6 −6.7 9.7 6.6 1.0 Other income and expenses, net (Note 7) ...... 133.8 106.9 13.7 10.1 3.2

Income before income taxes ...... 144.5 100.2 23.4 16.6 4.2 Imputed income taxes (Note 6) ...... 45.5 31.6 7.4 5.2 1.3

Net income ...... 98.9 68.6 16.0 11.4 2.9 Memo: Targeted return on equity (Note 6) ...... 80.4 63.2 8.8 6.3 2.0 Memo: Cost recovery (percent) (Note 8) ...... 101.9 100.7 107.6 107.3 103.7

Note: Components may not sum to totals because of The accompanying notes are an integral part of these rounding. pro forma priced services financial statements. 166 94th Annual Report, 2007

FEDERAL RESERVE BANKS Notes to Pro Forma Financial Statements for Priced Services (1) Short-Term Assets with long-term liabilities and clearing balances. As a result, no short- or long-term debt is imputed. Other short- The imputed reserve requirement on clearing balances term liabilities include clearing balances maintained at held at Reserve Banks by depository institutions reflects a Reserve Banks and deposit balances arising from float. treatment comparable to that of compensating balances Other long-term liabilities consist of accrued post- held at correspondent banks by respondent institutions. employment, postretirement, and nonqualified pension The reserve requirement imposed on respondent balances benefits costs and obligations on capital leases. must be held as vault cash or as non-earning balances In order to reflect the funded status of its benefit plans maintained at a Reserve Bank; thus, a portion of priced as required by SFAS No. 158, the Reserve Banks recog- services clearing balances held with the Federal Reserve nized the deferred items related to these plans, which is shown as required reserves on the asset side of the include prior service costs and actuarial gains or losses, balance sheet. Another portion of the clearing balances is on the balance sheet. In 2007, this resulted in a decrease used to finance short-term and long-term assets. The re- to the benefits obligation related to the priced services mainder of clearing balances is assumed to be invested in with an offsetting adjustment, net of tax, to AOCI, which a portfolio of investments, shown as imputed invest- is included in equity. ments. Equity is imputed at 5 percent of total assets. Receivables are (1) amounts due the Reserve Banks for priced services and (2) the share of suspense-account and difference-account balances related to priced services. (4) Revenue Materials and supplies are the inventory value of short- Revenue represents charges to depository institutions for term assets. priced services and is realized from each institution Prepaid expenses include salary advances and travel through one of two methods: direct charges to an institu- advances for priced-service personnel. tion’s account or charges against its accumulated earn- Items in process of collection is gross Federal Reserve ings credits (see Note 7). cash items in process of collection (CIPC) stated on a basis comparable to that of a commercial bank. It reflects (5) Operating Expenses adjustments for intra-System items that would otherwise be double-counted on a consolidated Federal Reserve bal- Operating expenses consist of the direct, indirect, and ance sheet; adjustments for items associated with non- other general administrative expenses of the Reserve priced items, such as those collected for government Banks for priced services plus the expenses for staff mem- agencies; and adjustments for items associated with pro- bers of the Board of Governors working directly on the viding fixed availability or credit before items are re- development of priced services. The expenses for Board ceived and processed. Among the costs to be recovered staff members were $6.7 million in 2007 and $7.5 million under the Monetary Control Act is the cost of float, or net in 2006. CIPC during the period (the difference between gross Effective January 1, 1987, the Reserve Banks imple- CIPC and deferred-availability items, which is the portion mented SFAS No. 87, Employers’ Accounting for Pen- of gross CIPC that involves a financing cost), valued at sions. Accordingly, the Reserve Banks recognized operat- the federal funds rate. ing expenses for the qualified pension plan of $21.3 million in 2007 and $11.5 million in 2006. Operat- (2) Long-Term Assets ing expenses also include the nonqualified pension ex- Long-term assets consist of long-term assets used solely pense of $3.1 million in 2007 and $3.2 million in 2006. in priced services, the priced-service portion of long-term The implementation of SFAS No. 158 does not change assets shared with nonpriced services, and an estimate of the systematic approach required by generally accepted the assets of the Board of Governors used in the develop- accounting principles to recognize the expenses associ- ment of priced services. ated with the Reserve Banks’ benefit plans in the income Effective December 31, 2006, the Reserve Banks statement. implemented the Financial Accounting Standard Board’s The income statement by service reflects revenue, op- Statement of Financial Accounting Standards (SFAS) No. erating expenses, imputed costs, and cost recovery. Cer- 158, Employers’ Accounting for Defined Benefit Pension tain corporate overhead costs not closely related to any and Other Postretirement Plans, which requires an em- particular priced service are allocated to priced services ployer to record the funded status of its benefit plans on based on an expense-ratio method. Corporate overhead its balance sheet. This resulted in a reduction to the pre- was allocated among the priced services during 2007 and paid pension asset related to priced services and the rec- 2006 as follows (in millions): ognition of an associated deferred tax asset with an offsetting adjustment, net of tax, to accumulated other 2007 2006 comprehensive income (AOCI) (see Note 3). Check ...... 34.7 30.6 ACH ...... 4.3 4.1 (3) Liabilities and Equity Fedwire funds ...... 3.0 2.8 Under the matched-book capital structure for assets, Fedwire securities ...... 1.7 1.5 short-term assets are financed with short-term payables Total ...... 43.7 39.0 and core clearing balances. Long-term assets are financed Federal Reserve Banks 167

(6) Imputed Costs Unrecovered float includes float generated by services to government agencies and by other central bank ser- Imputed costs consist of income taxes, return on equity, vices. Float recovered through income on clearing bal- interest on debt, sales taxes, the FDIC assessment, and ances is the result of the increase in investable clearing interest on float. Many imputed costs are derived from the balances; the increase is produced by a deduction for float private-sector adjustment factor (PSAF) model. The cost for CIPC, which reduces imputed reserve requirements. of debt and the effective tax rate are derived from bank The income on clearing balances reduces the float to be holding company data, which serves as the proxy for the recovered through other means. As-of adjustments and financial data of a representative private-sector firm, and direct charges refer to float that is created by interterritory are used to impute debt and income taxes in the PSAF check transportation and the observance of non-standard model. The after-tax rate of return on equity is based on holidays by some depository institutions. Such float may the returns of the equity market as a whole and is used to be recovered from the depository institutions through ad- impute the profit that would have been earned had the justments to institution reserve or clearing balances or by services been provided by a private-sector firm. billing institutions directly. Float recovered through direct Interest is imputed on the debt assumed necessary to charges and per-item fees is valued at the federal funds finance priced-service assets; however, no debt was im- rate; credit float recovered through per-item fees has been puted in 2007 or 2006. subtracted from the cost base subject to recovery in 2007. Effective in 2007, the Reserve Bank priced services imputed a one-time FDIC assessment credit of $16.6 million. In 2007, the credit fully offset the imputed $4.0 (7) Other Income and Expenses million assessment, resulting in a remaining credit of Other income and expenses consist of investment income $12.6 million. The remaining credit can be used to offset on clearing balances and the cost of earnings credits. up to 90 percent of the assessment in the future. Investment income on clearing balances for 2007 and Interest on float is derived from the value of float to be 2006 represents the average coupon-equivalent yield on recovered, either explicitly or through per-item fees, dur- three-month Treasury bills plus a constant spread, based ing the period. Float costs include costs for the Check, on the return on a portfolio of investments. The return is Fedwire Funds, National Settlement Service, ACH, and applied to the total clearing balance maintained, adjusted Fedwire Securities services. for the effect of reserve requirements on clearing bal- Float cost or income is based on the actual float in- ances. Expenses for earnings credits granted to depository curred for each priced service. Other imputed costs are institutions on their clearing balances are derived by ap- allocated among priced services according to the ratio of plying a discounted average coupon-equivalent yield on operating expenses, less shipping expenses, for each ser- three-month Treasury bills to the required portion of the vice to the total expenses, less the total shipping ex- clearing balances, adjusted for the net effect of reserve penses, for all services. requirements on clearing balances. The following shows the daily average recovery of actual float by the Reserve Banks for 2007 in millions of (8) Cost Recovery dollars: Annual cost recovery is the ratio of revenue to the sum of Total float –603.3 operating expenses, imputed costs, imputed income taxes, Unrecovered float 24.1 and targeted return on equity. Float subject to recovery –627.4 Sources of recovery of float Income on clearing balances –62.7 As-of adjustments –1.6 Direct charges 267.3 Per-item fees –833.6

169

The Board of Governors and the Government Performance and Results Act

The Government Performance and Re- liminary analysis indicates that the sults Act (GPRA) of 1993 requires that Board generally met its goals for 2006– federal agencies, in consultation with 07. Congress and outside stakeholders, pre- All of these documents are available pare a strategic plan covering a multi- on the Board’s web site, at www. year period and submit an annual perfor- federalreserve.gov/boarddocs/rptcongress. mance plan and performance report. The Board’s mission statement and a Although the Federal Reserve is not summary of the Federal Reserve’s goals covered by the GPRA, the Board of and objectives, as set forth in the most Governors voluntarily complies with the recently released strategic and per- spirit of the act. formance plans, are listed below. Updated documents will be posted on the website as they are completed. Strategic Plan, Performance Plan, and Performance Report Mission The Board’s strategic plan articulates the Board’s mission, sets forth major The mission of the Board is to foster the goals, outlines strategies for achieving stability, integrity, and efficiency of the those goals, and discusses the environ- nation’s monetary, financial, and payment and other factors that could affect ment systems so as to promote optimal their achievement. It also addresses is- macroeconomic performance. sues that cross agency jurisdictional lines, identifies key quantitative performance measures, and discusses perfor- Goals and Objectives mance evaluation. The most recent stra- The Federal Reserve has six primary tegic plan covers the period 2006–09. goals with interrelated and mutually re- Both the performance plan and the inforcing elements. performance report are prepared every two years. The performance plan in- Goal cludes specific targets for some of the performance measures identified in the To conduct monetary policy that pro- strategic plan and describes the opera- motes the achievement of maximum tional processes and resources needed to sustainable long-term growth and the meet those targets. It also discusses data price stability that fosters that goal validation and results verification. The Objectives most recent performance plan covers the period 2006–07. v Stay abreast of recent developments The performance report discusses the and prospects in the U.S. economy and Board’s performance in relation to its financial markets, and in those abroad, goals. The report covering the period so that monetary policy decisions will 2006–07 will be completed in 2008. Pre- be well informed. 170 94th Annual Report, 2007 v Enhance our knowledge of the struc- v Promote compliance by domestic and tural and behavioral relationships in foreign banking organizations super- the macroeconomic and financial mar- vised by the Federal Reserve with kets, and improve the quality of the applicable laws, rules, regulations, data used to gauge economic perfor- policies, and guidelines through a mance, through developmental re- comprehensive and effective supervi- search activities. sion program. v Implement monetary policy effectively in rapidly changing economic Goal circumstances and in an evolving financial market structure. To effectively implement federal laws v Contribute to the development of U.S. designed to inform and protect the con- international policies and procedures, sumer, to encourage community devel- in cooperation with the U.S. Depart- opment, and to promote access to bank- ment of the Treasury and other ing services in historically underserved agencies. markets v Promote understanding of Federal Re- Objectives serve policy among other government policy officials and the general public. v Take a leadership role in shaping the national dialogue on consumer protec- Goal tion in financial services, address the rapidly emerging issues that affect To promote a safe, sound, competitive, today’s consumers, strengthen con- and accessible banking system and sumer compliance supervision pro- stable financial markets grams when required, and remain sen- Objectives sitive to the burden on supervised institutions. v Promote overall financial stability, v Promote, develop, and strengthen ef- manage and contain systemic risk, and fective communications and collabo- identify emerging financial problems rations within the Board, the Federal early so that crises can be averted. Reserve Banks, and other agencies v Provide a safe, sound, competitive, and organizations. and accessible banking system v Increase public understanding of con- through comprehensive and effective sumer protection and community de- supervision of U.S. banks, bank and velopment and the Board’s role in financial holding companies, foreign these areas through increased outreach banking organizations, and related and by developing programs that entities. At the same time, remain address the information needs of sensitive to the burden on supervised consumers and the financial services institutions. industry. v Provide a dynamic work environment v Develop a staff that is highly skilled, that is challenging and rewarding. En- professional, innovative, and diverse; hance efficiency and effectiveness, provide career development oppor- while remaining sensitive to the bur- tunities to improve retention; and den on supervised institutions, by ad- recruit highly qualified and skilled dressing the supervision function’s employees. procedures, technology, resource allo- v Promote an efficient and effective cation, and staffing issues. work environment by aligning busi- Government Performance and Results Act 171

ness functions with appropriate work cient and reliable operations, effective processes and implementing solutions performance, and sound project man- for work products and processes that agement and should assist the Board can be handled more efficiently in the effective discharge of its over- through automation. sight responsibilities.

Goal Goal To foster the integrity, efficiency, and To foster the integrity, efficiency, and accessibility of U.S. payment and settle- effectiveness of the Board’s programs ment systems Objectives Objectives v Oversee a planning and budget pro- v Develop sound, effective policies and cess that clearly identifies the Board’s regulations that foster payment sys- mission, results in concise plans for tem integrity, efficiency, and accessi- the effective accomplishment of op- bility. Support and assist the Board in erations, transmits to the staff the in- overseeing U.S. dollar payment and formation needed to attain objectives securities settlement systems by as- efficiently, and allows the public to sessing their risks and risk manage- measure our accomplishments. ment approaches against relevant v Develop appropriate policies, over- policy objectives and standards. sight mechanisms, and measurement v Conduct research and analysis that criteria to ensure that the recruiting, contributes to policy development and training, and retention of staff meet increases the Board’s and others’ Board needs. understanding of payment system v Establish, encourage, and enforce a dynamics and risk. climate of fair and equitable treatment for all employees regardless of race, Goal creed, color, national origin, age, or sex. To provide high-quality oversight of v Provide financial management support Reserve Banks needed for sound business decisions. v Provide cost-effective and secure in- Objective formation resource management ser- v Produce high-quality assessments and vices to Board divisions and analyze oversight of Federal Reserve System information technology issues for the strategies, projects, and operations, in- Board, Reserve Banks, other financial cluding adoption of technology to the regulatory institutions, and other na- business and operational needs of the tions’ central banks. Federal Reserve. The oversight pro- v Efficiently provide safe, modern, and cess should help Federal Reserve secure facilities and necessary support management foster and strengthen for activities conducive to efficient sound internal control systems, effi- and effective Board operations. Á