Federal Reserve Operations (1.19 MB PDF)

Federal Reserve Operations 55

Consumer and Community Affairs

Among the Federal Reserve’s responsi­ consumer financial products and ser­ bilities in the areas of consumer and vices at the request of Congress. community affairs are During 2004, the Board issued final rules implementing provisions of the • writing and interpreting regulations to Fair and Accurate Credit Transactions implement federal laws that protect Act, an act that significantly amends and inform consumers, the Fair Credit Reporting Act. The Board also issued guidance on the stan­ • supervising state member banks to dards it and the Federal Deposit Insur­ ensure their compliance with the ance Corporation (FDIC) will use when regulations, determining whether to take supervisory or enforcement actions in cases involv­ • investigating complaints from the ing the unfair and deceptive trade prac­ public about state member bank com­ tices provisions of the Federal Trade pliance with regulations, and Commission Act. The Board produced two reports for Congress summarizing • promoting community development in the findings of Board studies on the historically underserved markets. disclosure of fees related to debit card purchases and on the ability of consum­ These responsibilities are carried out by ers to avoid receiving unsolicited writ­ the members of the Board of Governors, ten offers of credit or insurance. In addi­ the Board’s Division of Consumer and tion, the Board revised its Truth in Community Affairs, and the consumer Lending Act regulation and the associ­ and community affairs staff of the Fed­ ated commentary, issued interim final eral Reserve Banks. rules incorporating technical changes to the regulation implementing the Community Reinvestment Act, raised Implementation of Statutes certain thresholds that would trigger Designed to Inform and Protect additional requirements under the Home Consumers Ownership and Equity Protection Act, The Board of Governors writes regula­ and issued a final rule revising the dis­ tions to implement federal laws involv­ closure tables that the federal finan­ ing consumer financial services and fair cial regulatory agencies use to publicly lending. The Board revises and updates release Home Mortgage Disclosure Act these regulations to address the intro­ data reported by covered institutions. duction of new products, to implement legislative changes to existing laws, and to address problems consumers may Fair and Accurate Credit encounter in their financial transactions. Transactions Act To interpret and clarify the regulations, In December 2003, the President signed Board staff issues commentaries and the Fair and Accurate Credit Trans­ other guidance. In addition, the staff actions Act (the FACT Act) into law. may undertake studies on aspects of The FACT Act amends the Fair Credit 56 91st Annual Report, 2004

Reporting Act (FCRA) in numerous established December 31, 2003, as the respects, including making permanent effective date for the preemption pro­ an FCRA provision that preempts states visions of the FACT Act, as well as for from enacting laws in seven areas provisions authorizing the agencies to addressed by the FCRA. The FACT Act adopt rules or take other actions to also includes provisions to address iden­ implement the FACT Act. The final joint tity theft, the accuracy of consumer rules the agencies adopted in February reports, the duties of furnishers of infor­ 2004 included the same schedule of mation, the ability of consumers to opt effective dates contained in the interim out of receiving marketing solicitations rules. The Board’s final rule amended from an organization when the solicita­ its Regulation V, which implements the tion is based on information provided FCRA. to that organization by its affiliate, and Also in December 2003, the Board the ability of creditors to obtain or and the FTC had issued for comment use medical information in connection proposed joint rules that would establish with determining credit eligibility. (The a schedule of effective dates for other FACT Act also established the Finan­ provisions of the FACT Act that did not cial Literacy and Education Commis­ contain effective dates. After reviewing sion. See ‘‘Promotion of Community the comments on the proposal, the agen­ Economic Development in Historically cies, in the February 2004 joint final Underserved Markets’’ later in this rules, established March 31, 2004, as chapter.) the effective date for provisions of the The FACT Act requires the Board to FACT Act that did not require signifi­ issue regulations or guidelines to imple­ cant changes to business procedures. For ment various provisions of the statute. those FACT Act provisions that would In 2004, the Board issued three final likely entail significant changes to busi­ rules: one pertaining to effective dates ness procedures, the agencies estab­ for certain provisions of the FACT Act, lished December 1, 2004, as the effec­ one pertaining to the furnishing of nega­ tive date, to allow a reasonable time tive information to consumer reporting for the industry to establish systems that agencies, and one pertaining to the comply with the statute. disposal of consumer information. The Board is currently working on several Furnishing of Negative Information additional regulations or guidelines required by the FACT Act. In June, the Board issued a final rule amending Regulation V to add model Effective Dates notices that financial institutions may use to comply with the notice require­ In February, the Board and the Federal ment for furnishing negative informa­ Trade Commission (FTC) issued joint tion to nationwide consumer report­ final rules to implement section 3 of the ing agencies. Under section 217 of the FACT Act, which required these agen­ FACT Act, a financial institution that cies to establish effective dates for pro­ furnishes negative information about visions of the act that did not already credit extended to a customer (such as contain specific effective dates. The information on a customer’s delinquen­ Board and the FTC had jointly adopted cies or late payments) to a nationwide interim rules in December 2003 that consumer reporting agency is required Consumer and Community Affairs 57 to provide a clear and conspicuous writ­ measures for properly disposing of con­ ten notice to the customer about furnish­ sumer information derived from con­ ing negative information. The required sumer reports (such as credit reports). notice is a one-time notice, and a finan­ The agencies’ final rules implement sec­ cial institution may provide the notice tion 216 of the FACT Act by amending before, or no later than thirty days after, the Interagency Guidelines Establish­ furnishing the negative information to a ing Standards for Safeguarding Cus­ nationwide consumer reporting agency. tomer Information (retitled the Inter­ Section 217 of the FACT Act became agency Guidelines Establishing Stan­ effective on December 1, 2004. dards for Information Security), which The FACT Act required the Board were adopted in 2001 (as appendix D-2 to issue a concise model form not to of Regulation H). The National Credit exceed thirty words that institutions Union Administration, the FTC, and may, but are not required to, use to the Securities and Exchange Commis­ comply with the notice requirement. The sion adopted similar standards for their Board’s final rule added two model institutions. notices to Regulation V. One notice may The interagency guidelines currently be used by financial institutions that require financial institutions to protect give the notice before furnishing nega­ customer information by implementing tive information to a nationwide con­ information security programs. An insti­ sumer reporting agency. The other may tution’s information security program be used by financial institutions that must include measures for the proper give the notice after furnishing negative disposal of ‘‘customer information.’’ information to a nationwide consumer Such information is generally defined as reporting agency. The Board also nonpublic personal information about a amended Regulation V to incorporate a ‘‘customer,’’ namely, an individual who statutory safe harbor relating to the use obtains a financial product or service to of the model notices. The safe harbor in be used primarily for personal, family, the FACT Act provides that a financial or household purposes, and who has institution will be considered to be in a continuing relationship with the finan­ compliance with the notice requirement cial institution. The final rules amend if the institution uses the model notice the interagency guidelines to require in­ issued by the Board, or if it uses the model stitutions to also include measures for notice and rearranges the format. The the proper disposal of ‘‘consumer infor­ Board also provided additional guidance mation,’’ which is generally defined as about using the model notices, including information that is a consumer report guidance on how financial institutions (such as a credit report), or that is may rearrange the format of the notices derived from a consumer report about without losing the safe harbor from lia­ an individual (regardless of whether that bility that the model notices provide. individual is a customer), and that is maintained or otherwise possessed by, Disposal of Consumer Information or on behalf of, the institution for a business purpose. The final rules will In December, the Board along with the take effect on July 1, 2005; however, other federal financial regulatory agen­ financial institutions do not need to cies issued interagency final rules to modify existing contracts with their ser­ require financial institutions to adopt vice providers until July 1, 2006. 58 91st Annual Report, 2004

Interagency Guidance on Unfair unaware of the existence or the source and Deceptive Practices of PIN fees. The primary conclusions of the study address four principal areas: In March, the Board and the FDIC (1) the prevalence of PIN fees; (2) the jointly issued a statement outlining the degree of compliance by depository standards the agencies will use to deter­ institutions with current disclosure mine when state-chartered banks are requirements under the Electronic Fund engaging in unfair or deceptive trade Transfer Act (EFTA), as implemented practices. Such practices are illegal by the Board’s Regulation E; (3) the under section 5 of the Federal Trade adequacy of existing disclosures and the Commission Act. The Board and the likely benefits and costs of new require­ FDIC will apply these standards when ments for disclosure statements; and weighing the need to take supervisory or (4) the feasibility of real-time disclosure enforcement actions and when seeking (namely, disclosing PIN fees at the to ensure that unfair or deceptive prac­ time of a transaction on a POS terminal tices do not recur. The statement also display). provides best practices and general guid­ ance to state-chartered banks to help them manage risks relating to unfair or Prevalence of PIN Fees deceptive acts or practices, as well as to help them avoid engaging in such acts The Board estimated that in 2004 about or practices. The best practices address 15 percent of all customers with debit some of the business areas that have cards had accounts that were subject to the greatest potential for unfair or PIN fees. Because customers can deceptive acts and practices: advertis­ modify their behavior to avoid PIN fees ing and solicitation, servicing and col­ (for example, by using a signature lections, and managing and monitor­ instead of a PIN to secure a transac­ ing employees and third-party service tion), the fraction of customers with providers. debit cards who actually pay these fees is likely between 10 percent and 15 percent. Board Study of the Disclosure of Point-of-Sale Debit Fees under the Electronic Fund Transfer Act Degree of Compliance by Depository Institutions In November, the Board issued a report summarizing the results of its study of The EFTA and the Board’s Regulation E the disclosure of fees related to debit require depository institutions to dis­ card purchases. The study focused spe­ close certain fees to consumers on the cifically on the debit fees that a financial initial disclosure of account terms, on institution may impose when a customer change-in-terms notices, and on peri­ engages in a point-of-sale (POS) debit odic statements of account activity. The transaction and provides a personal Board found that more than 95 percent identification number (PIN). These fees of depository institutions satisfy all the are referred to as ‘‘PIN fees.’’ Some current regulatory requirements for any members of the U.S. Senate Committee electronic funds transfer, and that an on Banking, Housing, and Urban Affairs even higher percentage satisfy the spe­ requested the study because they were cific requirements for the disclosure of concerned that consumers may be PIN fees at the point of sale. Consumer and Community Affairs 59

Adequacy of Existing Disclosures gress directed the Board to study the ability of consumers to avoid (or opt out Consumer and other data suggest that of) receiving written offers of credit or the PIN fee information in initial disclo­ insurance in connection with transac­ sures and in change-in-terms notices tions the consumer did not initiate. The is of limited value to consumers. Some Board also studied the potential effect consumers first learn of debit fees from on consumers of any further restrictions their periodic statements, and many on providing them with such written institutions’ periodic statements do not offers of credit or insurance. In partic­ identify the recipient of a debit fee. ular, Congress directed the Board to These findings suggest that improving address the following five issues: (1) the periodic statements, and potentially availability to consumers of opt-out initial disclosures and change-in-terms mechanisms, that is, methods for con­ notices, could be a relatively low-cost sumers to opt out of having their names way to provide consumers with better and other information used for pre- information about the PIN fees their screened solicitations; (2) the extent to depository institutions impose. which consumers use existing opt-out mechanisms; (3) the benefits to consum­ Feasibility of Real-Time Disclosures ers of receiving written offers; (4) the The Board found that disclosing debit costs to consumers of receiving written fees in real time at a POS terminal (for offers, or any adverse effects on con­ example, showing fee information on a sumers from receiving the offers; and POS terminal display before a customer (5) the potential effects on certain fac­ commits to a method of payment) would tors, such as the cost and availability involve the most extensive changes to of credit, if further restrictions were the infrastructure of the payments sys­ imposed on the ability of creditors and tem. Although such disclosures would insurers to make written offers. improve consumers’ knowledge of debit fees, these improvements would be Availability and Use of achieved at extremely high costs. Opt-Out Provisions The Board found that currently about Board Study of Prescreened 6 percent of consumers with credit Solicitations under the Fair Credit records have opted out of receiving pre- Reporting Act screened written offers of credit or insur­ ance. Further, most consumers who elect In December, the Board issued a report to opt out use the statutory mechanisms to Congress summarizing the Board’s provided in section 604 of the FCRA, study of unsolicited written offers of which governs the use of prescreening credit or insurance in which the sender techniques. Beyond that statutory provi­ of the offer has prescreened the recip­ sion, industry groups and individual ients for creditworthiness and suit­ companies have voluntarily established ability on the basis of consumer credit ways for consumers to eliminate their records in the files of consumer report­ name from the listings companies use ing agencies. The FCRA allows con­ to make prescreened written offers of sumer credit records to be used for these credit or insurance. These voluntary so-called prescreened solicitations. In mechanisms are important in the mar­ section 213(e) of the FACT Act, Con­ ketplace; an estimated one-third of the 60 91st Annual Report, 2004 individuals on the opt-out lists of the The Board found that prescreened national consumer reporting agencies written solicitations for credit and insur­ used a voluntary mechanism to request ance carry some potential costs for con­ that their personal information not be sumers, including the inconvenience of used for prescreened offers. receiving unwanted mail, the possibil­ ity of identity theft, the possible loss of Benefits and Costs of Receiving privacy, and the potential for additional Written Offers debt burden. Although these are impor­ tant considerations, the Board did not The Board found that the benefits to find that restricting written offers of consumers of receiving prescreened credit or insurance would mitigate these written offers of credit or insurance are problems; the alternatives to prescreen­ significant. Because prescreened offers ing may even exacerbate some of them. must be ‘‘firm offers’’ of credit or insur­ ance, a consumer generally receives Potential Effects of offers for only those products for which Further Restrictions he or she is likely qualified. Conse­ quently, consumers shopping for credit The Board found that written offers of or insurance are able to quickly iden­ credit or insurance sent directly to con­ tify products suitable for them. These sumers have the potential to increase prescreened offers also contain pricing competition in the market for those and product information, often in a form consumer financial services. The pri­ that allows a consumer to compare the mary benefits of competition are lower terms of products offered with those of prices and an increased availability of accounts he or she already holds—and the product or service in question. As a with products offered by other compa­ result, the Board concluded that actions nies. Thus, the widespread availability undertaken to restrict the ability of lend­ of pricing and product information in ers and insurers to provide written offers prescreened offers helps to make the of credit or insurance to consumers market for these products more com­ would, on balance, result in a less com­ petitive, an advantage that benefits all petitive marketplace and thus relatively consumers. higher prices and the reduced availabil­ For creditors and insurers, the ability ity of credit or insurance. to tailor offers of credit or insurance to consumers’ pricing and product Other Regulatory Actions preferences at a relatively low cost enhances competition and marketing The Board also took the following regu­ efficiency. Moreover, by having access latory actions during 2004: to credit record information for the pur­ poses of prescreening, creditors and • In March, the Board revised Regu­ insurers are better able to control certain lation Z (Truth in Lending) and its risks related to offering these products. official staff commentary to add an In a competitive market, cost savings interpretative rule of construction for creditors and insurers translate into clarifying that the word ‘‘amount’’ lower prices and wider credit and insur­ referred to a numerical amount. The ance availability for consumers, possi­ revisions also provided guidance bly benefiting traditionally underserved on consumers’ exercise of rescission consumers. rights for certain home-secured loans. Consumer and Community Affairs 61

• In July, the Board and the other • In December, the Board raised to federal financial regulatory agencies $34 million the exemption threshold issued joint interim final rules contain­ for depository institutions required ing technical changes to their regu­ to collect data in 2005 under HMDA lations implementing the Commu­ and Regulation C. As prescribed by nity Reinvestment Act (CRA). The the statute, the increased threshold changes conform those regulations reflects changes in the consumer price to changes in (1) the Standards for index. Defining Metropolitan and Micropoli­ tan Statistical Areas, published by the U.S. Office of Management and Bud­ Economic Effects of the get in December 2000; (2) the census Electronic Fund Transfer Act tracts designated by the U.S. Bureau As required by the Electronic Fund of the Census; and (3) the Board’s Transfer Act (EFTA), the Board moni­ Regulation C, which implements tors the effects of the act on the costs of the Home Mortgage Disclosure Act compliance to financial institutions and (HMDA). The joint interim rules did the benefits of the act to consumers. not make substantive changes in the According to data from the most requirements of the CRA regulations. recent triennial Survey of Consumer The Board’s regulation implementing Finances (conducted in 2001), approxi­ the CRA is Regulation BB. mately 88 percent of U.S. families in that year used or had access to one or • In August, the Board amended the more EFT services—for example, an official staff commentary to Regula­ ATM card, a debit card, direct deposit, tion Z to raise from $499 to $510 the or direct payment—up from approxi­ total dollar amount of points and fees mately 85 percent in 1998. ATMs were that triggers additional requirements the most widely used EFT service; for certain mortgage loans under the approximately 70 percent of U.S. fami­ Home Ownership and Equity Protec­ lies had an ATM card. In 2003, the tion Act. As prescribed by the statute, number of ATM transactions per month the increased amount (effective Janu­ averaged approximately 902 million, ary 2005) reflects changes in the con­ and the number of installed ATMs sumer price index. rose nearly 5.4 percent from 2002, to 371,000. • In December, the Board issued a final Direct deposit was almost as widely rule revising disclosure tables the used. About 67 percent of U.S. families Board and the other federal financial had funds deposited directly into their regulatory agencies use to publicly checking or savings account. Use of the release data collected by lenders service is particularly common in the under HMDA and the Board’s Regu­ public sector; during fiscal year 2004, lation C. In particular, the final rule approximately 75 percent of all govern­ revised the formats for some of the ment payments were made using EFT, existing disclosure tables, deleted one including 81 percent of Social Security set of existing tables, and added new payments, 98 percent of federal salary tables. These changes reflect the and retirement payments, and 45 percent Board’s 2002 revisions to Regula­ of federal income tax refunds. tion C that required lenders to collect About 47 percent of U.S. families use new data beginning January 1, 2004. debit cards, which consumers can use at 62 91st Annual Report, 2004 merchant terminals to pay for purchases. • disseminates information on commu­ Approximately 16.2 billion debit card nity development techniques to bank­ transactions took place in 2003, an ers and the public through Community increase of approximately 21 percent Affairs Offices at the Reserve Banks. from the previous year’s volume. Direct payment is a less widely used EFT pay­ Examinations for Compliance ment mechanism; about 40 percent of with the CRA U.S. families have payments automati­ The Federal Reserve assesses and rates cally deducted from their accounts. the CRA performance of state mem­ The incremental costs associated with ber banks in the course of examina­ the EFTA are difficult to quantify tions conducted by staff at the twelve because no one knows how industry Reserve Banks. During the 2004 report­ practices would have evolved in the ing period, the Reserve Banks con­ absence of statutory requirements. The ducted 242 CRA examinations. Of the benefits of the EFTA are also difficult to banks examined, 43 were rated ‘‘out­ measure, as they cannot be isolated from standing’’ in meeting community credit consumer protections that would have needs, 198 were rated ‘‘satisfactory,’’ been provided in the absence of regula­ none was rated ‘‘needs to improve,’’ and tion. The available evidence suggests no 1 was rated as being in ‘‘substantial serious consumer problems with EFTA. noncompliance.’’ 1 (See ‘‘Agency Reports on Compliance with Consumer Protection Laws’’ later Analysis of Applications for in this chapter.) Mergers and Acquisitions in Relation to the CRA Supervision for Compliance Under the Bank Holding Company Act with Consumer Protection and and the Bank Merger Act, the Board Community Reinvestment Laws considers applications for which CRA protests are raised or significant issues Activities Related to the exist regarding CRA or consumer Community Reinvestment Act compliance. Other cases are decided by the Reserve Banks under delegated The Community Reinvestment Act authority. (CRA) requires that the Board and other During 2004, the Board of Governors banking agencies encourage financial considered applications for several sig­ institutions to help meet the credit needs nificant banking mergers and acquisi­ of the local communities in which they tions. The Board sponsored four pub­ do business, consistent with safe and lic meetings in connection with two of sound business practices. To carry out these applications. For the application this mandate, the Federal Reserve by Bank of America Corporation (Char­ lotte, North Carolina) to acquire Fleet • examines state member banks to Financial Group, Inc. (Boston, Massa­ assess their compliance with the CRA, chusetts), public meetings were held at the Federal Reserve Banks of Boston • analyzes applications for mergers and and San Francisco. Two public meetings acquisitions by state member banks and bank holding companies in rela­ 1. The 2004 reporting period was July 1, 2003, tion to CRA performance, and through June 30, 2004. Consumer and Community Affairs 63 were held at the Federal Reserve Banks The public submitted comments on of New York and Chicago in connection each of these applications. Most of the with the merger of J.P. Morgan Chase & commenters expressed concerns that Company (New York, New York) with lending to lower-income communities Bank One Corporation (Chicago, Illi­ and populations was insufficient and that nois). Members of the public submitted the institutions had failed to address the numerous comments on these two appli­ convenience and needs of affected com­ cations during the thirty-day comment munities. Commenters also raised issues period allocated for such applications. relating to potentially abusive lending The public meetings, however, allowed practices involving subprime and pay­ the public to enter oral or written testi­ day lenders; the potentially adverse mony into the record of information effects of branch closings; the failure of considered by the Board. The Board minority-owned and -operated institu­ approved the application by Bank of tions to adequately serve other minority America Corporation in March and the populations; the loss of local ownership; application by J.P. Morgan Chase & institutions’ alleged attempts to circum­ Company in June. Several other sig­ vent state consumer laws; and alleged nificant applications are summarized fraud. below. In addition to considering these appli­ cations for significant banking mergers • An application by NewAlliance Banc­ and acquisitions, the Board acted on shares (New Haven, Connecticut) to thirteen other bank and bank holding acquire New Haven Savings Bank company applications that involved pro­ (New Haven, Connecticut) was tests by members of the public con­ approved in February. cerning the performance under the CRA of insured depository institutions. The • Three applications by National City System also approved one application Corporation (Cleveland, Ohio) were that involved an institution having a approved in March, June, and August. CRA rating of lower than satisfactory and another thirty-three applications • An application by Regions Financial involving other issues related to CRA, Corporation (Birmingham, Alabama) fair lending, or compliance with con­ to acquire Union Planters Corporation sumer credit protection laws.2 (Memphis, Tennessee) was approved in June. Other Consumer Compliance • An application by Royal Bank of Activities Scotland and Citizens Financial Group The Division of Consumer and Com­ (both in Providence, Rhode Island) to munity Affairs supports and oversees acquire Charter One Financial Group, the supervisory efforts of the Federal Inc. (Cleveland, Ohio), was approved Reserve Banks to ensure that consumer in August. protection laws and regulations are fully and fairly enforced. Division staff pro­ • An application by Wachovia Corpo­ vide guidance and expertise to the ration (Charlotte, North Carolina) to Reserve Banks on consumer protection acquire SouthTrust Corporation (Bir­ mingham, Alabama) was approved in 2. In addition, five applications involving other October. CRA or compliance issues were withdrawn. 64 91st Annual Report, 2004 regulations, examination and enforce­ ciated with the rapid changes in elec­ ment techniques, examiner training, and tronic banking. emerging issues. They develop and update examination policies, proce­ Fair Lending dures, and guidelines, and review Reserve Bank supervisory reports and The Board has a responsibility to ensure work products. They also participate in that the banks under its jurisdiction com­ interagency activities that promote uni­ ply with the federal fair lending laws— formity in examination principles and the Equal Credit Opportunity Act standards. (ECOA) and the Fair Housing Act. The Examinations are the Federal Re­ ECOA prohibits all creditors from dis­ serve’s primary means of enforcing criminating against any applicant, in compliance with consumer protection any aspect of a credit transaction, on the laws. During the 2004 reporting period, basis of race, color, religion, national the Reserve Banks conducted 329 con­ origin, sex, marital status, or age. In sumer compliance examinations—305 addition, creditors may not discriminate of state member banks and 24 of foreign against an applicant because the appli­ banking organizations (FBOs).3 cant receives income from a public The Board periodically issues guid­ assistance program or has exercised, ance for Reserve Bank examiners on in good faith, any right under the Con­ consumer protection laws and regula­ sumer Credit Protection Act. As pro­ tions. In addition to updating examina­ vided by the ECOA, the Board enacted tion procedures for a number of regula­ Regulation B to fully implement the act tions in concert with the other federal for the banks under its jurisdiction and financial institution regulatory agen­ periodically reviews that regulation cies, the Board revised the procedures and modifies it as needed. Congress that Federal Reserve consumer compli­ assigned responsibility for administra­ ance examiners are to use when assess­ tive enforcement of the ECOA to the ing whether a compliance or CRA Board for banks under its jurisdiction, to examination of an FBO or special- other regulators for creditors that they purpose bank is necessary. Further, the regulate, and to the Federal Trade Com­ Board updated its risk-focused supervi­ mission for all other creditors. sion program to reflect new regulations The Fair Housing Act covers credit and the level of risk associated with for the purchase, construction, improve­ existing regulations. The Board also ment, repair, or maintenance of a dwell­ completed a pilot program for an inter­ ing. Under the act, it is unlawful for disciplinary electronic banking profile a creditor to deny any form of financial to identify and monitor risk factors asso­ assistance, or discriminate in fixing the amount, interest rate, or any other terms or conditions of any financial assistance, 3. The foreign banking organizations examined on the basis of race, color, religion, by the Federal Reserve are organizations operating under section 25 or 25A of the Federal Reserve national origin, handicap, familial sta­ Act (Edge Act and agreement corporations) and tus, or sex. state-chartered commercial lending companies The ECOA also obligates the Board owned or controlled by foreign banks. These insti­ and other agencies with enforcement tutions are not subject to the Community Reinvest­ ment Act and typically engage in relatively few responsibilities under the act to refer activities that are covered by consumer protection any pattern or practice of ECOA viola­ laws. tions to the Department of Justice Consumer and Community Affairs 65

(DOJ). When a violation of the ECOA that have an unintended but unjustified also violates the Fair Housing Act, the discriminatory ‘‘disparate impact.’’ In matter may be referred to the Depart­ 2004, division staff determined that a ment of Housing and Urban Develop­ lender’s adoption of a ‘‘housing proxy’’ ment. To promote consistency in how debt payment constituted a disparate- fair lending issues are analyzed through­ impact violation of the ECOA on the out the System, Division of Consumer basis of the prohibited characteristic of and Community Affairs staff coordinate age. The lender had been adding a multi- the investigation of potential fair lend­ hundred-dollar payment to the monthly ing violations with Reserve Bank staff debt of persons who applied for credit and develop recommendations for the but reported no housing cost on their division director regarding whether loan application—and for whom no referral is necessary or appropriate. housing cost appeared on their credit During 2004, division staff received bureau report. This proxy practice was and analyzed six reports from Reserve shown to adversely affect a dispropor­ Banks regarding possible referral mat­ tionate number of younger applicants, ters. Four of these reports had to do with and the lender failed to demonstrate an potentially discriminatory underwriting adequate ‘‘business-necessity’’ justifica­ standards affecting applicants on the tion for its adoption of the proxy. basis of marital status or sex; the other Since 1994, the Federal Reserve has two matters involved apparent discrimi­ used a two-stage statistical regression natory loan-pricing practices on the program to help assess fair lending com­ basis of marital status. In two of the six pliance by high-volume mortgage lend­ cases, the Board determined that refer­ ers. The program uses reported HMDA rals were not warranted; two cases were data for a stage one analysis to identify referred to the DOJ; and two cases are banks having significant disparities in pending. their loan-denial rates for loan applica­ In early 2004, division staff, together tions submitted by members of a pro­ with staff from the Board’s Legal Divi­ tected class and those submitted by sion and the Federal Reserve Bank of members of a nonprotected class; the New York, negotiated a consent order program then targets these banks for a to finalize an investigation of a major stage two analysis that considers exten­ holding company subsidiary. The order sive additional information taken from addressed issues raised during the inves­ a sample of a bank’s loan files. The tigation, including regulatory compli­ program produces statistically reliable ance violations, the making of loans that results, even in cases in which the num­ were unsafe and unsound and that bor­ ber of denied applicants in a protected rowers could not afford, and misleading class is small. and incorrect statements made by lend­ ing personnel to examiners. In addition Flood Insurance to a substantial civil money penalty, the consent order provided for extensive The National Flood Insurance Act corrective measures, including the pay­ imposes certain requirements on loans ment of restitution to victims. secured by buildings or mobile homes The ECOA prohibits not only prac­ located in, or to be located in, areas tices that constitute intentional discrimi­ determined to have special flood haz­ natory treatment of credit applicants ards. Under the Federal Reserve’s Regu­ on a prohibited basis but also practices lation H, which implements the act, state 66 91st Annual Report, 2004 member banks in general are prohibited developed a Check 21 web site to pro­ from making, extending, increasing, vide examiners and the financial indus­ or renewing any such loan unless the try with educational tools, reference building or mobile home and any per­ materials, and answers to frequently sonal property securing the loan are cov­ asked questions (www.ffiec.gov/exam/ ered by flood insurance for the term of check21). the loan. The act requires the Federal The FFIEC also issues guidance to Reserve to impose civil money penalties the agencies’ consumer compliance when it finds a pattern or practice of examination staff and to supervised violations of the regulation. The civil financial institutions. To ensure that money penalties are turned over to CRA performance evaluations are com­ the Federal Emergency Management prehensive and include facts and data Agency for deposit into the National to support the evaluation results, the Flood Mitigation Fund. FFIEC in 2004 developed interagency During 2004, the Board imposed civil guidance on examiners’ use of data money penalties on three state mem­ tables in CRA evaluations. Additionally, ber banks. The penalties, which were the FFIEC member agencies developed assessed via consent orders, ranged from interagency guidance on overdraft pro­ $3,250 to $10,000. tection programs, which was released for public comment in 2004. Finally, Coordination with in response to a review of preliminary Other Federal Banking Agencies 2004 HMDA data submissions, the FFIEC issued guidance to HMDA data The member agencies of the Federal reporters regarding proper collection Financial Institutions Examination and reporting of the new data fields Council (FFIEC) develop uniform being collected for the first time in 2004. examination principles, standards, pro­ 4 The Board and the FDIC issued joint cedures, and report formats. In 2004, guidance outlining standards the two the FFIEC issued revised examination agencies will consider when determin­ procedures for determining compliance ing whether specific acts or practices with the fair lending provisions of Regu­ at state-chartered banks are unfair or lation B (which implements the Equal deceptive. The Board, the OCC, and the Credit Opportunity Act), the Homeown­ FDIC also updated the host-state loan- ers Protection Act, and the new sub­ to-deposit ratios used to determine com­ part D of Regulation CC. Subpart D pliance with section 109 of the Riegle– implements the Check Clearing for the Neal Interstate Banking and Branching 21st Century Act, or Check 21. (Regu­ Efficiency Act of 1994. lation CC continues to implement the Expedited Funds Availability Act.) In addition to issuing revised examination Training for Bank Examiners procedures to implement Check 21, Ensuring that financial institutions com­ staff from the FFIEC member agencies ply with laws that protect consumers and encourage community reinvestment 4. The FFIEC member agencies are the Board is an important part of the bank exami­ of Governors of the Federal Reserve System, the nation and supervisory process. As the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of number and complexity of consumer Thrift Supervision, and the National Credit Union financial transactions grow, training for Administration. examiners of the state member banks for Consumer and Community Affairs 67 which the Federal Reserve has supervi­ In 2004, the consumer affairs function sory responsibility becomes even more added a new course to the core curricu­ important. The consumer affairs curricu­ lum, Consumer Affairs Risk-Focused lum comprises courses on various con­ Examination Techniques. The course is sumer protection laws, regulations, and designed to enhance examiners’ analyti­ examining concepts. In 2004, these cal, decisionmaking, and leadership courses were offered in eleven sessions skills. to more than 225 Federal Reserve con­ In addition to providing core training, sumer compliance examiners. the examiner curriculum emphasizes the Board and Reserve Bank staff reg­ importance of continuing professional ularly review the core curriculum for development. Opportunities for continu­ examiner training, updating subject mat­ ing development include special projects ter and adding new elements as appro­ and assignments, self-study programs, priate. During 2004, staff conducted rotational assignments, the opportunity curriculum reviews for two courses to to instruct at System schools, and men­ incorporate technical changes in policy toring programs. and laws, along with changes in instruc­ tional delivery techniques. The two courses reviewed were Reporting on Home Mortgage Disclosure Act Data • Community Reinvestment Act Exami­The Home Mortgage Disclosure Act nation Techniques. Equips assistant (HMDA) requires that mortgage lenders examiners and others to write the per­ collect and make public certain data formance evaluation for the CRA por­ about their home purchase, home tion of a consumer compliance bank improvement, and refinancing loan examination. transactions. A depository institution generally is covered by the act if (1) it is • Commercial Lending Essentials for located in a metropolitan statistical area, Consumer Affairs. Equips assistant (2) it met the asset threshold at the end examiners with the basic techniques of the preceding calendar year (for 2002 to underwrite and price commercial and 2003, assets of more than $32 mil­ loans. lion; for 2004, assets of more than $33 million), and (3) it originated at Staff members also look for opportu­ least one home purchase loan (or refi­ nities to deliver courses via alternative nancing) in the preceding calendar year. channels such as the Internet or other A for-profit mortgage company is cov­ distance-learning technologies. The two ered if (1) it has offices in a metropoli­ courses discussed above are now taught tan statistical area, (2) it had assets of using several instructional methods: more than $10 million (when combined classroom instruction focusing on case with the assets of any parent company) studies, specially developed computer- at the end of the preceding calendar based instruction, electronic bulletin year or it originated 100 or more boards, and vendor-delivered online home purchase loans or refinancings in instruction. Additionally, the new exam­ the preceding calendar year, and (3) in iner training on the consumer compli­ the preceding calendar year, its home ance aspects of the Check 21 Act was purchase loan originations and refinanc­ delivered on both an interactive web site ings accounted for at least 10 per­ and an interactive CD-ROM. cent of its total loans by dollar vol­ 68 91st Annual Report, 2004 ume, or if such loans equaled at least tions of lending discrimination and in $25 million. targeting lenders for further inquiry. In 2004, a total of 6,935 depository The HMDA data reported for 2003 institutions and affiliated mortgage com­ covered about 42 million loans and loan panies and 1,186 independent mortgage applications, about 33 percent more than companies reported HMDA data for in 2002. The greater volume was due calendar year 2003. Lenders submitted primarily to an increase of about 41 per­ information about the disposition of loan cent in refinancing activity. The num­ applications, the geographic location of ber of covered home purchase loans the properties related to loans and loan extended in 2003, compared with 2002, applications, and, in most cases, the race increased 16 percent for Asians, 18 per­ or national origin, income, and sex of cent for Hispanics, 15 percent for applicants and borrowers. The FFIEC blacks, and 11 percent for whites. processed the data and produced disclo­ Native Americans experienced a 5 per­ sure statements on behalf of the FFIEC cent decline in such lending from 2002 member agencies and the Department through 2003. Over the period from of Housing and Urban Development 1993 through 2003, the number of home (HUD). purchase loans extended to Hispanics The FFIEC prepared individual dis­ rose 236 percent; to Asians, 163 per­ closure statements for each lender that cent; to blacks, 106 percent; to Native reported data—one statement for each Americans, 50 percent; and to whites, metropolitan statistical area in which the 44 percent. For each income category, lender had offices and reported loan the number of home purchase loans activity for 2003. In 2004, the FFIEC reported was higher in 2003 than in prepared 65,808 disclosure statements.5 2002; the increase was 6 percent for In July, each institution made its disclo­ lower-income applicants; 8.6 percent for sure statement public, and reports con­ middle-income applicants; and 13 per­ taining aggregate data for all mortgage cent for upper-income applicants. From and home improvement loans in each of 1993 through 2003, the number of home the 337 metropolitan statistical areas in purchase loans to lower-, middle-, and the United States were also made avail­ upper-income applicants increased by able to the public at central deposi­ 102 percent, 68 percent, and 88 percent, tories.6 These data are used by the respectively. FFIEC agencies, the reporting institu­ In 2003, 19 percent of Hispanic appli­ tions, HUD, the Department of Justice cants and 21 percent of black appli­ (DOJ), and members of the public. They cants for home purchase loans reported also assist HUD, the DOJ, and state and under HMDA applied for government- local agencies in responding to allega­ backed mortgages; the comparable fig­ ures for Asians, whites, and Native Americans were 4 percent, 12 percent, 5. The FFIEC also compiles information on and 15 percent, respectively. Twenty- applications for private mortgage insurance (PMI) similar to the information on home mortgage lend­ one percent of lower-income applicants ing collected under HMDA. Lenders typically for home purchase loans, compared require PMI for conventional mortgages that with 5 percent of upper-income appli­ involve small down payments. cants, applied for government-backed 6. Central depository sites include libraries, universities, and city planning offices. A list of mortgages. sites can be found at www.ffiec.gov/hmdacf/ Overall, the denial rate in 2003 for centdep/default2.cfm. conventional home purchase loans Consumer and Community Affairs 69

(that is, loans that are not government- • note on the application form when backed) was 14 percent, a rate un­ an applicant chooses not to provide changed from 2002. The denial rate monitoring information regarding race rose from 1993 through 1998 but has or national origin and sex fallen since then. In 2003, denial rates for conventional home purchase loans • notify the credit applicant of the reported under HMDA declined slightly action taken within the time frames for black applicants, to 24 percent; the specified in the regulation rates rose modestly for Native Ameri­ cans and Asians, to 24 percent and • provide a written notice of credit 11 percent, respectively. Denial rates for denial or other adverse action contain­ whites and Hispanics remained the same ing a statement of the action taken, the from 2002 to 2003, at 12 percent and name and address of the creditor, a 18 percent, respectively. notice of rights, and the name and address of the federal agency that enforces compliance Agency Reports on Compliance with Consumer Protection Laws • collect information for monitoring The Board reports annually on compli­ purposes about the race, color, reli­ ance with consumer protection laws by gion, national origin, or sex of an entities supervised by federal agencies. applicant This section summarizes data collected from the twelve Federal Reserve Banks, During 2004, the Federal Trade Com­ the FFIEC member agencies, and other mission (FTC) entered into one settle­ federal enforcement agencies.7 ment with a telecommunications cor­ poration for alleged violations of the Regulation B ECOA and Regulation B. The defen­ (Equal Credit Opportunity) dants were required to pay civil money penalties of $1.125 million and provide The FFIEC agencies reported that injunctive relief. Additionally, the FTC 88 percent of the institutions examined continued litigation against a mort­ during the 2004 reporting period were in gage lender for alleged violations of the compliance with Regulation B, com­ ECOA and Regulation B, and continued pared with 84 percent for the 2003 its enforcement efforts against other reporting period. The most frequent vio­ organizations. lations involved failure to take one or The other agencies that enforce more of the following actions: the ECOA—the Farm Credit Admin­ istration (FCA), the Department of • collect information for monitoring Transportation, the Securities and purposes about the race or national Exchange Commission, the Small Bus­ origin and sex of applicants seeking iness Administration, and the Grain credit primarily for the purchase or Inspection, Packers and Stockyards refinancing of a principal residence Administration of the Department of Agriculture—reported substantial com­ 7. Because the agencies use different methods pliance among the entities they super­ to compile the data, the information presented here supports only general conclusions. The 2004 vise. The FCA’s examination and reporting period was July 1, 2003, through enforcement activities revealed that June 30, 2004. most Regulation B violations involved 70 91st Annual Report, 2004 creditors’ providing inadequate state­ In 2004, the FTC settled two cases in ments of specific reasons for denial federal district court involving viola­ or involved creditors’ failure to request tions of the Electronic Fund Transfer or provide information for government- Act (EFTA). In one case, the complaint monitoring purposes. These agencies alleged that the defendants had decep­ did not initiate any formal enforcement tively marketed videos and charged actions relating to Regulation B during consumers’ credit and debit cards on a 2004, although the FCA indicated that recurring basis, without obtaining writ­ its supervisory process requires correc­ ten authorization from the consumers to tive actions for violations noted. initiate preauthorized electronic fund transfers from their accounts, in viola­ Regulation E tion of the EFTA. Under the stipulated (Electronic Fund Transfers) court order in this case, defendants were required to pay approximately $1.1 mil­ The FFIEC agencies reported that lion in combined consumer redress and approximately 95 percent of the institu­ civil penalties and were barred from a tions examined during the 2004 report­ range of unlawful activities. In the sec­ ing period were in compliance with ond case, the complaint alleged that the Regulation E, compared with 94 per­ defendants initiated recurring automatic cent for the 2003 reporting period. charges from consumers’ accounts at the The most frequent violations involved conclusion of a ‘‘free’’ trial period asso­ failure to comply with the following ciated with a variety of offered services, requirements: without disclosing the cancellation policy or obtaining the consumers’ • determine whether an error occurred, written authorization. The court order in and transmit the results of the inves­ this case included injunctive relief and tigation to the consumer within ten required payment of $2.4 million. business days Regulation M • when a determination is made that no (Consumer Leasing) error has occurred, provide a written explanation and note the consumer’s The FFIEC agencies reported that more right to request documentation sup­ than 99 percent of the institutions exam­ porting the institution’s findings ined during the 2004 reporting period were in compliance with Regulation M, • provide initial disclosures that a con­ which is comparable to the level of com­ sumer may retain, at the time he or pliance for the 2003 reporting period. she contracts for an electronic fund The few violations noted involved fail­ transfer service or before the first ure to adhere to specific disclosure electronic fund transfer involving the requirements. The agencies did not issue consumer’s account is made any formal enforcement actions relating to Regulation M during the period.

• provide initial disclosures at the time Regulation P a consumer contracts for an electronic (Privacy of Consumer fund transfer service that contain Financial Information) required information, including limi­ tations on the types of transfers per­ The FFIEC agencies reported that mitted and error-resolution procedures 96 percent of the institutions exam­ Consumer and Community Affairs 71 ined during the 2004 reporting period summation, or not later than three were in compliance with Regulation P, business days after receipt of the loan compared with 97 percent for the 2003 application reporting period. The most frequent vio­ lations involved failure to comply with • ensure that disclosures reflect the the following requirements: terms of the legal obligation between the parties, and when any informa­ • provide a clear and conspicuous initial tion necessary for an accurate disclo­ privacy notice to customers that accu­ sure is unknown, ensure that the credi­ rately reflects the institution’s privacy tor states that the disclosure is an policies and practices, not later than estimate when the customer relationship is established • ensure that disclosures reflect that the creditor has or will acquire a security • provide a clear and conspicuous interest in the property identified annual privacy notice to customers

• disclose the institution’s information- The OCC issued one formal enforce­ sharing practices in initial, annual, and ment action containing provisions relat­ revised privacy notices ing to Regulation Z during the 2004 reporting period. In addition, 114 insti­ tutions supervised by the Federal No formal enforcement actions relat­ Reserve and the FDIC were required, ing to Regulation P were issued during under the Interagency Enforcement the reporting period. Policy on Regulation Z, to refund a total of approximately $500,000 to Regulation Z consumers. (Truth in Lending) The FTC continued its enforcement activities to halt unlawful subprime­ The FFIEC agencies reported that lending practices. The FTC filed two 84 percent of the institutions examined federal district court actions (currently during the 2004 reporting period were in litigation) and continued litigating in compliance with Regulation Z, com­ three cases; all five cases concern pared with 78 percent for the 2003 alleged violations of the Truth in Lend­ reporting period. The most frequent vio­ ing Act, Regulation Z, and the Fed­ lations involved failure to take one or eral Trade Commission Act. The defen­ more of the following actions: dants in these cases include mort­ gage brokers, a mortgage corporation, a • accurately disclose the finance charge, finance company, and a tax-shelter con­ using that term, and provide a brief sulting firm. definition of ‘‘finance charge’’ The FCA’s examination and enforce­ ment activities revealed that most Regu­ • accurately disclose the payment lation Z violations involved inadequate schedule for closed-end credit or incorrect disclosures for closed-end credit. FCA examiners determined that • on certain residential mortgage trans­ all violations had been or were being actions, provide a good faith estimate corrected or adequately addressed by the of the required disclosures before con­ respective institutions. 72 91st Annual Report, 2004

Regulation AA amount of checks deposited that are (Unfair or Deceptive Acts not subject to next-day availability or Practices) The three banking regulators with • follow special procedures when responsibility for enforcing Regula­ invoking the exception for large-dollar tion AA’s Credit Practices Rule—the deposits Federal Reserve, the OCC, and the FDIC—along with the NCUA, reported • when placing an exception hold on an that more than 99 percent of the institu­ account other than a new account, pro­ tions examined during the 2004 report­ vide the customer with a notice con­ ing period were in compliance with taining certain information within pre­ Regulation AA, which is comparable scribed time periods to the level of compliance for the 2003 reporting period. The few violations • make funds from certain checks, both involved the following actions: local and nonlocal, available for with­ drawal within the times prescribed by • failing to provide a clear and con­ the regulation spicuous disclosure regarding a cosigner’s liability for a debt • provide training to each employee that performs duties subject to this • entering into a consumer credit obliga­ regulation, and establish procedures tion that contains a waiver of exemp­ to ensure and monitor employee tion, or enforcing provisions in a pur­ compliance chased consumer credit obligation that contains such a waiver, unless the No formal enforcement actions relat­ waiver applies solely to property sub­ ing to Regulation CC were issued dur­ ject to a security interest executed in ing the reporting period. connection with the obligation No formal enforcement actions relat­ Regulation DD ing to Regulation AA were issued dur­ (Truth in Savings) ing the reporting period. The FFIEC agencies reported that 92 percent of institutions examined Regulation CC during the 2004 reporting period were (Availability of Funds and in compliance with Regulation DD, Collection of Checks) compared with 89 percent for the The FFIEC agencies reported that 2003 reporting period. Among the 93 percent of institutions examined dur­ institutions not in full compliance, ing the 2004 reporting period were in the most frequently cited violations compliance with Regulation CC, com­ involved pared with 90 percent for the 2003 reporting period. Among the institutions • using the phrase ‘‘annual percentage not in full compliance, the most fre­ yield’’ in an advertisement without quently cited violations involved the disclosing additional terms and condi­ failure to take one or more of the follow­ tions of customer accounts; ing actions: • failing to provide account disclo­ • make available on the next business sures containing certain required day the lesser of $100 or the aggregate information; Consumer and Community Affairs 73

• failing to provide timely maturity noti­ the scope of complaint investigations fication for time deposits; and improve the quality and timeliness of responses to consumers. • failing to provide account disclosures During 2004, the CAESAR Users clearly and conspicuously, in writing, Advisory Group finalized business and and in a form that the consumer may technical requirements for a web-based keep; and CAESAR application that will stream­ line the System’s consumer complaint • providing an advertisement that did process. These requirements entailed the not disclose that fees could reduce the development of new reports for analyz­ earnings on the account. ing and monitoring complaint trends. In addition, the advisory group developed No formal enforcement actions relat­ a new consumer code structure for the ing to Regulation DD were issued dur­ web-based system to allow users to clas­ ing the reporting period. sify consumer complaints in more detail and identify investigation findings more easily. Consumer Complaints The Federal Reserve investigates com­ Complaints against plaints against state member banks State Member Banks and forwards to the appropriate enforce­ ment agency complaints that involve In 2004 the Federal Reserve received other creditors and businesses. Each approximately 5,130 complaints from Reserve Bank investigates complaints consumers—by mail, by telephone, in against state member banks in its Dis­ person, and electronically via the Inter­ trict. Complaints and inquiries received net (see tables). About 45 percent of the by the Federal Reserve System are entered into its online database, Com­ Consumer Complaints against State plaint Analysis Evaluation System and Member Banks, by Classification, 2004 Reports (CAESAR). The Board provides guidance to the Classification Number Reserve Banks on complaint program policies and procedures through advi­ Regulation B (Equal Credit Opportunity) . . . 36 Regulation C (Home Mortgage sory letters and periodic updates to the Disclosure Act) ...... 1 Consumer Complaint Manual. In 2004, Regulation E (Electronic Fund Transfers) . . . 75 Regulation H (Bank Sales of Insurance) ..... 2 the Board issued guidance about new Regulation M (Consumer Leasing) ...... 0 codes for the CAESAR database. The Regulation P (Privacy of Consumer new codes will be used to track con­ Financial Information) ...... 17 sumer concerns about emerging issues, Regulation Q (Payment of Interest) ...... 1 Regulation Z (Truth in Lending) ...... 215 such as stored-value cards, reaffirmed Regulation BB (Community Reinvestment) . 1 debt, the Check Clearing for the Regulation CC (Expedited Funds Availability) ...... 25 21st Century Act, and the Fair and Regulation DD (Truth in Savings) ...... 28 Accurate Credit Transactions Act. Addi­ Fair Credit Reporting Act ...... 155 tional guidance on the CAESAR data­ Fair Debt Collection Practices Act ...... 24 Fair Housing Act ...... 3 base was issued to strengthen the docu­ Flood insurance rules ...... 11 mentation of complaint investigations. Regulations T, U, and X ...... 4 Real Estate Settlement Procedures Act ...... 12 In addition to the CAESAR guidance, Unregulated practices ...... 1,708 the Board issued guidance on new pro­ Total ...... 2,318 cedures that are intended to better focus 74 91st Annual Report, 2004

Consumer Complaints against State Member Banks, by Subject of Complaint, 2004

Total Not investigated

Unable Subject of complaint to obtain Explanation sufficient of law Number Percent information provided from to consumer consumer

Loans Discrimination alleged Real estate loans ...... 15 1 1 1 Credit cards ...... 13 1 1 1 Other loans ...... 8 0 1 1 Other type of complaint Real estate loans ...... 463 20 4 35 Credit cards ...... 892 38 4 74 Other loans ...... 174 8 1 16 Deposits ...... 460 20 6 59 Electronic fund transfers ...... 75 3 1 3 Trust services ...... 30 1 8 5 Other ...... 188 8 5 30 Total ...... 2,318 100 32 225 complaints (2,318) were against state vices, or other practices. Information member banks. Of the complaints on the outcomes of the investigations against state member banks, 68 percent of these complaints is provided in the involved consumer loans: 2 percent table. alleged discrimination on a basis pro­ During 2004, the Federal Reserve hibited by law (race, color, religion, System completed the investigation of national origin, sex, marital status, 125 complaints against state member age, the fact that the applicant’s income banks that were pending at year-end comes from a public assistance pro­ 2003, finding no violations of regula­ gram, or the fact that the applicant has tions. In 84 percent of the state member exercised a right under the Consumer bank complaints investigated in 2004, Credit Protection Act), and 66 percent the banks had correctly handled a cus­ concerned other credit-related practices, tomer’s account. In 44 percent of these such as the imposition of annual mem­ cases, the banks nevertheless chose to bership fees on credit card accounts, the reimburse or otherwise accommodate amount of interest banks charge on the customer. credit card accounts, or credit denial The Federal Reserve also handled on a basis not prohibited by law (for more than 1,600 inquiries about con­ example, credit history or length of sumer credit and banking policies and residence). Twenty percent of the practices during 2004. In responding complaints involved disputes about to these inquiries, the Board and the interest on deposits and other deposit Reserve Banks gave specific explana­ account practices; the remaining tions of laws, regulations, and banking 12 percent concerned disputes about practices and provided relevant printed electronic fund transfers, trust ser­ materials on consumer issues. Consumer and Community Affairs 75

Consumer Complaints—Continued

Investigated

Bank legally correct Factual or Possible contractual bank Pending, Goodwill Matter Withdrawn December 31 No reim­ reimburse­ Customer Bank dispute— violation— bursement error error resolvable bank took in by ment or litigation customer or other other only by corrective accommo­ accommo­ the courts action dation dation

6 2 0 0 0 1 0 0 4 6 0 0 0 0 0 0 0 5 6 0 0 0 0 0 0 0 0 192 125 0 49 6 13 20 10 9 257 379 1 54 14 5 3 27 74 86 25 0 23 11 1 4 5 2 203 100 0 45 19 4 6 13 5 20 27 0 7 2 10 1 3 1 8 3 0 2 0 0 0 3 1 72 25 0 9 8 2 14 5 18 856 686 1 189 60 36 48 66 119

Unregulated Practices areas, including credit card fraud, the amount charged for late payments, and As required by section 18(f) of the Fed­ disputes about the amount withdrawn eral Trade Commission Act, the Board from checking accounts. monitors complaints about banking practices that are not subject to exist­ Complaint Referrals to HUD ing regulations, focusing on those that concern possible unfair or deceptive In accordance with a memorandum of practices. In 2004 the Board received understanding between HUD and the approximately 1,700 complaints against federal bank regulatory agencies, in state member banks that involved 2004 the Federal Reserve referred six unregulated practices. The categories complaints to HUD that alleged state that received the most complaints member bank violations of the Fair involved real estate loans, credit card Housing Act. In five of the six cases accounts, and checking accounts. Con­ the Federal Reserve’s investigations sumers most frequently complained revealed no evidence of illegal discrimi­ about escrow account problems (78 nation. The remaining case was pending complaints); other complaints involved at year-end. customer service problems (75), debt collection practices (70), insufficient- funds charges and procedures (67), loan Advice from the and deposit account fees (64), and inter­ Consumer Advisory Council est rates and terms (61). The remainder The Board’s Consumer Advisory of the complaints concerned a wide Council—whose members represent range of unregulated practices in other consumer and community organizations, 76 91st Annual Report, 2004 the financial services industry, academic The Community Reinvestment Act institutions, and state agencies—advises (CRA) was a topic at each of the three the Board of Governors on matters con­ meetings. The discussions focused on cerning laws and regulations that the regulatory changes proposed by the Board administers and on other issues Board and three other federal financial related to consumer financial services. institution regulators (the Office of the Council meetings are open to the public. Comptroller of the Currency, the Office (For a list of members of the council, of Thrift Supervision, and the Federal see the section ‘‘Federal Reserve Sys­ Deposit Insurance Corporation). The tem Organization.’’) agencies proposed changing the criteria In 2004, the council met in March, for designation as a small bank and add­ June, and October. In March, council ing a caveat that abusive asset-based members discussed the Board’s proposal lending might reduce a bank’s CRA rat­ to provide more uniform and consistent ing. Some members expressed concern guidance on what constitutes a ‘‘clear about the proposal to change the criteria and conspicuous’’ disclosure for its for small-bank designation because a consumer regulations. The discussion larger number of banks would qualify focused on whether the standards and for a more limited CRA examination, guidance in Regulation P, which imple­ and some banks located in rural geogra­ ments the financial privacy provisions phies might not have incentives to of the Gramm–Leach–Bliley Act, could participate in community and economic be used as the model for providing clear development initiatives. Further, some and conspicuous standards. While mem­ members asserted that additional regula­ bers applauded the Board’s effort to tion of regulated depository institutions make disclosures more understand­ is not necessary and should instead be able, they did not support adopting the targeted at unregulated and unsuper­ Regulation P standard as a means of vised bank affiliates and other loosely providing more consistent standards supervised organizations. and guidance for consumer protection In June, council members discussed disclosures. an ongoing review to identify outdated The council also discussed the Janu­ and unduly burdensome regulatory ary 2004 General Accounting Office requirements pursuant to the Economic (GAO) study on predatory lending. The Growth and Regulatory Paperwork GAO recommended that Congress con­ Reduction Act of 1996. Members did sider making certain statutory changes not reach consensus on the necessity to consumer financial services and fair of the Truth in Lending Act provision lending laws. Members commented on giving consumers a three-day right to a proposal that would grant the Board rescind certain mortgage loan trans­ the authority to routinely monitor and, actions before financial institutions dis­ as necessary, examine nonbank mort­ burse the funds, nor did they agree on gage lending subsidiaries of bank and the importance of Home Mortgage Dis­ financial holding companies to poten­ closure Act data from small banks and tially deter predatory lending. Members rural areas. Members agreed that the who supported this proposal believed CRA provisions of the Gramm–Leach– that the Federal Reserve has the ability Bliley Act, which require financial insti­ and the expertise to conduct rigorous tutions and other community-based and consistent examinations. Others did organizations that are parties to certain not favor the recommendation. written CRA agreements to make the Consumer and Community Affairs 77 agreements available to the public and the Home Ownership and Equity Protec­ their primary regulator, serve no useful tion Act (HOEPA), which was estab­ purpose. Furthermore, the provisions lished to respond to predatory mortgage have created a data collection and lending practices and to protect consum­ reporting burden for all parties involved ers from these abusive lending practices. in the agreements. Another topic of dis­ Members had differing opinions on cussion at the June meeting was the whether state laws or federal legislation remittance market, or the transfer of is the most effective means of address­ funds by immigrant workers to families ing predatory lending. Some members and friends in their native countries (see believed that state laws provide the nec­ the related box ‘‘Remittances and Immi­ essary protections for deterring preda­ grant Markets: Opportunities and Chal­ tory lending practices—protections that lenges’’ later in this chapter). Members HOEPA does not offer. Other members emphasized the importance of lowering strongly preferred federal legislation the cost of remittances and of providing that preempts state laws because of its immigrants with access to banking uniform application and consistency. services—especially for lower-income The council also discussed proposed immigrant workers who regularly send amendments to Regulation E, which money to their home countries. implements the Electronic Fund Trans­ Courtesy overdraft protection, fre­ fer Act. Members commented on a revi­ quently referred to as bounced-check sion that would require that payroll card protection, was a topic at the June accounts, established on behalf of a con­ and October meetings. The courtesy sumer for the purpose of providing sal­ overdraft-protection services offered by ary, wages, and other employee compen­ some financial institutions are covered sation on a recurring basis, be covered under the Truth in Savings Act. Some by Regulation E. Specific comments members had concerns about the ade­ addressed whether periodic statements quacy of disclosures, the need for addi­ should apply to payroll cards. Some tional regulatory coverage, and decep­ members agreed that employers issuing tive marketing practices for these payroll cards either directly or through services. Council members discussed service providers should provide peri­ whether the Truth in Savings Act or the odic statements to employees. Other Truth in Lending Act is the most effec­ members noted that payroll cards are a tive way to inform and protect consum­ low-profit service for financial institu­ ers. Some council members asserted that tions; the additional costs associated bounced-check protection programs are with providing payroll statements could short-term extensions of credit that fit discourage institutions from offering the the definition of credit under the Truth cards. in Lending Act; others believed that the programs do not qualify as credit exten­ sions because there is no loan applica­ Promotion of Community tion, underwriting, note, or annual per­ Economic Development in centage rate calculation in connection Historically Underserved with the service. Markets At the October meeting, members During 2004, the community affairs discussed anti-predatory-lending laws. function within the Federal Reserve Sys­ Members reviewed various state and tem engaged in a variety of initiatives to federal legislative approaches, including promote community economic develop­ 78 91st Annual Report, 2004 ment that benefit low- and moderate- government to improve the level of income communities and populations. financial literacy among American The function continued to focus on consumers. In October, the web site financial literacy and education, the sus­ www.MyMoney.gov and a toll-free tainability of community development number (1-888-my-money [1-888-696­ organizations, emerging and immigrant 6639]) were launched to provide con­ markets, and community economic sumers with easy access to information development. Activities included con­ resources. The national strategy work­ ducting research, publishing newsletters ing group will continue its work, incor­ and articles, sponsoring conferences porating public remarks submitted in and seminars, and providing advisory response to a request for comment and services, all of which helped to deliver finalizing the national strategy in a pertinent information to both general report to Congress due in June 2005. and targeted audiences. Consistent with the national goal to As a decentralized function, the com­ increase financial literacy among con­ munity affairs programs at the Board sumers, community affairs staff assisted and each of the twelve Reserve Banks in the planning and delivery of financial design activities that are responsive to and consumer education programs to the communities in the regions they Board employees. Four programs were serve. At the Reserve Banks, Commu­ offered in 2004, and a web site for nity Affairs Offices focus on providing online personal finance education was information and promoting awareness established for Board employees. of investment opportunities to finan­ Board staff use surveys and focus cial institutions, government agencies, groups to learn about what issues are and organizations that serve low- and important to consumers and to test and moderate-income communities and develop educational materials. Last year populations, while the Board’s Commu­ Board staff updated the ‘‘Consumer’s nity Affairs Office engages in activities Guide to Mortgage Settlement Costs’’ that have implications for public policy. and the ‘‘Choosing a Credit Card’’ In 2004, Board staff actively partici­ brochures and issued two new publica­ pated in interagency working groups tions dealing with checks and the new created to fulfill the legislative man­ Check 21 provisions: the ‘‘Consumer dates of the U.S. Department of the Guide to Check 21 and Substitute Treasury’s Financial Literacy and Edu­ Checks’’ and ‘‘What You Should Know cation Commission (the commission), about Your Checks.’’ The Board, in established under the Fair and Accurate cooperation with the other federal bank, Credit Transactions Act (the FACT Act). thrift, and credit union regulators, pro­ The commission consists of the chiefs duced materials on ‘‘phishing,’’ ‘‘Inter­ of twenty federal agencies; Governor net Pirates Are Trying to Steal Your Edward Gramlich represents Chairman Personal Financial Information,’’ and on Alan Greenspan as the Board’s member. bounced-check fees, ‘‘Protecting Your­ Board staff participated on two of the self from Overdraft and Bounced-Check commission’s working groups: one to Fees.’’ These publications are avail­ help design and launch a web site to link able on the Board’s consumer informa­ consumers with financial education tion web site (www.federalreserve.gov/ resources available from federal gov­ consumers.htm). ernment agencies, and one to frame Board staff are involved in ongoing a national strategy for the federal research projects related to financial Consumer and Community Affairs 79 privacy disclosures, consumers’ use of program in Providence, Rhode Island, electronic banking services and stored- offers programs to teach seniors about value cards, remittances and immi­ credit card use, predatory lending, and grants’ use of financial services (see the financial planning. By serving as advis­ related box ‘‘Remittances and Immi­ ers to the mayors in the nearly thirty- grant Markets: Opportunities and five cities involved in the campaign, the Challenges’’), and the role of financial Federal Reserve Banks are helping to education in community development. increase the public’s awareness of and Board staff are also working with the access to resources for financial liter­ Department of Defense on a longi­ acy and education. In addition, Federal tudinal study on the effects of finan­ Reserve System community affairs staff cial education conducted on military continued to work closely with national installations. leaders from the Native American com­ Board staff assisted with national munity to develop a financial educa­ financial education initiatives through­ tion policy and other resources that are out the year. The director of the Divi­ responsive to the unique needs of resi­ sion of Consumer and Community dents in Indian Country. Board staff Affairs served as an adviser to the board hosted a meeting of the Native Ameri­ of Operation HOPE, a national non­ can Financial Education Task Force in profit organization dedicated to deliver­ December. The meeting provided an ing financial education programs to low- opportunity for the five committees income populations through schools and of the task force to focus on the finan­ community centers, as well as to com­ cial education needs of Native Ameri­ munities suffering from natural disas­ cans and on how to deliver education ters. In addition, staff participated in resources to these communities. two national forums: one sponsored by The Community Affairs Offices at the National Endowment for Financial the Reserve Banks continued their Education to explore strategies for pro­ financial education initiatives. The Fed­ moting positive financial management eral Reserve Bank of Cleveland worked behaviors, and another convened by the with bank and community partners in Government Accountability Office (for­ Cleveland, Pittsburgh, and Cincinnati merly the General Accounting Office) to to form regional collaborations to define the federal government’s role in develop and deliver financial education personal financial education. resources. The Federal Reserve Bank of System financial education projects Minneapolis was instrumental in form­ supplemented the Board’s efforts. The ing the Montana Financial Education community affairs and public informa­ Coalition. The Federal Reserve Bank tion officers at the Reserve Banks col­ of Boston partnered with a community laborated with the U.S. Conference of group to provide train-the-trainer work­ Mayors to explore strategies for estab­ shops to social service workers, hosted lishing financial education initiatives in a conference on best practices, and cities throughout the country. The result­ worked with Operation HOPE to launch ing ‘‘Dollar Wi$e’’ initiative enables a financial literacy campaign in the cities to create programs that meet the schools in Providence, Rhode Island. needs of their citizens. For example, the In addition, the Federal Reserve Bank campaign in Detroit, Michigan, focuses of Kansas City sponsored a number of on providing financial education train­ financial education events that spe­ ing to community educators, while the cifically targeted youth, Native Ameri­ 80 91st Annual Report, 2004

Remittances and Immigrant Markets: Opportunities and Challenges

The provision of remittance services is a potentially effective method by which mainstream financial institutions can attract unbanked immigrants. Ben S. Bernanke, Member, Board of Governors April 16, 2004

Immigrant workers typically send a large service fees as high as 15 percent of the portion of their earnings back to their home transfer, thus eroding the amount of money countries. The United States is the largest an immigrant’s family receives. Many fac­ source country for these cross-border funds tors influence the fees charged, including transfers, known as remittances: About the service provider’s operating costs and $32 billion was remitted in 2003, accord­ geographic coverage. ing to a recent report from the Inter- To facilitate cost-effective funds trans­ American Dialogue. (As used in this fers to Canada, Mexico, and five trans­ article, the term remittances refers specifi­ atlantic countries, the Reserve Banks offer cally to the international transfer of funds FedACH International products to banks. between individuals.) Because they are These products allow banks to send inter­ such a significant flow of funds, remit­ national credit transactions electronically tances have attracted the attention of law­ via the same process used to send domestic makers, bankers, consumer and community transactions. Intended primarily for inter­ groups, and domestic and international national corporate payments, the products banking agencies. provide a potentially less costly way for The Inter-American Development consumers to remit funds. In 2004, the Bank’s Multilateral Investment Fund service was expanded to include Mexico. reports that the highest volume of remit­ The Reserve Banks worked cooperatively tance traffic—an estimated 100 million with the Central Bank of Mexico to make it transactions each year—occurs between the easier for Mexican retail banking systems United States and Latin America. Billions to support remittances—an effort that may in Motion, a 2002 report published by the also encourage consumers in the United Pew Hispanic Center, described a typical States and Mexico to develop banking remitter in the United States as a thirty- relationships. seven-year-old, lower-skilled immigrant Along with the other Federal Financial from Mexico or another Latin American Institutions Examination Council agencies, country who earns less than $30,000 annu­ the Federal Reserve Board examined the ally, has not completed high school, does role of the Community Reinvestment Act not have a credit card, does not own his or in encouraging banks to provide financial her home, and is among the 43 percent of services to immigrants—who are typically Latino immigrants who do not have a bank a low-income, underserved population. As account. a result of policy guidance issued in June The process of remitting funds has 2004, banks that offer remittance services changed significantly since 1990, when may receive CRA credit if these services many immigrants used informal networks, are affordable and meet the needs of the such as friends and family, to transfer lower-income remitters in their markets. funds. Today, money-transfer organizations For banks, immigrants and remittances are the dominant providers of remittance present a market opportunity. The Remit­ services. But these firms typically charge tance Marketplace, a 2004 report from the Consumer and Community Affairs 81

Pew Hispanic Center, found that only about Conference participants shared insights 3 percent of remittance transactions to on essential policies and practices. Mexico were conducted through banks. • The Federal Reserve Bank of Boston’s Despite recent efforts by banks and credit Community Affairs Office conducted unions to increase account ownership in-depth market research on immigrant among Hispanic markets, the report also communities in the First District. The found that 8 million Latinos remain office’s other financial education initia­ ‘‘unbanked.’’ tives targeted Hispanic communities in Banks, however, need to understand the Boston, Massachusetts, and Providence, many issues involved in serving immi­ Rhode Island. grants. For example, many immigrants are As the U.S. population becomes more uncomfortable using banks and do not diverse, the Federal Reserve System will understand how banks charge for their ser­ continue to work with policymakers, com­ vices. In 2004, the Federal Reserve System munity groups, and bankers to ensure that undertook several initiatives to share infor­ immigrants have fair and equal access to mation on reaching immigrant markets. the U.S. financial system. The following Reserve Bank publications provide more • The Federal Reserve Bank of Chicago information on remittances and immigrant launched the Center for the Study of banking. Financial Access for Immigrants, which hosted a national conference, ‘‘Financial •‘‘Financial Access for Immigrants Access for Immigrants: Learning from Conference: Learning from Diverse Diverse Perspectives,’’ in collaboration Perspectives,’’ Profitwise News and with the Brookings Institution. In addi­ Views, Federal Reserve Bank of Chicago, tion, the Chicago Reserve Bank’s Com­ October 2004, www.chicagofed.org/ munity Affairs Office convened several community_development/ forums throughout the Seventh District •‘‘Meeting in the Mainstream,’’ Banking to gain insight into the social, economic, and Community Perspectives, Federal and other issues that inhibit immigrants Reserve Bank of Dallas, issue 1, 2004, from using banks. www.dallasfed.org/ca/index.html • The Federal Reserve Bank of Atlanta •‘‘FedACH International Services Opens hosted ‘‘Payments in the Americas,’’ a Payments Channel to Mexico,’’ Part­ conference that explored the policy and ners in Community and Economic Devel­ regulatory challenges of providing remit­ opment, Federal Reserve Bank of tance services. Staff from the Board and Atlanta, volume 14, number 1, 2004, the Atlanta Reserve Bank are also spon­ www.atl.frb.org/comm.cfm soring focus groups with Mexican immi­ •‘‘Banking Unbanked Immigrants through grants to learn about the factors influ­ Remittances,’’ Communities and Bank­ encing their banking and remitting ing, Federal Reserve Bank of Boston, behaviors. Fall 2003, www.bos.frb.org/commdev/ • Federal Reserve Board staff participated index.htm on a remittances panel at the 2004 • Community Investments Online, Federal conference of the American Council of Reserve Bank of San Francisco, Novem­ Consumer Interests. The panel addressed ber 2003, www.sf.frb.org/community/ consumer information, disclosure, and index.html protection issues. •‘‘Banking Latino Immigrants: A Lucra­ • The Community Affairs Office of the tive New Market for Progressive Federal Reserve Bank of Dallas hosted Financial Institutions,’’ Bridges, Federal ‘‘The Business of Immigrant Markets: Reserve Bank of St. Louis, Autumn Providing Access to Financial Services.’’ 2002, www.stlouisfed.org/community/ 82 91st Annual Report, 2004 can, and Hispanic populations. The Development Investments; the Bank’s Federal Reserve Banks of Atlanta, staff worked closely with an advisory Chicago, and Philadelphia hosted board of industry experts to develop a events on wealth-building and asset- web site of resources, training, and tech­ accumulation strategies and initiatives nical assistance on community develop­ throughout their Districts. An article ment investments. The System’s Com­ highlighting the various financial educa­ munity Affairs Offices also continued to tion efforts of the Federal Reserve Sys­ work with the Wall Street Without Walls tem was published in the Autumn 2004 initiative to help community develop­ edition of the Federal Reserve Bulletin ment organizations increase their access (www.federalreserve.gov/pubs/bulletin/ to the capital markets for funding. The default.htm). Federal Reserve Banks of Chicago, In recent years, reduced funding and San Francisco, and New York hosted changing priorities among government training events that attracted nearly 370 and philanthropic organizations have community development leaders inter­ diminished access to resources for many ested in understanding the requirements community development organizations. of the capital markets. In addition, the As it did in 2003, the Board’s Com­ Community Affairs Office of the Boston munity Affairs Office convened meet­ Reserve Bank collaborated with Wall ings of federal government officials Street Without Walls and Southern New and national community development Hampshire University to sponsor the leaders to explore the sustainability and inaugural session of the ‘‘Capital Mar­ capitalization of community economic kets Training Institute’’ in Manchester, development finance (CEDF) orga­ New Hampshire. Participants at this nizations. The Board’s Community three-day event learned how they can Affairs Office convened a policy forum use the capital markets to fulfill their in April with the Aspen Institute, organizations’ missions more efficiently a national research and leadership and learned how to adapt their opera­ development organization. The forum tions to allow their organizations to discussed Aspen’s research on the access the capital markets. Demonstrat­ attributes of industries, organizations, ing the ongoing commitment of the and products that achieve scale and System’s Community Affairs Offices, become self-sustaining. The research the director of the Board’s Division compared and contrasted the funding of Consumer and Community Affairs and business strategies of sustainable began serving on the Walls Street With­ enterprises with those of CEDF insti­ out Walls advisory board in 2004. tutions, identifying areas where the field Reserve Bank efforts also explored needs to focus efforts to increase its ways to increase the effectiveness of future viability. The forum assembled community development finances in leaders from financial institutions, their Districts. The Federal Reserve government agencies, foundations, and Bank of Dallas sponsored ‘‘Momentum membership associations. Texas: The Texas Community Devel­ Reserve Bank Community Affairs opment Finance Summit’’ to examine Offices explored new sources of capital the state’s strategies for securing and to increase the sustainability of CEDF using community economic develop­ organizations. The Federal Reserve ment funds. The Cleveland Reserve Bank of San Francisco expanded the Bank organized a policy summit, scope of its Center for Community ‘‘Recapitalization of Communities,’’ in Consumer and Community Affairs 83 which regional and national community Rodham Clinton was the keynote development leaders discussed chal­ speaker. lenges to and opportunities for attracting The Board’s Community Affairs new capital to fund CEDF institutions’ Office continued to improve and support initiatives for infrastructure develop­ its Fiscal Impact Tool (FIT), a web- ment, wealth-building, and other asset- based modeling tool designed to support accumulation programs. the evaluation of prospective commu­ The System’s Community Affairs nity and economic development projects Offices remain committed to increasing in midsize communities. This analytic the role of research in their work. Prepa­ tool enables community economic rations have begun for the biennial com­ developers to conduct a cost–benefit munity affairs research conference in analysis of a proposed development April 2005; Chairman Greenspan will project by estimating its effect on be a keynote speaker at the two-day local sales and property tax reve­ event. System community affairs staff nues and on costs to local government. collaborated with their research col­ Available at no cost on the Board’s leagues at the Board and the Cleveland web site (www.federalreserve.gov/forms/ Reserve Bank to identify and review fiscalimpactrequest.cfm), FIT can aid papers that would best address the con­ decisionmakers in determining the eco­ ference’s theme, ‘‘Promises and Pitfalls: nomic value of a proposed activity for As Consumer Finance Options Multiply, their community. Who Is Being Served and at What The Board’s Community Affairs Cost?’’ Studies chosen will assess the Office, in partnership with the Chi­ impact that consumer behavior, alterna­ cago, Kansas City, Philadelphia, tive financial services providers, finan­ Richmond, and St. Louis Reserve cial education, and other factors have on Banks, continued to develop best- consumers’ access to and experiences practice case studies for the web-based with the financial sector. database Lessons Learned: Community The New York, Philadelphia, and and Economic Development Case Cleveland Reserve Banks collaborated Studies (www.chicagofed.org/cedric/ to host a community development lesle_index.cfm). The database provides finance research conference in Decem­ detailed case studies that identify a ber. The conference commissioned community development issue, present papers from leading researchers on a one community’s solution, describe the broad range of topics, including strate­ results, and offer ‘‘lessons learned’’ to gies for asset creation among lower- community developers addressing simi­ income populations, the role of micro- lar concerns in their communities. The lending in community development, database can be accessed on the Sys­ methods for measuring the impact of tem’s research repository web site, the community development, and the rela­ Community and Economic Develop­ tionship between subprime markets and ment Research Information Center predatory lending. In addition, scholars (CEDRIC). and practitioners explored the roles of alternative depository institutions and public policy in helping traditionally Outreach Activities underserved populations and communi­ The Board engages in outreach activi­ ties access capital for asset accumula­ ties throughout the year to provide infor­ tion and development. Senator Hillary mation to the public about the Board’s 84 91st Annual Report, 2004 responsibilities, to facilitate understand­ the Board again participated in the ing of changes in banking regulations Congressional Black Caucus Founda­ and their impact on banks and consum­ tion’s 2004 annual legislative confer­ ers, to promote community development ence, which provides a national forum and consumer education, and to foster for examining strategies and viable solu­ discussion of public policy issues. Board tions to public policy issues facing Afri­ staff periodically meet with financial can Americans. Board staff distributed institutions, community groups, and consumer education materials provided other members of the public in formal by the Federal Reserve System and used and informal settings. The Board spon­ the opportunity to inform conference sors and participates in meetings, con­ attendees about the Federal Reserve and ferences, and seminars for the general its multifaceted responsibilities. public and targeted audiences. This year, 85

Banking Supervision and Regulation

Earnings of insured commercial banks slightly, to 1.35 percent, the third exceeded the $100 billion mark for the consecutive year in which this ratio second consecutive year in 2004 amid exceeded 1.30 percent. significant changes in the interest rate Loans grew a remarkable 11.0 per­ environment, an end to the boom period cent, or $480 billion, in 2004, with most in mortgage refinancings, and several growth occurring in commercial real mergers among large bank holding estate ($131 billion), home equity companies. ($114 billion), residential mortgages At $106.7 billion, profits rose 6.4 per­ ($89 billion), and credit card loans cent from 2003, fueled by growth in ($61 billion). The growth of commercial loans (11.0 percent overall) and invest­ real estate lending was even more rapid ment securities (6.4 percent) and by a than in the past few years, with con­ decline in provisions for loan loss struction lending up 25.2 percent and (22.3 percent). The net interest margin loans secured by nonfarm nonresidential on all earning assets fell 7 basis points, properties up 10.7 percent. Home equity to 3.72 percent, low by historical stan­ loans grew an extraordinary 40.2 per­ dards. Non-interest income grew mod­ cent, the fifth consecutive year in which estly overall (3.9 percent) despite lower their growth exceeded 20 percent. The revenues from mortgage originations growth of residential mortgages came and soft trading income. Servicing mostly in the first half of the year and income, income from fiduciary activi­ slowed considerably once short-term ties, and deposit fees accounted for most market interest rates began to rise in of the growth. Expenses rose sharply June. Some of the increase in credit card (9.4 percent), significantly influenced by lending was technical in nature, related nonrecurring items related to mergers to the reclassification of balances from and the creation of litigation reserves at credit-card-related securities to loans as a few large institutions. accounting treatments were harmonized Return on total shareholders’ equity at newly merged large banks. Commer­ fell a full percentage point, to a still- cial and industrial (C&I) loans rose strong 14.27 percent. The decline in $37 billion, or 4.3 percent, for the year this profitability ratio was due primarily despite having declined modestly in the to significant merger-related increases first quarter amid weak loan demand. in equity that were largely offset by Holdings of investment securities increases in merger-related intangible grew less rapidly than loans, expanding assets.1 Return on assets fell only 6.4 percent overall (or $93 billion) for the full year while experiencing substan­ tial shifts as the year progressed in 1. The number and size of bank-related merger response to changing market conditions. transactions significantly affected the aggregation Essentially all the net growth for the of commercial bank reports of income and con­ year could be attributed to mortgage dition (Call Reports) in 2004. The data used in this discussion have been adjusted to address the effects of purchase accounting and, in particular, large holding companies acquired by other bank push-down accounting for bank subsidiaries of holding companies. 86 91st Annual Report, 2004 pass-through securities acquired during significantly ($10.5 billion, or 1.6 per­ the first quarter. Reacting to changes in cent); the bulk of the increase came the interest rate environment, banks sold in the final quarter of the year as con­ off $36 billion (or 5.9 percent) of their sumers sought to take advantage of mortgage pass-through securities hold­ rising interest rates. Time deposits ings in the second and third quarters over $100,000 rose $128.3 billion, or and then purchased roughly the same 21.5 percent, and foreign deposits grew amount during the fourth quarter as $125 billion, or 16.8 percent; these longer-term interest rates stabilized. categories include large-denomination Banks also sold off a modest proportion deposits raised in wholesale and off­ of their structured mortgage securities shore money markets, which, along with (for example, collateralized mortgage a modest rise in short-term non-deposit obligations) and asset-backed securities borrowings (4.6 percent), accommo­ in the third quarter and then acquired dated the growth in assets. additional foreign-issued debt securities Influenced by both balance sheet during the fourth quarter. These reposi­ changes and movements in market inter­ tioning transactions came in response est rates, net interest margins narrowed to actual and anticipated movements 7 basis points, to 3.72 percent. Yields on in market interest rates (together with domestic real estate loans—including unexpected stability in long-term rates, commercial real estate and home equity leading to a flatter yield curve) and the loans—fell 25 basis points despite associated volatility in the carrying higher short-term interest rates. Over­ value of mortgage-servicing assets. all yields on securities holdings rose Supporting this robust asset growth, modestly—in part because of rising core deposits continued their recent short-term interest rates—while yields strong expansion. Money market deposit on C&I loans held steady at 6.00 per­ account (MMDA) deposits and sav­ cent amid reports that bankers were eas­ ings deposits grew $270 billion, or ing their lending standards through the 11.7 percent, slightly exceeding the year. Changes in the effective rates for remarkable growth rate for loans. Note­ credit cards and other consumer loans worthy increases were evident among were mixed. Funding costs reflected other core deposit categories, including some resistance to higher interest rates, other transaction accounts (up $6.1 bil­ as the effective cost of MMDA and lion) and demand deposits (up $24.5 bil­ savings deposits remained essentially lion). The increase in demand deposits unchanged from 2003, at 0.73 percent, was influenced by an inflow of balances while the effective cost of other deposits from corporate customers in the latter and borrowings declined 20–30 basis half of the year as short-term market points. interest rates rose, boosting earnings Equity-to-assets ratios rose a full per­ credits on compensating balances.2 centage point in 2004, primarily as a Time deposits under $100,000 grew less result of the merger-related increases in shareholders’ equity noted earlier. 2. Although banks are prohibited from paying Regulatory capital ratios, in contrast, interest on transaction accounts held by commer­ remained relatively steady, as the cial customers, these customers in many cases merger-related increase in equity was receive ‘‘earnings credits’’ on their transaction balances that may be used to offset service charges they incur. The amounts of such earnings credits the size of collected balances and prevailing short- are determined by a number of factors, including term market interest rates. Banking Supervision and Regulation 87 largely offset by goodwill-related intan­ Scope of Responsibilities for gible assets, which are deducted from Supervision and Regulation regulatory capital measures. Dividends The Federal Reserve is the federal paid by commercial banks fell sharply, supervisor and regulator of all U.S. bank declining $18 billion, or 23.4 percent. holding companies, including financial Most of the decline (61 percent) came in holding companies formed under the dividends paid to the five largest bank authority of the 1999 Gramm–Leach– holding companies (Citigroup, JPMor­ Bliley Act, and of state-chartered com­ gan Chase, Bank of America, Wachovia mercial banks that are members of the and Wells Fargo, all on a merger- Federal Reserve System. In overseeing adjusted basis) by their commercial these organizations, the Federal Reserve bank subsidiaries; dividend payments seeks primarily to promote their safe from the holding companies to their and sound operation, including their shareholders rose. compliance with laws and regulations.3 Already-strong asset quality im­ The Federal Reserve also has respon­ proved further in 2004 according to all sibility for the supervision of all Edge conventional measures. Nonperforming Act and agreement corporations; the assets fell to 0.62 percent of loans and international operations of state member related assets, well below both the banks and U.S. bank holding companies; 0.94 percent rate for 2003 and the pre­ and the operations of foreign banking vious credit-cycle low point in 1997–99 companies in the United States. (0.75 percent). Net charge-offs fell to The Federal Reserve exercises impor­ 0.63 percent of loans, from 0.88 per­ tant regulatory influence over entry into cent in 2003, roughly in line with the the U.S. banking system and the struc­ 1997–99 period. Reserves fell in abso­ ture of the system through its adminis­ lute terms (4.2 percent), but reserve tration of the Bank Holding Company coverage of nonperforming assets still Act, the Bank Merger Act (with regard improved substantially. to state member banks), the Change in Reflecting ongoing consolidation in Bank Control Act (with regard to bank the industry, the number of insured com­ holding companies and state member mercial banks declined by 142 (on a net banks), and the International Banking basis), to 7,621. Still, some 122 new Act. The Federal Reserve is also respon­ charters were granted in 2004 (105 of sible for imposing margin requirements these by state authorities), a sign of the on securities transactions. In carrying continuing attractiveness of commercial out these responsibilities, the Federal bank charters. Assuming a minimum Reserve coordinates its supervisory initial capitalization of $8 million, these newly chartered institutions attracted nearly $1 billion of new capital into the 3. The Board’s Division of Consumer and banking industry. Community Affairs coordinates the Federal Consistent with the industry’s strong Reserve’s supervisory activities with regard to compliance with consumer protection and civil earnings and balance sheets, only three rights laws. Those activities are described in banks failed in 2004 (combined assets the chapter ‘‘Consumer and Community Affairs.’’ of roughly $200 million), one more than Compliance with other banking laws and regu­ in 2003. The number of problem banks lations, which is treated in this chapter, is the responsibility of the Board’s Division of Bank­ (that is, those receiving a supervisory ing Supervision and Regulation and the Federal rating of 4 or 5 on overall condition) Reserve Banks, whose examiners also check for declined by 28, to 90 institutions. safety and soundness. 88 91st Annual Report, 2004 activities with other federal banking State Member Banks agencies, state agencies, functional At the end of 2004, 919 state-chartered regulators, and the bank regulatory banks (excluding nondepository trust agencies of other nations. companies and private banks) were members of the Federal Reserve Sys­ Supervision for tem. These banks represented approxi­ Safety and Soundness mately 12 percent of all insured U.S. commercial banks and held approxi­ To ensure the safety and soundness of mately 15 percent of all insured com­ banking organizations, the Federal mercial bank assets in the United States. Reserve conducts on-site examinations The guidelines for Federal Reserve and inspections and off-site surveillance examinations of state member banks and monitoring. It also undertakes are fully consistent with section 10 of enforcement and other supervisory the Federal Deposit Insurance Act, as actions. amended by section 111 of the Federal Deposit Insurance Corporation Improve­ ment Act of 1991 and by the Riegle Examinations and Inspections Community Development and Regula­ The Federal Reserve conducts examina­ tory Improvement Act of 1994. A full- tions of state member banks, the U.S. scope, on-site examination of these branches and agencies of foreign banks, banks is required at least once a year; and Edge Act and agreement corpora­ exceptions are certain well-capitalized, tions. In a process distinct from exami­ well-managed organizations having nations, it conducts inspections of bank assets of less than $250 million, which holding companies and their nonbank may be examined once every eighteen subsidiaries. Pre-examination planning months. and on-site review of operations are integral parts of the overall effort to Bank Holding Companies ensure the safety and soundness of banking organizations. Whether it is an At year-end 2004, a total of 5,863 U.S. examination or an inspection, the review bank holding companies were in opera­ entails (1) an assessment of the quality tion, of which 5,151 were top-tier bank of the processes in place to identify, holding companies. These organizations measure, monitor, and control risks, controlled 6,235 insured commercial (2) an assessment of the quality of the banks and held approximately 96 per­ organization’s assets, (3) an evaluation cent of all insured commercial bank of management, including an assess­ assets in the United States. ment of internal policies, procedures, Federal Reserve guidelines call for controls, and operations, (4) an assess­ annual inspections of large bank holding ment of the key financial factors of capi­ companies as well as smaller companies tal, earnings, liquidity, and sensitivity to that have significant nonbank assets. In market risk, and (5) a review for compli­ judging the financial condition of the ance with applicable laws and regula­ subsidiary banks owned by holding tions. The table provides information companies, Federal Reserve examiners on the examinations and inspections consult examination reports prepared conducted by the Federal Reserve dur­ by the federal and state banking authori­ ing the past five years. ties that have primary responsibility for Banking Supervision and Regulation 89

State Member Banks and Holding Companies, 2000–2004

Entity/Item 2004 2003 2002 2001 2000

State member banks Total number ...... 919 935 949 970 991 Total assets (billions of dollars) ...... 1,275 1,912 1,863 1,823 1,645 Number of examinations ...... 809 822 814 816 899 By Federal Reserve System ...... 581 581 550 561 610 By state banking agency ...... 228 241 264 255 289 Top-tier bank holding companies Large (assets of more than $1 billion) Total number ...... 355 365 329 312 309 Total assets (billions of dollars) ...... 8,429 8,295 7,483 6,905 6,213 Number of inspections ...... 500 454 439 413 352 By Federal Reserve System1 ...... 491 446 431 409 346 On site ...... 440 399 385 372 309 Off site ...... 51 47 46 37 37 By state banking agency ...... 9 8 8 4 6 Small (assets of $1 billion or less) Total number ...... 4,796 4,787 4,806 4,816 4,800 Total assets (billions of dollars) ...... 852 847 821 768 716 Number of inspections ...... 3,703 3,453 3,726 3,486 3,347 By Federal Reserve System ...... 3,526 3,324 3,625 3,396 3,264 On site 2 ...... 186 183 264 730 835 Off site ...... 3,340 3,141 3,361 2,666 2,429 By state banking agency ...... 177 129 101 90 83 Financial holding companies Domestic ...... 600 612 602 567 462 Foreign ...... 36 32 30 23 21

1. For large bank holding companies subject to con­ inspections being performed off site versus on site. tinuous, risk-focused supervision, includes multiple tar­ See text section ‘‘Bank Holding Companies’’ for more geted reviews. information. 2. In 2002, the supervisory program for small bank holding companies was revised, resulting in more the supervision of those banks, thereby rial outstanding issues at the holding minimizing duplication of effort and company or consolidated level are other­ reducing the burden on banking wise indicated, only a composite rating organizations. and a management rating based on the Small, noncomplex bank holding ratings of the lead subsidiary depository companies—those that have consoli­ institution are assigned to the company. dated assets of $1 billion or less—are In 2004 the Federal Reserve conducted subject to a special supervisory program 3,703 reviews of such bank holding that was implemented in 1997 and companies. If a company’s subsidiary modified in 2002.4 The program permits depository institutions have ratings a more flexible approach to supervision lower than ‘‘satisfactory’’ or have other of such companies. If all of a company’s significant supervisory issues, a more subsidiary depository institutions have thorough off-site review of the organiza­ composite and management ratings of tion is conducted using surveillance ‘‘satisfactory’’ or better, and if no mate­ results and other information. If the information obtained off-site from these 4. Refer to SR Letter 02–01 for a discussion sources is not sufficient to determine the of the factors considered in determining whether a bank holding company is complex or noncomplex overall financial condition of the hold­ (www.federalreserve.gov/boarddocs/SRLETTERS/ ing company and to assign the compos­ 2002/sr0201.htm). ite and management ratings, the holding 90 91st Annual Report, 2004 company is subject to increased supervi­ The BSA and separate Board regu­ sory review that may include an on-site lations require banking organizations review and off-site monitoring. supervised by the Board to file reports on suspicious activity related to possible Financial Holding Companies violations of federal law, including money laundering, terrorist financing, Under the Gramm–Leach–Bliley Act, and other financial crimes. In addition, bank holding companies that meet cer­ BSA and Board regulations require that tain capital, managerial, and other re­ banks develop written programs on BSA quirements may elect to become finan­ compliance and that the programs be cial holding companies and thereby formally approved by bank boards of engage in full-scope securities under­ directors. An institution’s compliance writing, merchant banking, and insur­ program must (1) establish a system of ance underwriting and sales activities. internal controls to ensure compliance The statute streamlines the Federal with the BSA, (2) provide for inde­ Reserve’s supervision of all bank hold­ pendent compliance testing, (3) identify ing companies, including financial hold­ individuals responsible for coordinating ing companies, and sets forth param­ and monitoring day-to-day compliance, eters for the relationship between the and (4) provide training for personnel as Federal Reserve and other regulators. appropriate. The statute also differentiates between The Federal Reserve is responsible the Federal Reserve’s relations with for examining supervised institutions for regulators of depository institutions and compliance with various anti-money­ its relations with functional regulators laundering regulations. During examina­ (that is, regulators for insurance, securi­ tions of state member banks and U.S. ties, and commodities). branches and agencies of foreign banks As of year-end 2004, 600 domestic and, when appropriate, inspections of bank holding companies and 36 foreign bank holding companies, examiners banking organizations had financial review the institution’s compliance with holding company status. Of the domes­ the BSA and determine whether ade­ tic financial holding companies, 34 had quate procedures and controls to guard consolidated assets of $15 billion or against money laundering are in place. more; 110, between $1 billion and The Anti-Money-Laundering Policy $15 billion; 82, between $500 million and Compliance Section of the Board’s and $1 billion; and 374, less than Division of Banking Supervision and $500 million. Regulation is responsible for BSA/anti­ money-laundering matters. The section Anti-Money-Laundering develops BSA polices and examination Examinations guidance and oversees the Federal Reserve Banks’ implementation of this The U.S. Department of the Treasury guidance. regulations (31 CFR 103) implement­ ing the Bank Secrecy Act (BSA) gen­ erally require banks and other types Business Continuity of financial institutions to file certain In 2004 the Federal Reserve continued reports and maintain certain records that its efforts to strengthen the resilience of are useful in criminal or regulatory the U.S. financial system in the event proceedings. of unexpected disruptions. Throughout Banking Supervision and Regulation 91 the year, the Federal Reserve monitored ness examinations are now expected to financial institutions’ progress toward include a review of information technol­ implementing the sound practices iden­ ogy risks and activities. During 2004 the tified in the April 2003 ‘‘Interagency Federal Reserve was the lead agency in Paper on Sound Practices to Strengthen two examinations of large, multiregional the Resilience of the U.S. Financial data processing servicers examined in System,’’ a joint publication with the cooperation with the other federal bank­ Office of the Comptroller of the Cur­ ing agencies. rency (OCC) and the Securities and Exchange Commission (SEC), which Fiduciary Activities specifies 2005–06 implementation dates. The agencies also began analyzing the The Federal Reserve has supervisory risks associated with business continuity responsibility for organizations that testing, in order to develop examiner together hold more than $24 trillion of guidance, and continue to coordinate assets in various fiduciary capacities, efforts to ensure a consistent supervi­ including custodial capacities. During sory approach toward implementation of on-site examinations of fiduciary activi­ the sound practices. ties, the organization’s compliance with laws, regulations, and general fiduciary principles and potential conflicts of Specialized Examinations interest are reviewed; its management The Federal Reserve conducts special­ and operations, including its asset- and ized examinations of banking organiza­ account-management, risk-management, tions in the areas of information technol­ and audit and control procedures, are ogy, fiduciary activities, transfer agent also evaluated. In 2004 Federal Reserve activities, and government and munici­ examiners conducted 163 on-site fidu­ pal securities dealing and brokering. The ciary examinations. Federal Reserve also conducts special­ ized examinations of certain entities, Transfer Agents and other than banks, brokers, or dealers, Securities Clearing Agencies that extend credit subject to the Board’s margin regulations. As directed by the Securities Exchange Act of 1934, the Federal Reserve con­ Information Technology Activities ducts specialized examinations of those state member banks and bank holding In recognition of the importance of companies that are registered with the information technology to safe and Board as transfer agents. Among other sound operations in the financial things, transfer agents countersign and industry, the Federal Reserve reviews monitor the issuance of securities, reg­ the information technology activities ister the transfer of securities, and of supervised banking organizations as exchange or convert securities. On-site well as certain independent data centers examinations focus on the effective­ that provide information technology ness of an organization’s operations and services to these organizations. Several its compliance with relevant securities years ago, the information technology regulations. During 2004 the Federal reviews of banking organizations were Reserve conducted on-site examinations integrated into the overall supervisory at 21 of the 86 state member banks and process, and thus all safety and sound­ bank holding companies that were reg­ 92 91st Annual Report, 2004 istered as transfer agents. Also during for compliance with the Board’s margin the year the Federal Reserve examined regulations as part of its general exami­ 1 state member limited-purpose trust nation program, the Federal Reserve company acting as a national securities maintains a registry of persons other depository. than banks, brokers, and dealers who extend credit subject to those regula­ Government and Municipal Securities tions. The Federal Reserve may conduct Dealers and Brokers specialized examinations of these lend­ ers if they are not already subject to The Federal Reserve is responsible for supervision by the Farm Credit Admin­ examining state member banks and for­ istration, the National Credit Union eign banks for compliance with the Gov­ Administration, or the Office of Thrift ernment Securities Act of 1986 and with Supervision (OTS). Department of the Treasury regulations At the end of 2004, 679 lenders other governing dealing and brokering in than banks, brokers, or dealers were reg­ government securities. Twenty-eight istered with the Federal Reserve. Other state member banks and 7 state branches federal regulators supervised 215 of of foreign banks have notified the Board these lenders, and the remaining 464 that they are government securities deal­ were subject to limited Federal Reserve ers or brokers not exempt from Trea­ supervision. On the basis of regulatory sury’s regulations. During 2004 the Fed­ requirements and annual reports, the eral Reserve conducted 6 examinations Federal Reserve exempted 245 lenders of broker–dealer activities in govern­ from its on-site inspection program. The ment securities at these organizations. securities credit activities of the remain­ These examinations are generally con­ ing 219 lenders were subject to either ducted concurrently with the Federal biennial or triennial inspection. Fifty- Reserve’s examination of the state mem­ five inspections were conducted during ber bank or branch. the year, compared with 89 in 2003. The Federal Reserve is also respon­ sible for ensuring compliance with the Securities Act Amendments of 1975 by Enforcement Activities state member banks and bank holding and Special Investigations companies that act as municipal securi­ The Federal Reserve has enforcement ties dealers, which are examined pursu­ authority over the banking organizations ant to the Municipal Securities Rule- it supervises and their affiliated parties. making Board’s rule G-16 at least once Enforcement action may be taken to every two calendar years. Of the 22 enti­ address unsafe and unsound practices or ties that dealt in municipal securities violations of any law or regulation. For­ during 2004, 6 were examined during mal enforcement actions include orders the year. to cease and desist, written agreements, removal and prohibition orders, and Securities Credit Lenders civil money penalties. Informal enforce­ Under the Securities Exchange Act of ment actions include memorandums of 1934, the Federal Reserve Board is understanding and board of directors responsible for regulating credit in cer­ resolutions. tain transactions involving the purchase In 2004 the Federal Reserve com­ or carrying of securities. In addition to pleted 64 formal enforcement actions, examining banks under its jurisdiction including the issuance of cease-and­ Banking Supervision and Regulation 93 desist orders, written agreements, and Regional Banking Organizations removal and prohibition orders and the The risk-focused supervision program imposition of civil money penalties. for regional banking organizations Civil money penalties totaling $188 mil­ applies to organizations having a man­ lion were assessed. All civil money agement structure organized by func­ penalties, as directed by statute, are tion or business line, a broad array remitted either to the Department of the of products, and operations that span Treasury or to the Federal Emergency multiple supervisory jurisdictions. For Management Agency. Enforcement smaller regional banking organizations, orders, which are issued by the Board, the supervisory program may be imple­ and written agreements, which are mented with a point-in-time inspection. executed by the Reserve Banks, are pub­ For larger organizations, it may take the lic information and are posted on the form of a series of targeted reviews. For Board’s web site (www.federalreserve.gov/ the largest, most complex organizations, boarddocs/enforcement). In addition to the process is continuous, as described formal enforcement actions, the Reserve in the next section. To minimize burden Banks completed 102 informal enforce­ on the organization, work is performed ment actions in 2004. Information about off-site to the greatest extent possible. these actions is not available to the Additionally, to minimize the number of public. requests for information from organiza­ The Special Investigations Section of tions, examiners make use of public and the Division of Banking Supervision and regulatory financial reports, market data, Regulation conducts financial investi­ information from automated screening gations, provides expertise to U.S. law systems (see the section ‘‘Surveillance enforcement in connection with finan­ and Off-Site Monitoring’’), and internal cial crimes investigations, and offers management reports. training to foreign and domestic gov­ ernment agencies. Board staff also work Large, Complex Banking Organizations with law enforcement, the financial industry, and other regulatory agencies The Federal Reserve applies a risk- on various task forces and groups estab­ focused supervision program to large, lished to combat bank fraud and other complex banking organizations financial crimes. (LCBOs).5 The key features of the LCBO supervision program are (1) iden­ Risk-Focused Supervision tifying those LCBOs that are judged, on Programs the basis of their shared risk character­ istics, to present the highest level of In recent years the Federal Reserve has supervisory risk to the Federal Reserve created several programs aimed at System, (2) maintaining continual super­ enhancing the effectiveness of the super­ vision of these organizations to keep visory process. The main objective of current the Federal Reserve’s assess­ these programs has been to sharpen the ment of each organization’s condition, focus on (1) those business activities posing the greatest risk to banking orga­ nizations and (2) the organizations’ 5. For more information, see Lisa M. DeFerrari and David E. Palmer, ‘‘Supervision of Large Com­ management processes for identifying, plex Banking Organizations,’’ Federal Reserve measuring, monitoring, and controlling Bulletin, vol. 87 (February 2001), pp. 47–57 risks. (www.federalreserve.gov/pubs/bulletin/default.htm). 94 91st Annual Report, 2004

(3) assigning to each LCBO a super­ inspections. This analysis aids in direct­ visory team composed of Reserve Bank ing examination resources to those orga­ staff members who have skills appro­ nizations that exhibit relatively high- priate for the organization’s risk pro­ risk profiles. Screening systems also file (the team leader is the central point assist in the planning of examinations of contact, has responsibility for only by identifying companies that are engag­ one LCBO, and is supported by spe­ ing in new or complex activities. The cialists skilled in evaluating the risks Federal Reserve also has systems that of LCBO business activities and func­ monitor market data, including equity tions), and (4) promoting Systemwide prices, debt spreads, agency ratings, and and interagency information-sharing measures of expected default frequency, through automated systems. to gauge market perceptions of the risk in banking organizations. Community Banks In addition to using automated screen­ ing systems, the Federal Reserve pre­ The risk-focused supervision program pares quarterly Bank Holding Company for community banks emphasizes the Performance Reports (BHCPRs) for review of activities posing the greatest use in monitoring and inspecting super­ risk to an organization and provides for vised banking organizations. The reports a tiered approach to the examination of are compiled from data provided by those activities. Examination procedures large bank holding companies in quar­ are tailored to the bank’s characteristics, terly regulatory reports (FR Y-9C and keeping in mind its size, complexity, FR Y-9LP) and contain, for individual and risk profile. The examination entails bank holding companies, financial sta­ both off-site and on-site work, including tistics and comparisons with peer com­ planning, completing a pre-examination panies. BHCPRs are available to the visit, preparing a detailed scope-of­ public via the Board’s National Informa­ examination memorandum, document­ tion Center web site (www.ffiec.gov/nic). ing the work done, and preparing an During 2004 the web-based Perfor­ examination report tailored to the scope mance Report Information and Surveil­ and findings of the examination. The lance Monitoring (PRISM) application framework for risk-focused supervision received major upgrades. PRISM is a of community banks was developed querying tool used by Federal Reserve jointly with the Federal Deposit Insur­ analysts to access and display financial, ance Corporation (FDIC) and has been surveillance, and examination data. In adopted by the Conference of State the analytical module, users can cus­ Bank Supervisors. tomize the presentation of institutional financial data drawn from Call Reports, Surveillance and Uniform Bank Performance Reports, Off-Site Monitoring FR Y-9 statements, Bank Holding Com­ pany Performance Reports, and other The Federal Reserve uses automated regulatory reports. In the surveillance screening systems that monitor super­ module, users can generate reports sum­ visory data and regulatory financial marizing the results of surveillance reports in order to analyze the financial screens for banks and bank holding condition and performance of state companies. The upgrades established member banks and bank holding compa­ direct links between PRISM and other nies between on-site examinations and automated supervisory tools (the Bank­ Banking Supervision and Regulation 95 ing Organization National Desktop, or efforts to implement corrective measures BOND, and the National Examination or to test their adherence to safe and Database), expanded the number of sur­ sound banking practices. Examinations veillance screens available from BOND, abroad are conducted with the coopera­ and enhanced the range of regulatory tion of the supervisory authorities of the data available for querying. countries in which they take place; when The Federal Reserve works through appropriate, the examinations are coor­ the Federal Financial Institutions dinated with the OCC. Examination Council (FFIEC) Task At the end of 2004, 56 member banks Force on Surveillance Systems to coor­ were operating 763 branches in for­ dinate surveillance activities with the eign countries and overseas areas of the other federal banking agencies.6 United States; 32 national banks were operating 706 of these branches, and 24 International Activities state member banks were operating the remaining 57. In addition, 16 nonmem­ The Federal Reserve supervises the for­ ber banks were operating 17 branches in eign branches and overseas investments foreign countries and overseas areas of of member banks, Edge Act and agree­ the United States. ment corporations, and bank holding companies and also the investments by bank holding companies in export Edge Act and Agreement Corporations trading companies. In addition, it super­ Edge Act corporations are international vises the activities that foreign banking banking organizations chartered by the organizations conduct through entities Board to provide all segments of the in the United States, including branches, U.S. economy with a means of financ­ agencies, representative offices, and ing international business, especially subsidiaries. exports. Agreement corporations are similar organizations, state chartered or Foreign Operations of federally chartered, that enter into an U.S. Banking Organizations agreement with the Board to refrain The Federal Reserve examines the from exercising any power that is not international operations of state mem­ permissible for an Edge Act corporation. ber banks, Edge Act and agreement cor­ Sections 25 and 25A of the Federal porations, and bank holding companies Reserve Act grant Edge Act and agree­ generally at the U.S. head offices of ment corporations permission to engage these organizations, where the ultimate in international banking and foreign responsibility for their foreign offices financial transactions. These corpora­ lies. Examiners also visit the overseas tions, most of which are subsidiaries offices of U.S. banks to obtain financial of member banks, may (1) conduct a and operating information and, in some deposit and loan business in states other instances, to evaluate the organizations’ than that of the parent, provided that the business is strictly related to interna­ 6. The member agencies of the FFIEC are the tional transactions, and (2) make foreign Board of Governors, the Federal Deposit Insur­ investments that are broader than those ance Corporation, the National Credit Union made by member banks, as they may Administration, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. invest in foreign financial organizations, State supervisory authorities also participate in such as finance companies and leasing some FFIEC initiatives. companies, as well as in foreign banks. 96 91st Annual Report, 2004

At year-end 2004, 79 banking orga­ if the branch or agency meets certain nizations, operating 9 branches, were criteria. chartered as Edge Act or agreement cor­ The Federal Reserve conducts a joint porations. These corporations are exam­ program for supervising the U.S. opera­ ined annually. tions of foreign banking organizations in cooperation with the other federal U.S. Activities of Foreign Banks banking agencies and state banking agencies. The program has two main The Federal Reserve has broad authority parts. One part addresses the examina­ to supervise and regulate the U.S. activ­ tion process for those foreign banking ities of foreign banks that engage in organizations that have multiple U.S. banking and related activities in the operations and is intended to ensure United States through branches, agen­ coordination among the various U.S. cies, representative offices, commercial supervisory agencies. The other part is a lending companies, Edge Act corpora­ review of the financial and operational tions, commercial banks, and certain profile of each organization to assess its nonbank companies. Foreign banks con­ general ability to support its U.S. opera­ tinue to be significant participants in the tions and to determine what risks, if any, U.S. banking system. the organization poses through its U.S. As of year-end 2004, 188 foreign operations. Together, these two pro­ banks from 54 countries were operating cesses provide critical information to 228 state-licensed branches and agen­ U.S. supervisors in a logical, uniform, cies (of which 8 were insured by the and timely manner. The Federal Reserve FDIC) as well as 51 branches licensed conducted or participated with state by the OCC (of which 5 had FDIC and federal regulatory authorities in insurance). These foreign banks also 256 examinations in 2004. directly owned 14 Edge Act and agree­ ment corporations and 3 commercial lending companies; in addition, they Technical Assistance held an equity interest of at least 25 per­ In 2004 the Federal Reserve System cent in 88 U.S. commercial banks. continued to provide technical assis­ Altogether, the U.S. offices of these tance on bank supervisory matters to foreign banks at the end of 2004 con­ foreign central banks and supervi­ trolled approximately 16 percent of U.S. sory authorities. Technical assistance commercial banking assets. These for­ involves visits by System staff members eign banks also operated 68 repre­ to foreign authorities as well as con­ sentative offices; an additional 56 for­ sultations with foreign supervisors who eign banks operated in the United States visit the Board or the Reserve Banks. solely through a representative office. Technical assistance in 2004 was con­ State-licensed and federally licensed centrated in Latin America, Asia, and branches and agencies of foreign banks former Soviet bloc countries. are examined on-site at least once every During the year, the Federal Reserve eighteen months, either by the Federal offered training courses exclusively for Reserve or by a state or other federal foreign supervisory authorities in Wash­ regulator; in most cases, on-site exami­ ington, D.C., and in a number of for­ nations are conducted at least once eign jurisdictions. System staff also took every twelve months, but the period part in technical assistance and training may be extended to eighteen months missions led by the International Mone­ Banking Supervision and Regulation 97 tary Fund, the World Bank, the Inter- The rule permits banking organizations American Development Bank, the Asian to continue to exclude from their risk- Development Bank, the Basel Commit­ weighted asset base, for purposes of cal­ tee on Banking Supervision, and the culating their risk-based capital ratios, Financial Stability Institute. ABCP program assets that are consoli­ dated onto the balance sheets of spon­ soring banking organizations as a result Supervisory Policy of Financial Accounting Standards Board Financial Interpretation No. 46, The Federal Reserve’s supervisory pol­ ‘‘Consolidation of Variable Interest icy function is responsible for develop­ Entities’’ (FIN 46). Sponsoring bank­ ing guidance for examiners and banking ing organizations must continue to organizations as well as regulations for hold risk-based capital against all other banking organizations under the Federal risk exposures arising in connection Reserve’s supervision. Staff members with ABCP programs, including direct participate in international supervisory credit substitutes, recourse obligations, forums and provide support for the work residual interests, long-term liquidity of the FFIEC. facilities, and loans, in accordance with existing risk-based capital standards. In addition, any minority interests in Capital Adequacy Standards ABCP programs that are consolidated During 2004 the Federal Reserve, as a result of FIN 46 are to be excluded together with the OCC, the FDIC, and from the sponsoring banking organi­ the OTS (collectively, the federal bank­ zation’s minority interest component ing agencies), issued a final rule on capi­ of tier 1 capital and, hence, from risk- tal requirements for asset-backed com­ based capital. The amended capital mercial paper programs. The agencies treatment does not alter the accounting also continued to consider possible rules for balance sheet consolidation, revisions to their risk-based capital nor does it affect the denominator of the adequacy regulations to reflect the new tier 1 leverage capital ratio calculation, Basel II framework and issued proposed which continues to be based primarily guidance for internal-ratings-based sys­ on on-balance-sheet assets as reported tems that may be used to determine under generally accepted accounting capital for retail credit risk. In addition, principles. Thus, as a result of FIN 46, the Federal Reserve requested public banking organizations must include all comment on a proposed rule concerning assets of consolidated ABCP programs the treatment of trust preferred securi­ in on-balance-sheet assets for purposes ties in the tier 1 capital of bank holding of calculating their tier 1 leverage capi­ companies. tal ratio. In addition, the rules impose a risk- Asset-Backed based capital charge on liquidity facili­ Commercial Paper Programs ties having an original maturity of one year or less that organizations provide to In July the Federal Reserve and the ABCP programs by imposing a 10 per­ other federal banking agencies adopted cent credit conversion factor on such a final rule that amended the agencies’ facilities. This treatment recognizes that risk-based capital rules for asset-backed such facilities expose banking organiza­ commercial paper (ABCP) programs. tions to credit risk and is consistent with 98 91st Annual Report, 2004 the industry’s practice of internally allo­ Basel II framework, see the box ‘‘Imple­ cating economic capital against the risk menting the Basel II Framework in the associated with such facilities. A sepa­ United States.’’) rate capital charge on liquidity facilities provided to an ABCP program is not Capital Treatment of required of banking organizations that Trust Preferred Securities consolidate the program for purposes of risk-based capital. In May the Federal Reserve Board pro­ posed to allow the continued inclusion Risk-Based Capital Standards of outstanding and prospective issuances for Certain Internationally Active of trust preferred securities in the tier 1 Banking Organizations capital of bank holding companies while imposing stricter quantitative limits and In August 2003 the Federal Reserve, clarifying qualitative standards for capi­ together with the other federal banking tal instruments included in regulatory agencies, issued for public comment an capital. The stricter quantitative limits advance notice of proposed rulemaking would apply to the aggregate amount and draft supervisory guidance setting of trust preferred securities, cumulative forth the agencies’ views on implement­ perpetual preferred stock, and minority ing the Basel II framework in the United interests in the equity accounts of cer­ States. The proposed plan would allow tain consolidated subsidiaries (collec­ banking organizations that meet spe­ tively, restricted core capital elements) cific criteria to use their own estimates included in bank holding company tier 1 of certain risk parameters as key inputs capital. The proposed rule would make in determining their regulatory capital explicit a general expectation that inter­ requirements. nationally active bank holding compa­ Over the course of 2004, working nies would limit the amount of restricted both independently and with the mem­ core capital elements to 15 percent of ber countries of the Basel Committee on the sum of core capital elements, includ­ Banking Supervision, the federal bank­ ing restricted core capital elements, net ing agencies continued to modify the of goodwill less any associated deferred methodologies in the Basel II frame­ tax liability, consistent with a 1998 work. In October the agencies issued Basel agreement. Other bank holding proposed guidance on internal-ratings­ companies would be subject to a 25 per­ based systems that may be used to deter­ cent limit on the amount of restricted mine regulatory capital for retail credit core capital elements. The proposal pro­ risk under the Basel II framework. The vides for a three-year transition period proposed guidance describes the agen­ for compliance with the stricter quantita­ cies’ views on the components and tive limits. characteristics of a qualifying internal- These revisions were proposed to ratings-based system for measuring address supervisory concerns, competi­ the credit risk associated with retail tive equity considerations, and changes exposures, including residential mort­ in generally accepted accounting prin­ gages, consumer credit cards, automo­ ciples. They would have the effect of bile loans, personal loans, and some strengthening the definition of regula­ small business loans. The comment tory capital for bank holding compa­ period was scheduled to end in January nies. A final rule is to be issued in early 2005. (For more information on the 2005. Banking Supervision and Regulation 99

Bank-Owned Life Insurance assessment of the subsidiary depository institution(s), as had been the case for In December 2004, the Federal Reserve the bank rating under the previous rat­ and the other federal banking agencies ing system, BOPEC (Bank subsidiaries, issued guidance on the safety-and­ Other subsidiaries, Parent, Earnings, soundness and risk-management impli­ Capital). cations of purchases and holdings of To provide a consistent framework life insurance by banks and savings for assessing risk management, the risk- associations. The guidance addresses management component of the new rat­ the unique characteristics of bank- ing system is supported by four subcom­ owned life insurance (BOLI) as well as ponents that reflect the effectiveness of the need for a comprehensive pre- and the banking organization’s risk man­ post-purchase analysis of the risks and agement and controls: board and senior rewards of BOLI. management oversight; policies, pro­ cedures, and limits; risk monitoring Bank Holding Company and management information systems; Rating System and internal controls. The financial- condition component is similarly sup­ To more closely align the supervisory ported by four subcomponents that rating system for bank holding compa­ reflect an assessment of the quality nies with its supervisory practices, the of the banking organization’s capital, Federal Reserve in December 2004 assets, earnings, and liquidity. A simpli­ adopted a revised bank holding com­ fied version of the rating system that pany rating system, effective January 1, requires only the assignment of the risk- 2005. The increased complexity of the management component rating and U.S. banking industry has necessitated composite rating (C) will be applied to a shift over time in the focus of the noncomplex bank holding companies Federal Reserve’s supervisory practices having assets of less than $1 billion. for bank holding companies away from historical analyses of financial condition toward more-forward-looking assess­ Bank Secrecy Act and ments of risk management and financial Anti–Money Laundering factors. Under the revised rating system, The Federal Reserve in 2004 issued a each bank holding company is assigned number of supervisory letters to domes­ a composite rating based on an eval­ tic and foreign banking organizations on uation and rating of its managerial and such topics as examination procedures financial condition and an assessment for customer identification programs of future potential risk to its subsidiary and the imposition of ‘‘special mea­ depository institution(s). The three main sures’’ by the Department of the Trea­ components of the new RFI/C (D) rating sury on certain jurisdictions and for­ system are Risk management, Financial eign financial institutions suspected of condition, and potential Impact of the being of ‘‘primary money laundering parent company and nondepository sub­ concern.’’ sidiaries (collectively, nondepository The Federal Reserve is actively work­ entities) on the subsidiary depository ing with the other federal and state institution(s). The rating of a fourth banking agencies to develop inter­ component, Depository institution, will agency Bank Secrecy Act/anti-money­ generally mirror the primary regulator’s laundering examination procedures to be 100 91st Annual Report, 2004

Implementing the Basel II Framework in the United States

We are embarking on an effort to achieve considerably more precision in correlating the riskiness of an institution’s activities and its regulatory capital. Roger Ferguson, Vice Chairman, Board of Governors November 2004

Preparation continued during 2004 for Scope of Application in the United States implementation in the United States of a new international agreement on capital ade­ Final rules for application of the Basel II quacy for banking organizations.1 The new framework in the United States are still agreement, familiarly known as Basel II, being developed. It is expected that only sets forth a framework for ensuring that a small number of large, internationally banks hold adequate capital against risk active U.S. banking organizations will be and builds on the initial international capi­ subject to the new framework. Those tal agreement adopted in 1988. institutions would be required to use the The original Basel Capital Accord, most advanced options of the framework though widely considered to have achieved for determining their risk-based capital its principal objectives of promoting finan­ requirements (the advanced internal- cial stability and providing an equitable ratings-based approach, or A-IRB, for basis for competition among internation­ credit risk and the advanced measurement ally active banks, has in recent years been approaches, or AMA, for operational risk). viewed as too simple to address the activi­ Other U.S. banking organizations would ties of today’s large, complex banking not be required to adopt Basel II but could organizations. Basel II creates a stronger opt to do so, provided they could demon­ framework for these organizations through strate the ability to develop the risk mea­ minimum capital requirements that are sures required as inputs to determine capi­ more sensitive to each organization’s risk tal requirements. Those banks not adopting profile and that reinforce incentives for Basel II would continue to operate under strong risk management.2 existing capital rules. The Basel II framework contains provi­ sions addressing credit risk (the risk of loss Implementation Plan and Timetable due to failure of a counterparty to meet its obligations) and operational risk (the The U.S. banking and thrift agencies have risk of loss resulting from inadequate or been coordinating their efforts to imple­ failed internal processes, people, or sys­ tems or from external events).3 It relies on the Basel Committee on Banking Supervision, three pillars—minimum capital require­ which is made up of representatives of the cen­ ments, supervisory review, and market tral banks or other supervisory authorities of the discipline—and is the basis on which G-10 countries plus Luxembourg and has its revisions to existing U.S. capital ade­ secretariat at the Bank for International Settle­ quacy regulations and standards are being ments in Basel, Switzerland. See www.bis.org/ publ/bcbs107.htm. developed. 2. See ‘‘Capital Standards for Banks: The Evolving Basel Accord,’’ Federal Reserve Bulle­ 1. The final agreement, titled ‘‘International tin, vol. 89 (September 2003), pp. 395–405 Convergence of Capital Measurement and (www.federalreserve.gov/pubs/bulletin/default.htm). Capital Standards: A Revised Framework’’ and 3. Basel I was updated in 1996 to account for published in June 2004, was developed by market risk. Banking Supervision and Regulation 101

ment Basel II. The new rules are expected capital requirements is seen as among the to take effect on January 1, 2008; before most significant steps institutions can take then, institutions subject to the new rules in advance of the issuance of final rules will be required to conduct a year of paral­ and associated guidance. The qualification lel calculations—that is, to simultaneously process will be iterative. The plans will calculate capital requirements according to serve as instruments of communication the Basel II-based rules and the current between institutions and their supervisors rules. Both supervisors and bankers have in their home country and other juris­ much to accomplish before the target 2008 dictions. They are expected to include a date, including the writing of final rules self-assessment by the institution, a gap and guidance by the agencies and the analysis (based on the self-assessment) development and execution of an accept­ identifying areas needing additional work, able, detailed written plan for implementa­ an action plan for addressing shortcom­ tion by each adopting institution. ings, objectively measurable milestones, and an assessment of resources needed. Revision of Regulations Issuance of Supervisory Guidance Comments on an advance notice of pro­ posed rulemaking issued in August 2003 During 2005 the agencies will continue to that set forth possible revisions to the capi­ develop supervisory guidance concerning tal adequacy regulations are currently being the various portfolios and risk exposures reviewed. Importantly, all U.S. banking addressed by Basel II; draft supervisory organizations would continue to be sub­ guidance on corporate and retail credit risk ject to leverage ratio requirements and to and operational risk has already been pub­ prompt corrective action regulations, which lished. The guidance will set forth super­ closely link enforcement actions to banks’ visory expectations for banking organiza­ capital levels. tions adopting the Basel II-based rules, for The agencies expect that a notice of pro­ example, the components and characteris­ posed rulemaking on possible revisions tics of an acceptable risk-measurement and to the regulations will be published in risk-management infrastructure. mid-2005. Final rules are expected in the second quarter of 2006. The agencies are Completion of Quantitative Studies also considering possible changes to risk- based capital regulations for U.S. institu­ In 2004 the agencies began a fourth Quan­ tions not subject to the Basel II-based reg­ titative Impact Study (QIS-4) to evaluate ulations; these changes are expected to the potential effects of U.S. implementa­ become effective at the same time as the tion of the Basel II framework and a ‘‘loss Basel II-based regulations. data collection exercise’’ (LDCE) focused on operational risk. About thirty banking Qualification for Using organizations are participating in QIS-4; Advanced Approaches about twenty are participating in the LDCE. These studies are intended to help The agencies have issued guidance setting banking organizations and their supervisors forth their ideas about the qualification pro­ better understand the implications of the cess for Basel II in the United States. The Basel II framework for regulatory capital development of a detailed written plan and may provide some insight on impli­ for implementing the A-IRB and AMA cations of the new approaches for competi­ approaches for determining risk-based tion within the banking industry. 102 91st Annual Report, 2004 released in 2005. The Department of the supervisory policies for internation­ Treasury’s Financial Crimes Enforce­ ally active banking organizations and ment Network (FinCEN) has partici­ to improve the stability of the interna­ pated in this initiative. tional banking system. The efforts are To support this work and to pro­ described in the following sections. vide a forum for the federal banking agencies to discuss matters related Capital Adequacy to Bank Secrecy Act/anti-money­ During 2004 the Federal Reserve con­ laundering examination and training, a tinued to participate in a number of tech­ Bank Secrecy Act Working Group was nical working groups of the Basel Com­ formed in 2004 under the FFIEC. The mittee in efforts to develop the revised working group, which also includes Basel framework (familiarly referred FinCEN and state bank regulators, to as Basel II), which was published complements other interagency and in June, and to address issues not fully international efforts, such as the Bank resolved in that framework. In particu­ Fraud Working Group, the Financial lar, the Federal Reserve participated in Action Task Force, and various super­ a joint Basel Committee–International visors committees within the Basel Organization of Securities Commissions Committee on Banking Supervision. (IOSCO) working group on the trading The Federal Reserve participates in book to review issues related to counter- another such group, the BSA Advisory party credit risk, double default effects Group, which was established by statute (reflecting the low probability that both to seek ways to reduce unnecessary bur­ a borrower and its guarantor will default den created by the BSA and to increase at the same time), and the definition of the utility of data gathered under the act the trading book. to aid regulators and law enforcement. In addition, through this group, the Fed­ Risk Management eral Reserve assists the Treasury Depart­ ment in providing feedback to financial The Federal Reserve contributed to institutions on the reporting of suspi­ several supervisory policy papers, cious activity. Finally, staff of the Divi­ reports, and recommendations issued sion of Banking Supervision and Regu­ by the Basel Committee during 2004 lation engage in outreach to the financial that were generally aimed at improv­ services industry by, for example, speak­ ing the supervision of banking organiza­ ing at banking conferences to promote tions’ risk-management practices. best practices to combat money launder­ ing and terrorist financing. •‘‘Consolidated Know-Your-Customer Risk Management,’’ issued in Octo­ ber, provides guidance to help interna­ International Guidance on tional banking organizations establish Supervisory Policies centralized processes for sharing As a member of the Basel Committee information and for coordinating and on Banking Supervision, the Federal promulgating customer due diligence Reserve in 2004 participated in efforts policies and procedures on a consoli­ to revise the international capital regime dated basis. The guidance, which and to develop international supervisory builds on Basel Committee publica­ guidance. The Federal Reserve’s goals tions issued in 2001 and 2003, also in these activities are to advance sound encourages government jurisdictions Banking Supervision and Regulation 103

to facilitate consolidated customer due •‘‘Principles for the Home–Host Rec­ diligence risk management by provid­ ognition of AMA Operational Risk ing a legal framework that allows Capital,’’ issued in January, addresses overseas subsidiaries and affiliates of industry concerns about practical banking organizations to share infor­ impediments to the cross-border mation with their head offices or par­ implementation of the advanced mea­ ent banks. surement approaches for operational risk, an element of the Basel II •‘‘Principles for the Management and framework. Supervision of Interest Rate Risk,’’ issued in July, describes the pillar 2 Joint Forum (supervisory review) approach to calculating interest rate risk under In its work with the Basel Committee, Basel II. The paper reflects comments the Federal Reserve also continued its received on a September 2003 consul­ participation in the Joint Forum—a tative paper. group made up of representatives of the committee, IOSCO, and the Interna­ •‘‘Implementation of Basel II: Practi­ tional Association of Insurance Supervi­ cal Considerations,’’ issued in July, sors. The Joint Forum works to increase discusses the costs and benefits of mutual understanding of issues related Basel II implementation from the to the supervision of firms operating point of view of non–G10 countries, in each of the financial sectors. The focusing in particular on potential Joint Forum issued three publications in changes to the legal and regulatory 2004: framework and on resource and train­ ing requirements. •‘‘Credit Risk Transfer,’’ issued in October, reviews the rapid growth in • In January the Basel Committee credit risk transfer products, such as issued changes to the internal-ratings­ single-name credit default swaps and based approach to securitization expo­ collateralized debt obligations, and sures under Basel II, in response to concludes that these markets have industry concerns related to the com­ provided banking organizations with plexity of the proposal and the opera­ significantly more liquid and efficient tional burdens of implementation. methods of trading and diversifying their credit risks. The report notes that • In January the Basel Committee although these products do not raise announced its decision to base the immediate and significant financial Basel II framework on unexpected stability concerns, financial organiza­ losses rather than a combination of tions should adopt appropriate risk- unexpected and expected losses, in management practices when conduct­ response to industry requests and ing business in these products. comments. However, under the frame­ work, banks would be required to •‘‘Outsourcing in Financial Services,’’ compare provisions with expected issued in August, discusses the key losses and to deduct any deficiency issues and risks associated with finan­ from capital. Excess provisions would cial firms’ outsourcing of significant be eligible for inclusion in tier 2 capi­ parts of their regulated and unregu­ tal, subject to a cap. lated activities to third parties and sets 104 91st Annual Report, 2004

forth principles to help firms mitigate The Federal Reserve and the Basel these risks. Committee also worked with other inter­ national regulatory organizations, such •‘‘Financial Disclosure in the Banking, as IOSCO, the International Association Insurance and Securities Sectors: of Insurance Supervisors, the World Issues and Analysis,’’ issued in May, Bank, and the Financial Stability Forum, outlines the findings of a working as part of an organization called the group established to follow up on Monitoring Group, to promote stronger recommendations contained in a 1999 international audit standards and prac­ report that provided advice to super­ tices. This effort led to the adoption by visors on enhancing financial institu­ the International Federation of Accoun­ tions’ public disclosures of their finan­ tants (IFAC) of comprehensive reforms cial risks. that will result in greater public over­ sight of IFAC’s audit-standard-setting International Accounting activities. and Disclosure The Federal Reserve participates in the Sarbanes–Oxley Act Basel Committee’s Accounting Task Force and represents the Basel Commit­ During 2004 the Federal Reserve con­ tee at international meetings on account­ tinued to evaluate the effects of the ing, auditing, and disclosure issues Sarbanes–Oxley Act on banking organi­ affecting global banking organizations. zations. The effort involved the Federal In particular, officials of the Federal Reserve’s working closely with banking Reserve represent the Basel Committee organizations and their external audi­ at meetings that address financial instru­ tors to better understand the challenges ments accounting and disclosure issues they are encountering in complying with associated with international accounting the sections of the act that relate to standards. In addition, an official of the internal controls. It also involved dia­ Federal Reserve is a member of the logue with the SEC and the Public Standards Advisory Council of the Inter­ Company Accounting Oversight Board national Accounting Standards Board (PCAOB) on various interpretative (IASB). issues related to these matters. During 2004 the Federal Reserve had In addition, an official of the Federal a key role in development of the Basel Reserve serves on the Standing Advi­ Committee’s comments on the IASB’s sory Group of the PCAOB, which is proposed amendment to the guidance in advising the PCAOB as it develops stan­ International Accounting Standard 39 on dards for the external audits of publicly the optional use of fair value accounting traded companies in the United States. for financial instruments. In addition, The Federal Reserve also continued in the Federal Reserve strongly supported 2004 to work with the FDIC and other the Basel Committee’s efforts to develop banking agencies to consider changes guidance on improving disclosure for that should be made to the regulations the purpose of enhancing market dis­ implementing the Federal Deposit cipline. This support contributed to Insurance Corporation Improvement Act the finalization of pillar 3 guidance on to promote strong internal controls improved disclosures in support of and consistency with the Sarbanes– Basel II. Oxley Act requirements. Banking Supervision and Regulation 105

Efforts to Enhance Transparency holding companies and their nonbank subsidiaries. As part of ongoing efforts to promote The FR Y-9 series of reports provides sound accounting and disclosure prac­ standardized financial statements for tices by banking organizations, the Fed­ bank holding companies on a consoli­ eral Reserve, together with the other dated and parent-only basis. The reports banking agencies, in February issued are used to detect emerging financial guidance on the appropriate accounting problems, review performance and con­ treatment for obligations under certain duct pre-inspection analysis, monitor types of deferred compensation agree­ and evaluate risk profiles and capital ments (see SR Letter 04-4). In March adequacy, evaluate proposals for bank the Federal Reserve and the other bank­ holding company mergers and acquisi­ ing agencies issued guidance identifying tions, and analyze the holding compa­ current sources of generally accepted ny’s overall financial condition. The accounting principles (GAAP) and nonbank subsidiary reports—FR Y-11, supervisory guidance that should be FR 2314, and FR Y-7N—aid the Fed­ used by banking organizations in deter­ eral Reserve in determining the condi­ mining their allowance for loan and tion of bank holding companies that are lease losses (see SR Letter 04-5). The engaged in nonbanking activities and in Federal Reserve also worked with for­ monitoring the volume, nature, and con­ eign supervisors in developing pillar 3 dition of their nonbanking subsidiaries. of the Basel II framework, which aims The FR Y-8 report collects information to enhance banking organizations’ pub­ on transactions between an insured lic disclosure of their risk exposures, depository institution and its affiliate capital, and capital adequacy. that are subject to section 23A of the In October the Federal Reserve sub­ Federal Reserve Act; it enhances the mitted a comment letter to the Financial Federal Reserve’s ability to monitor Accounting Standards Board (FASB) on bank exposures to affiliates and to its ‘‘Fair Value Measurements Exposure ensure compliance with section 23A of Draft.’’ In addition, Federal Reserve the act. staff provided comments to FASB on an In March 2004, several revisions to accounting interpretation that addressed the FR Y-9C report were implemented impairment of securities. for the purpose of collecting preliminary data from selected large bank holding companies on a voluntary basis, improv­ Bank Holding Company ing the reporting of trust preferred secu­ Regulatory Financial Reports rities, and collecting from some of the largest bank holding companies the The Federal Reserve requires that U.S. addresses of their web pages display­ bank holding companies periodically ing risk disclosures. In September and submit reports providing financial and December the electronic filing process structure information. This information for the FR Y-9 series of reports was is essential to the supervision of the enhanced to require respondents to per­ organizations and the formulation of form data validation checks prior to regulations and supervisory policies. filing. The information is also used in respond­ In May revisions were made to ing to requests from Congress and clarify the language in the reporting the public for information on bank forms and instructions for three 106 91st Annual Report, 2004 reports—the Annual Report of Bank ments to the data collection and disclo­ Holding Companies (FR Y-6), the sure process include requiring electronic Report of Changes in Organizational submission of Call Reports to a central Structure (FR Y-10), and the Report data repository, moving forward the of Changes in FBO Organizational deadline for filing reports, and requiring Structure for foreign banking organiza­ respondents to validate their data before tions (FR Y-10F). filing. The effort to set up a central data In June the FR Y-8 was revised to repository is currently in the testing allow for collection of additional infor­ phase, and the repository is expected to mation to be used in monitoring compli­ be operational in 2005. ance with section 23A of the Federal No significant changes were made to Reserve Act and to assist in monitoring the Call Report in 2004. A proposal was derivatives transactions and establishing issued in April to make two instruc­ policy for regulating such transactions. tional clarifications to the report. The report was also revised to reflect Also in 2004, the Report of Assets interpretations and definitions in Regu­ and Liabilities of U.S. Branches and lation W, the rule that comprehensively Agencies of Foreign Banks (FFIEC 002) implements sections 23A and 23B of the was revised, effective in March, to act. include additional information on derivatives contracts. A proposal was issued in August to revise the Country Commercial Bank Exposure Report (FFIEC 009) and the Regulatory Financial Reports Country Exposure Information Report As the federal supervisor of state mem­ (FFIEC 009a) to harmonize U.S. data ber banks, the Federal Reserve, acting in with data on cross-border exposures col­ concert with the other federal banking lected by other countries. agencies through the FFIEC, requires banks to submit quarterly Reports of Condition and Income (Call Reports). Federal Financial Institutions Call Reports are the primary source of Examination Council data for the supervision and regulation During 2004 the Federal Financial Insti­ of banks and for the ongoing assessment tutions Examination Council focused on of the overall soundness of the nation’s coordinating the agencies’ efforts in the banking system. Call Report data, which area of Bank Secrecy Act examination also serve as benchmarks for the finan­ and training by enhancing communica­ cial information required by many other tion and cooperation with FinCEN, an Federal Reserve regulatory financial agency within the Treasury Department reports, are widely used by state and whose mission is to safeguard the finan­ local governments, state banking super­ cial system from terrorist financing, visors, the banking industry, securities money laundering, and other financial analysts, and the academic community. crimes. It also continued its efforts to The Federal Reserve and the other identify and eliminate outdated, unnec­ banking agencies have begun a Call essary, or unduly burdensome regula­ Report modernization project to tions, pursuant to the Economic Growth improve the timeliness and quality of and Regulatory Paperwork Reduction supervisory data and to enhance market Act of 1996. The FFIEC made signifi­ discipline by ensuring more timely cant progress on a project to modern­ access by the public. Proposed enhance­ ize and streamline the way in which Banking Supervision and Regulation 107 the banking agencies collect, process, Banks, as well as through a Systemwide and distribute quarterly bank financial committee structure, to ensure that key reports. In addition, the FFIEC contin­ staff members throughout the System ued its efforts related to examiner train­ participate in identifying requirements ing and education, consumer compli­ and setting priorities for IT initiatives. ance issues, bank surveillance processes, and information-sharing. SIT Project Management In 2004 the SIT project management Supervisory Information staff, in partnership with other Federal Technology Reserve System staff, developed a stra­ Under the direction of the division’s tegic plan for 2005–09 that identifies chief technology officer, the supervisory opportunities for enhancing business information technology (SIT) function value through the use of information within the Division of Banking Super­ technology. Another major activity was vision and Regulation facilitates the development of a program to ensure management of information technology compliance with the Federal Informa­ within the Federal Reserve System’s tion Security Management Act. In addi­ supervision function. Its goals are to tion, staff members supported modern­ ensure that ization of the Shared National Credit program as well as assessments of • IT initiatives support a broad range of opportunities in the areas of electronic supervisory activities without duplica­ applications, administrative systems, tion or overlap; and learning management systems to improve information technology ser­ • the underlying IT architecture fully vices in conjunction with efforts of supports those initiatives; Board and Reserve Bank internal IT providers. • adequate resources are devoted to interagency working groups on super­ visory initiatives (for example, Call National Information Center Report modernization and the federal The National Information Center (NIC) bridge investigation initiatives); is the Federal Reserve’s comprehensive repository for supervisory, financial, and • the supervision function’s use of tech­ banking structure data and documents. nology leverages the resources and NIC includes the structure data sys­ expertise available more broadly tem; the National Examination Database within the Federal Reserve System; (NED), which provides supervisory and personnel and state banking authorities with access to NIC data; and the Cen­ • practices that maximize the supervi­ tral Document and Text Repository sion function’s business value, cost (CDTR), which contains documents effectiveness, and quality are iden­ supporting the supervisory process. tified, analyzed, and approved for In 2004 the structure data system was implementation. modified to adhere to the industry stan­ dards for use of NAICS (North Ameri­ SIT works through assigned staff at the can Industry Classification System) Board of Governors and the Reserve business activity codes. Changes were 108 91st Annual Report, 2004 made to NED to accommodate the new effort that aims to reduce examination bank holding company supervisory rat­ costs and improve the timeliness and ing system and to provide user inter- reliability of data associated with the operability with PRISM and the CDTR. review of large, syndicated credit facili­ The CDTR was expanded to contain ties of commercial banks. At year-end examination reports for regional and 2004, BOND had 2,850 registered users community banking organizations pre­ across the Federal Reserve System, the pared by Reserve Banks. Significant OCC, the FDIC, and ten state banking resources continue to be devoted to Call departments. Report modernization for the FFIEC Central Data Repository initiative, with implementation expected in 2005. Staff Development The Federal Reserve System’s staff Banking Organization development program trains staff mem­ National Desktop bers at the Board, the Reserve Banks, Supervision of domestic banking orga­ and state banking departments who have nizations and the U.S. operations of supervisory and regulatory responsi­ foreign banking organizations is sup­ bilities as well as students from for­ ported by an automated application— eign supervisory authorities. Training the Banking Organization National is offered at the basic, intermediate, and Desktop (BOND)—that facilitates advanced levels in several disciplines secure, real-time electronic information- within bank supervision: safety and sharing and collaboration among federal soundness, information technology, and state banking regulators. During international banking, and consumer 2004 BOND was enhanced to improve affairs. Classes are conducted in Wash­ its usability, reduce administrative bur­ ington, D.C., as well as at Reserve den, increase the effectiveness of man­ Banks and other locations. agement reporting, and facilitate the The Federal Reserve System also sharing of information related to Basel II participates in training offered by the and the tracking of parallel-owned banks FFIEC and by certain other regulatory or bank holding companies (that is, agencies. The System’s involvement organizations in the United States and includes developing and implementing another country that have the same con­ basic and advanced training in relation trolling shareholder). Other enhance­ to various emerging issues as well as ments included financial holding com­ in specialized areas such as interna­ pany compliance monitoring, improved tional banking, information technology, data quality edits, the addition of appli­ municipal securities dealing, capital cations data, and changes to accommo­ markets, payment systems risk, white date the new RFI/C (D) rating scheme collar crime, and real estate lending. In for bank holding companies (see the addition, the System co-hosts the World section ‘‘Bank Holding Company Rat­ Bank Seminar for students from devel­ ing System’’). BOND has been updated oping countries. to include seamless links to the Federal In 2004 the Federal Reserve trained Reserve’s Applications Management 2,365 students in System schools, 721 in and Processing System and to a new schools sponsored by the FFIEC, and 20 system for accessing data on the Shared in other schools, for a total of 3,106, National Credit program, an interagency including 293 representatives of foreign Banking Supervision and Regulation 109

Training Programs for Banking Supervision and Regulation, 2004

Number of sessions conducted Program Total Regional

Schools or seminars conducted by the Federal Reserve Core schools Banking and supervision elements ...... 8 7 Operations and analysis ...... 5 43 Bank management ...... 1 2 Report writing ...... 12 12 Management skills ...... 9 8 Conducting meetings with management ...... 13 13 Other schools Credit risk analysis ...... 5 3 Examination management ...... 6 5 Real estate lending seminar ...... 4 3 Senior forum for current banking and regulatory issues ...... 2 2 Basel II corporate activities ...... 1 0 Basel II retail activities ...... 1 0 Principles of fiduciary supervision ...... 2 1 Commercial lending essentials for consumer affairs ...... 1 1 Consumer compliance examinations I ...... 2 0 Consumer compliance examinations II ...... 2 1 CRA examination techniques ...... 2 2 CRA risk-focused examinations ...... 2 2 Fair lending examination techniques ...... 2 2 Foreign banking organizations ...... 1 1 Information systems continuing education ...... 5 5 Capital markets seminars ...... 9 7 Technology risk integration ...... 6 6 Leadership dynamics ...... 6 6 Internal bank ratings and credit risk modeling ...... 2 2 Seminar for senior supervisors of foreign central banks1 and seven other international courses ...... 8 0

Other agencies conducting courses 2 Federal Financial Institutions Examination Council ...... 65 5 The Options Institute ...... 2 2

1. Conducted jointly with the World Bank. 2. Open to Federal Reserve employees. central banks (see table). The number of examination in one of three specialty training days in 2004 totaled 17,738. areas: safety and soundness, consumer The System gave scholarship assis­ affairs, or information technology. In tance to the states for training their 2004, 135 examiners passed the first examiners in Federal Reserve and proficiency examination. In the second FFIEC schools. Through this program, proficiency examination, 87 examiners 410 state examiners were trained—242 passed the safety and soundness exami­ in Federal Reserve courses, 158 in nation, 29 passed the consumer affairs FFIEC programs, and 10 in other examination, and 6 passed the informa­ courses. tion technology examination. The over­ A staff member seeking an examin­ all pass rate for these examinations was er’s commission is required to take a 79 percent. At the end of 2004, the first proficiency examination, which System had 1,223 field examiners, of tests knowledge of a core body of infor­ which 950 were commissioned (see mation, and also a second proficiency table). 110 91st Annual Report, 2004

Year-End Reserve Bank Supervision Levels, 2000–2004

Type of staff 2004 2003 2002 2001 2000

Field examination staff ...... 1,223 1,239 1,234 1,242 1,172 Commissioned field staff ..... 950 936 892 861 786

Regulation of the considers the financial and managerial U.S. Banking Structure resources of the applicant, the future prospects of both the applicant and the The Federal Reserve administers sev­ firm to be acquired, the convenience and eral federal statutes in relation to bank needs of the community to be served, holding companies, financial holding the potential public benefits, the com­ companies, member banks, and foreign petitive effects of the proposal, and the banking organizations—the Bank Hold­ applicant’s ability to make available to ing Company Act, the Bank Merger Act, the Federal Reserve information deemed the Change in Bank Control Act, and necessary to ensure compliance with the International Banking Act. In admin­ applicable law. In the case of a foreign istering these statutes, the Federal banking organization seeking to acquire Reserve acts on a variety of proposals control of a U.S. bank, the Federal that would directly or indirectly affect Reserve also considers whether the for­ the structure of U.S. banking at the local, eign bank is subject to comprehensive regional, and national levels; the inter­ supervision or regulation on a consoli­ national operations of domestic banking dated basis by its home country supervi­ organizations; and the U.S. banking sor. Data on decisions regarding domes­ operations of foreign banks. tic and international applications in 2004 are shown in the accompanying table. Bank Holding Company Act Bank holding companies generally may engage in only those activities that Under the Bank Holding Company Act, the Board has previously determined a corporation or similar organization to be closely related to banking under must obtain the Federal Reserve’s section 4(c)(8) of the Bank Holding approval before forming a bank holding Company Act. Since 1996, the act has company through the acquisition of one provided an expedited prior-notice pro­ or more banks in the United States. cedure for certain permissible nonbank Once formed, a bank holding company activities and for acquisitions of small must receive Federal Reserve approval banks and nonbank entities. Since that before acquiring or establishing addi­ time the act has also permitted well-run tional banks. The act also identifies bank holding companies that satisfy cer­ activities permissible for bank holding tain criteria to commence certain other companies; depending on the circum­ nonbank activities on a de novo basis stances, these activities may or may not without first obtaining Federal Reserve require Federal Reserve approval in approval. advance of their commencement. Since 2000, the Bank Holding Com­ When reviewing a bank holding com­ pany Act has permitted the creation pany application or notice that requires of a special type of bank holding com­ prior approval, the Federal Reserve pany called a financial holding com­ Banking Supervision and Regulation 111

Decisions by the Federal Reserve on Domestic and International Applications, 2004

Action under authority delegated by the Board of Governors Direct action by the Director of the Board of Governors Office Proposal Division of Banking of the Federal Total Supervision and Secretary Reserve Banks Regulation

Approved Denied Permitted Approved Denied Approved Approved Permitted

Formation of bank holding company ...... 9 0 0 0 0 0 135 43 187 Merger of bank holding company ...... 14 0 1 0 0 3 27 25 70 Acquisition or retention of bank ...... 16 0 1 0 0 11 114 26 168 Acquisition of nonbank ...... 0 0 31 0 0 5 0 108 144 Merger of bank ...... 4 0 0 0 0 9 67 0 80 Change in control .... 0 0 1 0 0 0 0 124 125 Establishment of a branch, agency, or representative officebya foreign bank .... 1 0 0 8 0 0 0 0 9 Other ...... 134 0 0 85 0 98 941 507 1,765 Total ...... 178 0 34 93 0 126 1,284 833 2,548

pany. Financial holding companies are agency. If the institution surviving the allowed to engage in a broader range of merger is a state member bank, the Fed­ nonbank activities than are traditional eral Reserve has primary jurisdiction. bank holding companies. Among other Before acting on a merger proposal, the things, they may affiliate with securi­ Federal Reserve considers the financial ties firms and insurance companies and and managerial resources of the appli­ engage in certain merchant banking cant, the future prospects of the existing activities. Bank holding companies and combined organizations, the con­ seeking financial holding company sta­ venience and needs of the community tus must file a written declaration with to be served, and the competitive effects the Federal Reserve. In 2004, 47 domes­ of the proposed merger. It also consid­ tic financial holding company declara­ ers the views of certain other agen­ tions and 5 foreign bank declarations cies regarding the competitive factors were approved. involved in the transaction. In 2004 the Federal Reserve approved 80 merger applications. Bank Merger Act When the FDIC, the OCC, or the The Bank Merger Act requires that OTS has jurisdiction over a merger, the all proposals involving the merger of Federal Reserve is asked to comment insured depository institutions be acted on the competitive factors related to the on by the appropriate federal banking proposal. By using standard terminol­ 112 91st Annual Report, 2004 ogy in assessing competitive factors agencies, commercial lending company in merger proposals, the four agencies subsidiaries, or representative offices in have sought to ensure consistency in the United States. administering the Bank Merger Act. The In reviewing proposals, the Federal Federal Reserve submitted 534 reports Reserve generally considers whether on competitive factors to the other agen­ the foreign bank is subject to compre­ cies in 2004. hensive supervision or regulation on a consolidated basis by its home country supervisor. It also considers whether the Change in Bank Control Act home country supervisor has consented to the establishment of the U.S. office; The Change in Bank Control Act the financial condition and resources of requires persons seeking control of a the foreign bank and its existing U.S. U.S. bank or bank holding company to operations; the managerial resources obtain approval from the appropriate of the foreign bank; whether the home federal banking agency before complet­ country supervisor shares information ing the transaction. The Federal Reserve regarding the operations of the foreign is responsible for reviewing changes in bank with other supervisory authorities; the control of state member banks and whether the foreign bank has provided bank holding companies. In its review, adequate assurances that information the Federal Reserve considers the finan­ concerning its operations and activities cial position, competence, experience, will be made available to the Federal and integrity of the acquiring person; Reserve, if deemed necessary to deter­ the effect of the proposed change on the mine and enforce compliance with financial condition of the bank or bank applicable law; whether the foreign bank holding company being acquired; the has adopted and implemented proce­ effect of the proposed change on compe­ dures to combat money laundering and tition in any relevant market; the com­ whether the home country of the foreign pleteness of the information submitted bank is developing a legal regime to by the acquiring person; and whether address money laundering or is partici­ the proposed change would have an pating in multilateral efforts to combat adverse effect on the federal deposit money laundering; and the record of the insurance funds. As part of the process, foreign bank with respect to compliance the Federal Reserve may contact other with U.S. law. regulatory or law enforcement agen­ In 2004 the Federal Reserve approved cies for information about relevant 9 applications by foreign banks to estab­ individuals. lish branches, agencies, and representa­ In 2004 the Federal Reserve approved tive offices in the United States. 125 changes in control of state member banks and bank holding companies. Overseas Investments by U.S. Banking Organizations International Banking Act U.S. banking organizations may engage The International Banking Act, as in a broad range of activities overseas. amended by the Foreign Bank Supervi­ Many of the activities are conducted sion Enhancement Act of 1991, requires indirectly through Edge Act and agree­ foreign banks to obtain Federal Reserve ment corporation subsidiaries. Although approval before establishing branches, most foreign investments are made Banking Supervision and Regulation 113 under general consent procedures that Stock Repurchases by involve only after-the-fact notification Bank Holding Companies to the Federal Reserve, large and other significant investments require prior A bank holding company may repur­ approval. In 2004 the Federal Reserve chase its own shares from its share­ approved 27 proposals for significant holders. When the company borrows overseas investments by U.S. banking money to buy the shares, the trans­ organizations. The Federal Reserve also action increases the company’s debt approved 14 applications to make addi­ and decreases its equity. The Federal tional investments through an Edge Act Reserve may object to stock repurchases or agreement corporation, 5 applications by holding companies that fail to meet to extend the corporate existence of certain standards, including the Board’s or acquire an Edge Act corporation, and capital adequacy guidelines. In 2004 4 applications to establish or acquire an the Federal Reserve reviewed 16 stock agreement corporation. repurchase proposals by bank holding companies; all were approved by a Reserve Bank under delegated authority. Applications by Member Banks Public Notice of State member banks must obtain Fed­ Federal Reserve Decisions eral Reserve approval to establish domestic branches, and all member Certain decisions by the Federal Reserve banks (including national banks) must that involve a bank holding company, a obtain Federal Reserve approval to bank merger, a change in control, or the establish foreign branches. When establishment of a new U.S. banking reviewing proposals to establish domes­ presence by a foreign bank are made tic branches, the Federal Reserve con­ known to the public by an order or an siders the scope and nature of the announcement. Orders state the decision, banking activities to be conducted. the essential facts of the application or When reviewing proposals for foreign notice, and the basis for the decision; branches, the Federal Reserve consid­ announcements state only the decision. ers, among other things, the condition of All orders and announcements are made the bank and the bank’s experience in public immediately; they are subse­ international banking. In 2004 the Fed­ quently reported in the Board’s weekly eral Reserve acted on new and merger- H.2 statistical release and in the Federal related branch proposals for 1,428 Reserve Bulletin. The H.2 release also domestic branches and granted prior contains announcements of applications approval for the establishment of and notices received by the Federal 34 new foreign branches. Reserve upon which action has not yet State member banks must also obtain been taken. For each pending application Federal Reserve approval to establish and notice, the related H.2A contains the financial subsidiaries. These subsidiaries deadline for comments. The Board’s web may engage in activities that are finan­ site (www.federalreserve.gov) provides cial in nature or incidental to financial information on orders and announce­ activities, including securities and insur­ ments as well as a guide for U.S. and ance agency-related activities. In 2004, foreign banking organizations submitting 2 applications for financial subsidiaries applications or notices to the Federal were approved. Reserve. 114 91st Annual Report, 2004

Timely Processing of Applications the credit is used to trade debt and equity securities. The Board’s Regula­ The Federal Reserve sets internal target tion U limits the amount of credit that time frames for the processing of appli­ may be provided by lenders other than cations. The setting of internal targets brokers and dealers when the credit is promotes efficiency at the Board and the used to purchase or carry publicly held Reserve Banks and reduces the burden equity securities if the loan is secured by on applicants. Generally, the length of those or other publicly held equity secu­ the target period ranges from twelve rities. The Board’s Regulation X applies to sixty days, depending on the type of these credit limitations, or margin application or notice filed. In 2004, requirements, to certain borrowers and 92 percent of decisions were made to certain credit extensions, such as within the target time period. credit obtained from foreign lenders by U.S. citizens. Enforcement of Several regulatory agencies enforce Other Laws and Regulations the Board’s securities credit regulations. The SEC, the National Association of The Federal Reserve’s enforcement Securities Dealers, and the national responsibilities also extend to financial securities exchanges examine brokers disclosures by state member banks, and dealers for compliance with Regula­ securities credit, and extensions of credit tion T. With respect to compliance with to executive officers. Regulation U, the federal banking agen­ cies examine banks under their respec­ Financial Disclosures by tive jurisdictions; the Farm Credit State Member Banks Administration, the National Credit Union Administration, and the OTS State member banks that issue securities examine lenders under their respective registered under the Securities Exchange jurisdictions; and the Federal Reserve Act of 1934 must disclose certain infor­ examines other Regulation U lenders. mation of interest to investors, including Since 1998, the Board has published annual and quarterly financial reports a list of foreign stocks that meet the and proxy statements. By statute, the requirements of section 220.11 of Regu­ Board’s financial disclosure rules must lation T (Credit by Brokers and Deal­ be substantially similar to those of ers), thereby making them eligible for the SEC. At the end of 2004, 15 state margin treatment at broker–dealers on member banks were registered with the the same basis as domestic margin secu­ Board under the Securities Exchange rities. In March 2004 the Board removed Act. all the stocks from its Foreign Mar­ gin Stock List because the stocks had Securities Credit not been recertified under procedures approved by the Board in 1990. For­ Under the Securities Exchange Act, the eign stocks may also qualify as margin Board is responsible for regulating securities by being deemed to have credit in certain transactions involving a ‘‘ready market’’ under the SEC’s the purchase or carrying of securities. net capital rule (17 CFR 240.15c3-3) The Board’s Regulation T limits the (see the March 3, 2004, press release amount of credit that may be provided at www.federalreserve.gov/boarddocs/ by securities brokers and dealers when press/all/2004/). Banking Supervision and Regulation 115

Extensions of Credit by State Member Banks to their Executive Officers, 2003 and 2004

Range of interest Period Number Amount (dollars) rates charged (percent)

2003 October 1–December 31 ...... 590 66,901,000 0.0–18.0 2004 January 1–March 31 ...... 545 62,624,000 0.0–18.0 April 1–June 30 ...... 576 79,207,000 0.0–18.0 July 1–September 30 ...... 479 72,401,000 0.0–19.8 October 1–December 31 ...... 476 53,083,000 0.0–20.8

Source. Call Reports.

Extensions of Federal Reserve Membership Credit to Executive Officers At the end of 2004, 2,794 banks were Under section 22(g) of the Federal members of the Federal Reserve System Reserve Act, a state member bank must and were operating 51,864 branches. include in its quarterly Call Report These banks accounted for 37 percent of information on all extensions of credit all commercial banks in the United by the bank to its executive officers States and for 73 percent of all commer­ since the date of the preceding report. cial banking offices. The accompanying table summarizes this information for 2004. 117

Federal Reserve Banks

The Federal Reserve Banks contribute environment, see the box ‘‘Reserve to the setting of national monetary pol­ Bank Services in a Changing Payments icy and are involved in the supervision Market.’’) and regulation of banks and other finan­ In addition to acting to control costs cial entities. They also operate a nation­ for priced services, the Reserve Banks wide payments system, distribute the have undertaken a number of projects nation’s currency and coin, and serve as to reduce support and overhead costs. fiscal agent and depository to the United They have consolidated operations States. locally and nationally, adopted more- efficient practices, and adjusted staffing levels commensurate with a shrinking Major Initiatives base of internal customers requiring sup­ In 2004, the Federal Reserve Banks con­ port services. Reserve Bank support and tinued to pursue efficiencies in their overhead costs, including national sup­ operations, including the provision of port services, decreased $68 million, or priced services, and in support and 6 percent, from 2003 to 2004.1 Over the overhead. same period, ANP associated with sup­ The Reserve Banks are processing a port and overhead areas declined 700, or declining number of checks as consum­ 8 percent.2 ers and businesses make more payments Over the past several years, the electronically. Because of the decline, Reserve Banks have consolidated their the Banks have found it challenging to employee health and welfare plans, fully recover their costs as required by human resources information systems, the Monetary Control Act of 1980. In and payroll-processing operations. response, the Banks are fundamentally These plans, systems, and operations restructuring their check operations. previously were unique to each Bank During the year, they completed the first and were managed and administered phase of a check restructuring initiative, from each Reserve Bank head office. reducing the number of Federal Reserve Although some of the consolidations are check-processing and check-adjustment not yet complete, each has already gen­ locations. The initiative has reduced erated significant cost savings. The sav­ Reserve Bank check operating expenses ings resulting from staff reductions in and staffing levels; since 1999, the num­ support and overhead functions is ber of employees processing checks has expected to be $3.9 million when fully declined about 25 percent, to approxi­ implemented in 2006. The savings mately 4,000 at the end of 2004. As the resulting from lower vendor fees and market for check collection services continues to decline, the Banks will pur­ sue additional restructuring efforts and 1. National support services include functions and projects managed by a Reserve Bank on staffing reductions to achieve full cost behalf of the other Reserve Banks. recovery. (For a broad discussion of 2. ANP is the number of employees during a the Reserve Banks’ response to today’s year in terms of full-time positions. 118 91st Annual Report, 2004

Reserve Bank Services in a Changing Payments Market

More payments in the United States are wide-ranging dialogue on improving the now being made electronically than by payments system by sponsoring several check. The number of checks written annu­ conferences and seminars and by conduct­ ally peaked in the mid-1990s at around ing other outreach activities. 50 billion. By 2003, the number was down The Federal Reserve also worked with to about 37 billion. In contrast, the number the financial services industry, the legal of payments made electronically via credit community, consumer and business repre­ and debit cards, the automated clearing­ sentatives, and Congress to enact the house (ACH), and electronic benefit trans­ Check Clearing for the 21st Century Act fer cards was about 45 billion in 2003, up (Check 21), which facilitates (but does not from approximately 15 billion in the mid­ mandate) the greater use of electronics 1990s. in the processing of checks. The Board The shift largely reflects a growing con­ amended two of its regulations concerned sumer and business preference for mak­ with check processing (Regulations J and ing payments electronically, particularly by CC) to implement the law and has worked debit card. It has also been spurred by the closely with the Reserve Banks and the financial services industry through its use industry to educate the public about the of new technologies, introduction of new implications of Check 21 for consumers. products and services, and adoption of The Board also clarified the application of operating rules and standards that support the consumer protections in Regulation E the greater use of electronic payments. For to electronic payments made via check example, recent industry rule changes have conversion.1 enabled businesses to use the informa­ The ongoing shift to electronic payments tion on a consumer’s check to transfer has affected the Reserve Banks’ check- funds electronically using the ACH, a pro­ processing operations. The number of cess now commonly known as check checks collected annually through the conversion. Banks has fallen nearly 20 percent since The Federal Reserve has supported and helped facilitate this ongoing transition to a 1. Consumer information on Check 21 and more-electronic payments system. Its Pay­ electronic check conversion is available at ments System Development Committee, www.federalreserve.gov/consumers.htm. Bank­ chaired by Vice Chairman Roger Ferguson ing industry educational and reference material and Minneapolis Federal Reserve Bank on Check 21 is available at www.ffiec.gov/ President Gary Stern, has promoted a exam/check21/default.htm. from lower plan costs due to consoli­ innovation and to increase payments dation of health and welfare plans is system efficiency by reducing legal expected to be $25 million in 2005. impediments to check truncation. The other significant initiative affect­ ing Reserve Bank check operations in 2004 was the introduction of products, Developments in services, and associated infrastructure Federal Reserve Priced Services related to the Check Clearing for the The Monetary Control Act of 1980 21st Century Act (Check 21), which requires that the Federal Reserve set took effect in October. Check 21 is fees for providing ‘‘priced services’’ to intended to foster payments system depository institutions that, over the Federal Reserve Banks 119

1999, to fewer than 14 billion in 2004. And with a declining check market, the Banks the decline is accelerating, as the Banks also have begun to fundamentally restruc­ processed 12 percent fewer checks in 2004 ture the location and nature of their than in 2003. As a result, the revenue the national check-processing operations. The Banks earn from providing check collec­ number of offices at which checks are pro­ tion services to depository institutions has cessed was reduced from forty-five at the begun to decline. Over the past five years, beginning of 2003 to thirty-two by the end the Banks also made a significant invest­ of 2004. A further reduction, to twenty- ment in modernizing and improving three offices, will be completed in early the longer-term efficiency of their check- 2006. As part of these changes, five processing operations. regional sites dedicated solely to process­ This combination of market and busi­ ing checks have been closed. Additional ness factors has challenged the Reserve restructuring will occur in response to con­ Banks’ ability to meet the expectations of tinued market changes in the use of checks. the Monetary Control Act of 1980 (MCA). Major improvements in the operational The MCA requires that the Banks set fees efficiency and productivity of Reserve for providing payment services (including Bank check-collection operations have check collection services) to depository resulted from these initiatives. The Cincin­ institutions to recover, over the long run, nati check-processing office, for example, all the direct, indirect, and imputed costs of now processes both its own usual volume providing the services, including the taxes and the checks previously processed at the that would have been paid and the return Indianapolis, Louisville, and Charleston on equity that would have been earned had offices. The number of employees provid­ the services been provided by a private ing check-collection services has been firm. reduced to approximately 4,000, about one- To better meet the MCA requirements, fourth fewer than in 1999 and the lowest the Reserve Banks have undertaken a range level since enactment of MCA. Although of cost-reduction and revenue-generation the one-time charges associated with the initiatives as part of a long-term business restructuring efforts have been substantial, strategy to facilitate the greater use of elec­ the costs of ongoing operations have tronics in check processing. These initia­ decreased. As a result, the Reserve Banks tives have included streamlining manage­ expect to recover fully all the costs of ment structures, reducing staffing levels, providing check-collection services in 2005 increasing productivity, and selectively and to continue to meet their broader statu­ raising fees. To better align their operations tory obligations over the longer term. long run, recover all the direct and indi­ years, the Federal Reserve Banks have rect costs of providing the services as recovered 97.5 percent of their priced well as the imputed costs, such as the services costs, including the PSAF income taxes that would have been paid (table). and the return on equity that would have been earned had the services been pro­ costs: interest on debt, sales taxes, and assess­ vided by a private firm. The imputed ments for deposit insurance by the Federal Deposit costs and imputed profit are collectively Insurance Corporation. Also allocated to priced services are assets and personnel costs of the referred to as the private-sector adjust­ Board of Governors that are related to priced 3 ment factor (PSAF). Over the past ten services; in the pro forma statements at the end of this chapter, Board expenses are included in oper­ 3. In addition to income taxes and the return on ating expenses and Board assets are part of long- equity, the PSAF is made up of three imputed term assets. 120 91st Annual Report, 2004

Priced Services Cost Recovery, 1995–2004 Millions of dollars except as noted

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

1995 ...... 765.2 752.7 31.5 784.2 97.6 1996 ...... 815.9 746.4 42.9 789.3 103.4 1997 ...... 818.8 752.8 54.3 807.1 101.5 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

1995–2004 ...... 8,705.1 8,156.4 769.9 8,926.5 97.5

Note. Here and elsewhere in this chapter, components 2. For the ten-year period, includes operating expenses may not sum to totals or yield percentages shown because of $7,490.2 million, imputed costs of $387.7 million, and of rounding. imputed income taxes of $259.1 million. Also includes 1. For the ten-year period, includes revenue from ser­ the effect of a one-time accounting change net of taxes of vices of $8,444.2 million and other income and expense $19.4 million for 1995. (net) of $261.0 million. 3. Revenue from services divided by total costs.

Overall, the price index for priced totaled $709.6 million, of which services increased 6.7 percent from $45.3 million was attributable to the 2003. Revenue from priced services transportation of commercial checks amounted to $865.9 million, other between Reserve Bank check- income related to priced services was processing centers. Revenue amounted $48.7 million, and costs related to priced to $719.7 million, of which $45.8 mil­ services were $842.6 million, resulting lion was attributable to estimated reve­ in net income of $72.0 million. In 2004, nues derived from the transportation the Reserve Banks recovered 95.8 per­ of commercial checks between Reserve cent of total costs of $955 million, Bank check-processing centers, and including the PSAF.4 other income was $40.5 million. The resulting net income was $50.5 million. Check service revenue in 2004 declined Commercial Check $22.3 million from 2003, largely because Collection Service of declining volume and customers’ moving to lower-priced products. In 2004, operating expenses and The Reserve Banks handled 13.9 bil­ imputed costs for the Reserve Banks’ lion checks in 2004, a decrease of commercial check collection service 12.0 percent from the 15.8 billion checks handled in 2003 (table). The decline in Reserve Bank check volume 4. Financial data reported throughout this chapter—revenue, other income, cost, net reve­ is consistent with nationwide trends nue, and income before taxes—can be linked to the pro forma statements at the end of this chapter. Other income is revenue from investment of clear­ (interest on debt, interest on float, sales taxes, and ing balances net of earnings credits, an amount the Federal Deposit Insurance Corporation assess­ termed net income on clearing balances. Total cost ment), imputed income taxes, and the targeted is the sum of operating expenses, imputed costs return on equity. Federal Reserve Banks 121

Activity in Federal Reserve Priced Services, 2002–2004 Thousands of items

Percent change Service 2004 2003 2002 2003 to 2004 2002 to 2003

Commercial check ...... 13,904,382 15,805,894 16,586,804 −12.0 −4.7 Funds transfer ...... 128,270 125,936 117,133 1.9 7.5 Securities transfer ...... 9,208 10,071 8,480 −8.6 18.8 Commercial ACH ...... 6,486,091 5,588,381 4,986,152 16.1 12.1 Noncash ...... 211 280 333 −24.7 −15.8

Note. Activity in commercial check is the total num­ line; in commercial ACH, the total number of commercial ber of commercial checks collected, including processed items processed; and in noncash, the number of items on and fine-sort items; in funds transfer and securities trans­ which fees were assessed. fer, the number of transactions originated online and off- away from the use of checks and toward ville. Omaha check processing has been greater use of electronic payment meth­ consolidated to Des Moines; Richmond ods.5 Overall, the price index for check to Baltimore; Little Rock to Memphis; services increased 8.7 percent from and Columbia (South Carolina) to Char­ 2003. lotte. Both El Paso and San Antonio In response to the continuing decline have been consolidated to Dallas, and in check volume, the Reserve Banks both Milwaukee and Peoria to Chicago. took further steps in 2004 to reduce Volume from Charleston (West Vir­ check service operating costs by imple­ gina), Louisville, and Indianapolis is menting a business and operational strat­ now processed in Cincinnati. egy that will position the service to Of all the checks presented by the achieve its financial and payment sys­ Reserve Banks to paying banks, tem objectives over the long term. The 23.1 percent (approximately 3.2 bil­ strategy will reduce operating costs lion checks) were presented electroni­ through a combination of measures: cally, compared with 22.7 percent in streamlining management structures, 2003. The Banks captured images of reducing staff, decreasing the number of 10.4 percent of the checks they col­ check-processing locations, and increas­ lected, an increase from 9.3 percent in ing processing capacity at some 2003. locations. In 2004, check-processing The Reserve Banks also expanded the facilities were closed at some locations services available to depository institu­ and the work moved to others. Checks tions through the web during the year. that would have been processed in These investments are expected to Miami are now processed in Jackson­ increase operating efficiency and the Reserve Banks’ ability to offer addi­ 5. The Federal Reserve System’s recent retail tional services to depository institutions. payments research suggests that the number of checks written in the United States has been declining since the mid-1990s. See Federal Commercial Automated Reserve System, ‘‘The 2004 Federal Reserve Payments Study: Analysis of Noncash Pay­ Clearinghouse Services ments Trends in the United States, 2000–2003’’ (December 2004). (www.frbservices.org/Retail/ Reserve Bank operating expenses and pdf/2004PaymentResearchReport.pdf) imputed costs for commercial automated 122 91st Annual Report, 2004 clearinghouse (ACH) services totaled eastern time. The impetus for the expan­ $64.0 million in 2004. Revenue from sion of operating hours was industry ACH operations totaled $71.1 million requests to achieve greater overlap of and other income totaled $4.0 million, wholesale payments system operating resulting in net income of $11.1 million. hours in U.S. and Asia–Pacific markets. The Banks processed 6.5 billion commercial ACH transactions (worth National Settlement Service $12.5 trillion), an increase of 16.1 per­ Private clearing arrangements that cent from 2003. Overall, the price index exchange and settle transactions may for ACH services decreased 10.2 per­ use the Reserve Banks’ National Settle­ cent from 2003. ment Service to settle their transactions. In 2004, the Reserve Banks began This service is provided to approxi­ offering international ACH funds trans­ mately seventy local and national pri­ fer service from the United States to vate arrangements, primarily check Austria, Canada, Germany, Mexico, and clearinghouse associations but also other the Netherlands. The Banks also offer types of arrangements. In 2004, the service to Switzerland and the United Reserve Banks processed slightly fewer Kingdom. than 435,000 settlement entries for these arrangements. Fedwire Funds and National Settlement Services Fedwire Securities Service Reserve Bank operating expenses and The Fedwire Securities Service allows imputed costs for the Fedwire Funds participants to electronically transfer and National Settlement Services totaled securities issued by the U.S. Trea­ $50.7 million in 2004. Revenue from sury, federal government agencies, these operations totaled $54.1 mil­ government-sponsored enterprises, and lion, and other income amounted to certain international organizations to $3.0 million, resulting in net income of other participants in the United States.6 $6.5 million. Reserve Bank operating expenses and imputed costs for providing this service Fedwire Funds Service totaled $16.9 million in 2004. Revenue The Fedwire Funds Service allows par­ from the service totaled $19.3 mil­ ticipants to draw on their reserve or lion, and other income totaled $1.1 mil­ clearing balances at the Reserve Banks lion, resulting in net income of $3.4 mil­ and transfer funds to other institutions lion. Approximately 9.2 million trans­ that maintain accounts at the Banks. In fers of Treasury and other securities 2004, the number of Fedwire funds transfers originated by depository insti­ tutions increased 1.9 percent from 2003, 6. The expenses, revenues, and volumes reported here are for transfers of securities issued to approximately 128.3 million. In May, by federal government agencies, government- the Banks expanded the operating hours sponsored enterprises, and international institu­ for the online service. The service is tions. The Treasury Department assesses fees on now open three and one-half hours depository institutions for some of the transfer, account maintenance, and settlement services for earlier—at 9:00 p.m. eastern time the U.S. Treasury securities provided by the Reserve preceding calendar day rather than the Banks. For details, see the section ‘‘Debt Ser­ previous opening time of 12:30 a.m. vices’’ later in this chapter. Federal Reserve Banks 123 were processed by the service during The Federal Reserve includes the cost the year, a decrease of 8.6 percent of or income from float associated with from 2003. In 2004, the fee for securi­ priced services as part of the fees for ties transfers decreased from $0.40 to those services. $0.32, and the surcharge for offline transfers increased from $25 to $28. Developments in Currency and Coin Noncash Collection Service The Reserve Banks received 37.5 billion The Reserve Banks provide a service to Federal Reserve notes from circulation collect and process municipal bearer in 2004, a 5.1 percent increase from bonds and coupons issued by state and 2003, and made payments of 37.9 bil­ local governments (referred to as ‘‘non­ lion notes into circulation, a 3.6 percent cash’’ items). The service, which is cen­ increase from 2003. They received tralized at one Federal Reserve office, 55.7 billion coins from circulation in processed slightly less than 211,000 2004, a 15.6 percent increase from 2003, noncash transactions in 2004, represent­ and made payments of 67.5 billion coins ing a 24.7 percent decline in volume into circulation, a 9.8 percent increase from 2003. Operating expenses and from 2003.8 imputed costs for noncash operations In October 2004, the Reserve Banks totaled $1.4 million in 2004, and reve­ began issuing the redesigned $50 Fed­ nue and other income totaled $1.9 mil­ eral Reserve note, which has enhanced lion, resulting in net income of $0.5 mil­ security features and subtle background lion. The fee for return items increased colors. In connection with issuance of from $20 to $35. the new notes, the Federal Reserve and In October, the Board requested com­ the Bureau of Engraving and Printing ment on a proposal to withdraw from conducted a public education campaign the noncash collection service at year­ to raise awareness of the note’s design end 2005. The volume of coupons and and security features. bonds presented for collection is declin­ In 2003, the Board requested com­ ing, a result of a continuing decline in ments on a proposed cash-recirculation the number of physical municipal secu­ policy intended to change its cash- rities outstanding since passage of the services policy to reduce overuse of Tax Equity and Fiscal Responsibility Reserve Bank cash-processing services. Act of 1982, which removed tax advan­ Currently, many depository institutions tages for investors and effectively led to order currency late in the week to meet the end of issuance of bearer municipal temporary, cyclical demand and then securities. return the currency to a Federal Reserve facility several days later to minimize their holdings of vault cash, which does Float not earn interest. The process repeats The Federal Reserve had daily average each week, and the Federal Reserve credit float of $76.4 million in 2004, facility receiving the returned currency compared with $43.0 million in 2003.7 must process it each time. To test the effectiveness of a program that supports 7. Credit float occurs when the Reserve Banks receive settlement for items prior to providing 8. Percentages reflect restatements of previ­ credit to the depositing institution. ously reported data. 124 91st Annual Report, 2004 the proposed cash-recirculation policy, The cost of providing services to other the Banks established eleven custodial entities was $28.4 million, compared inventory sites in 2004. Custodial inven­ with $35.3 million in 2003. In 2004, as tories allow depository institutions to in 2003, the Treasury and other entities transfer a portion of their cash holdings reimbursed the Reserve Banks for the to the books of a Reserve Bank and are costs of providing these services. intended to encourage depository insti­ The most significant development in tutions to recirculate fit currency rather relation to the fiscal agency service in than return it to the Federal Reserve for 2004 was the Reserve Banks’ consoli­ processing. The program will operate dation of operations that support the for six months, after which the Federal Treasury’s retail securities programs, Reserve will evaluate the program’s through which retail investors purchase effectiveness in promoting currency and hold marketable Treasury securities recirculation. and savings bonds. As the Treasury In 2004, the Federal Reserve also replaced paper processes in retail securi­ established a group to study the poten­ ties with more-efficient electronic pro­ tial effects of the proposed cash- cesses, fewer operations sites were recirculation policy on the quality of needed. In December 2003, the Trea­ currency in circulation. The group is sury directed the Banks to consolidate working with the vending industry and their retail securities operations from manufacturers of currency-handling seven sites to two. The consolidation equipment to evaluate the importance of has proceeded ahead of schedule and currency quality for their industries. should be completed late in 2005. The Banks expect that in 2006, annual oper­ ating costs for the retail securities opera­ Developments in tions will decline significantly because Fiscal Agency and of lower personnel costs. Government Depository Services As fiscal agents and depositories for the Debt Services federal government, the Federal Reserve The Reserve Banks auction, provide Banks provide services related to the safekeeping for, and transfer market­ federal debt, help the Treasury collect able Treasury securities. Reserve Bank funds owed to the government, process operating expenses for these activi­ electronic and check payments for the ties totaled $23.4 million in 2004, an Treasury, maintain the Treasury’s bank 8.3 percent increase from 2003. The account, and invest excess Treasury bal­ Banks processed more than 156,000 ten­ ances. The Reserve Banks also provide ders for Treasury securities, compared limited fiscal agency and depository ser­ with 140,000 in 2003, and handled vices to other entities. 2 million reinvestment requests, com­ The total cost of providing fiscal pared with 2.2 million in 2003. The agency and depository services to the Banks originated 10.7 million trans­ Treasury and other entities in 2004 fers of Treasury securities in 2004, a amounted to $369.8 million, compared 13.6 percent increase from 2003. As of with $327.0 million in 2003 (table). December 31, 2004, the Reserve Banks’ Treasury-related costs were $341.4 mil­ Fedwire Securities Service maintained lion in 2004, compared with $291.7 mil­ custody of $3.9 trillion (par value) of lion in 2003, an increase of 17 percent. Treasury securities. Federal Reserve Banks 125

Expenses of the Federal Reserve Banks for Fiscal Agency and Depository Services, 2002–2004 Thousands of dollars

Agency and service 2004 2003 2002

Department of the Treasury Bureau of the Public Debt Treasury retail securities Savings bonds ...... 72,385.1 66,403.7 68,888.3 TreasuryDirect and Treasury coupons ...... 30,872.7 33,013.5 33,953.6 Treasury securities safekeeping and transfer ...... 6,267.0 4,836.3 8,830.1 Treasury auction ...... 17,159.5 16,802.6 14,597.6 Computer infrastructure development and support ...... 5,935.1 7,836.7 2,349.6 Other services ...... 1,709.8 1,460.7 2,385.8 Total ...... 134,329.1 130,353.4 131,005.0 Financial Management Service Payment services Government check processing ...... 24,245.4 25,624.7 30,284.4 Automated clearinghouse ...... 5,352.9 6,253.9 6,280.0 Fedwire funds transfers ...... 111.6 187.3 201.4 Other payment-related services ...... 33,646.9 23,630.8 20,172.1 Collection services Tax and other revenue collections ...... 34,248.4 29,782.9 26,361.3 Other collection-related services ...... 12,922.8 12,532.6 10,296.4 Cash management services ...... 21,835.8 18,227.8 17,310.8 Computer infrastructure development and support ...... 52,673.3 24,575.3 7,592.6 Other services ...... 6,931.6 6,666.2 5,415.8 Total ...... 191,968.6 147,481.5 123,914.7 Other Treasury Total ...... 15,106.1 13,913.5 14,471.2 Total, Treasury ...... 341,403.7 291,748.5 269,390.9 Other Federal Agencies Department of Agriculture Food coupons ...... 4,519.0 7,791.4 10,240.8 U.S. Postal Service Postal money orders ...... 7,774.6 10,959.5 12,381.6 Other agencies Other services ...... 16,104.0 16,508.2 16,494.1 Total, other agencies ...... 28,397.5 35,259.2 39,116.5 Total reimbursable expenses ...... 369,801.2 327,007.7 308,507.4

In support of the Treasury’s retail As of December 31, 2004, Treasury- securities programs, the Reserve Banks Direct held $62.2 billion (par value) of operate TreasuryDirect, a program that marketable Treasury securities. allows retail investors to purchase and TreasuryDirect customers may sell hold Treasury securities directly with their securities for a fee through Sell the Treasury instead of through a broker. Direct, a program operated by one of As the program was designed for inves­ the Reserve Banks. That Bank sold tors who plan to hold their securities approximately 15,000 securities worth to maturity, TreasuryDirect provides $673.3 million in 2004, compared with custody services only. Reserve Bank more than 14,000 securities worth operating expenses for TreasuryDirect $671.6 million in 2003. It collected totaled $30.9 million in 2004, compared approximately $504,000 in fees on with $33.0 million in 2003. In 2004, behalf of the Treasury, an increase of investors purchased 13.7 billion of Trea­ 2.6 percent from the more than $491,000 sury securities through TreasuryDirect. in fees collected in 2003. 126 91st Annual Report, 2004

Reserve Bank operating expenses for sury’s stored value card program, which issuing, servicing, and redeeming sav­ provides salary and allowance payments ings bonds totaled $72.4 million in to military personnel, via a smart card, 2004, an increase of 9 percent from for use at military bases. In 2004, the 2003. The Banks printed and mailed Banks worked with the Treasury on more than 35 million savings bonds, an plans for a web-based application to 11.4 percent decrease from 2003. They allow federal agencies and vendors to issued more than 4.2 million Series I electronically exchange purchase orders (inflation indexed) bonds and 25.4 mil­ and invoices and initiate ACH pay­ lion Series EE bonds. Reissued or ments. The operating costs for these exchanged bonds accounted for the three programs totaled $15.4 million in remaining bonds printed. The Banks 2004, compared with $14.3 million in processed about 601,000 redemption, 2003. reissue, and exchange transactions, a 5.8 percent increase from 2003. Collection Services The Reserve Banks support several Payments Services Treasury programs to collect funds The Reserve Banks process both elec­ owed the government. Reserve Bank tronic and check payments for the Trea­ operating expenses related to these pro­ sury. Reserve Bank operating expenses grams totaled $47.2 million in 2004, for processing government payments compared with $42.3 million in 2003. totaled $63.4 million in 2004, compared The Banks operate the Federal Reserve with $55.7 million in 2003. The Banks Electronic Tax Application (FR-ETA) as processed 940 million ACH payments an adjunct to the Treasury’s Electronic for the Treasury, an increase of 3.0 per­ Federal Tax Payment System (EFTPS). cent from 2003, and 876,000 Fedwire EFTPS allows businesses and individual funds transfers, a decrease of 11.5 per­ taxpayers to pay their taxes electroni­ cent from 2003 (the latter percentage cally. Because EFTPS uses the auto­ reflects a restatement of previously mated clearinghouse to collect funds, reported data). They also processed tax payments must be scheduled at least 234.1 million paper government checks, one day in advance. Some business tax­ a decline of 12.3 percent from 2003. In payers, however, do not know their tax addition, the Banks issued more than liability until the tax due date. FR-ETA, 278,000 fiscal agency checks, a decrease for wire payments, allows these taxpay­ of 10.4 percent from 2003. ers to use EFTPS by providing a same- In addition to processing payments, day electronic federal tax payment alter­ the Reserve Banks operate programs to native. FR-ETA collected $344.8 billion help the Treasury increase the use of for the Treasury in 2004, compared with electronic payments. They operate a $275.8 billion in 2003. program that enables recipients of fed­ The Reserve Banks also operate eral grants to request payments using Pay.gov, a Treasury program that allows the Internet. This application, the Auto­ members of the public to make pay­ mated Standard Application for Pay­ ments to the federal government over ment, processed $404.7 billion in Fed- the Internet. They also operate the Trea­ wire funds transfers and ACH payments sury’s Paper Check Conversion and in 2004, compared with $384.2 billion Electronic Check Processing programs, in 2003. The Banks also operate Trea­ whereby checks written to government Federal Reserve Banks 127 agencies are converted at the point of FedLine Advantage, the next-generation sale or at lockbox locations into auto­ platform for providing PC-based elec­ mated clearinghouse transactions. In tronic access to Federal Reserve finan­ 2004, the Reserve Banks originated cial services. The new platform uses more than 1.9 million ACH transactions web technology to provide financial through these programs, a 58.3 percent institutions with more-efficient access increase from the 1.2 million originated to such payments services as the in 2003. Fedwire Funds Service, the Fedwire Securities Service, and FedACH Ser­ Cash Management Services vices. To complement the transition to web-based electronic access, the The Treasury maintains its bank account Reserve Banks completed consolidation at the Reserve Banks and invests the of the electronic-access customer sup­ funds it does not need for making cur­ port function to two offices. The con­ rent payments with qualified depository solidation will improve the efficiency institutions through the Treasury Tax and consistency of customer support. and Loan (TT&L) program, which the Reserve Banks operate. Reserve Bank operating expenses related to this pro­ Information Technology gram totaled $21.8 million in 2004, In 2004, the Federal Reserve Banks compared with $18.2 million in 2003. completed an initiative to standardize The investments either are callable on desktop hardware and software across demand or are for a set term. In 2004, Banks. In addition to reducing costs the Reserve Banks placed a total of over the long term, the standardization $17.1 billion in immediately callable is expected to facilitate interoperability, investments. The rate for term invest­ increase productivity, and improve the ments is set at Term Investment Option Federal Reserve’s ability to respond to (TIO) auctions; the Reserve Banks cyber security threats. Projects are now held 45 TIO auctions in 2004, placing under way to standardize local area net­ $309 billion in term investments, com­ work components and telephone private pared with 12 auctions placing $66 bil­ branch exchange systems and to imple­ lion in 2003. In 2004, the Treasury’s ment reduced-cost wide area network investment income, which comes from telecommunications services. the TT&L program, was $87 million. In partnership with the agencies that make up the Financial and Banking Services Provided to Other Entities Information Infrastructure Committee, The Reserve Banks provide fiscal the Federal Reserve continued in 2004 agency and depository services to other to sponsor clearing and settlement utili­ domestic and international entities when ties, key financial institutions, and key required to do so by the Secretary of the market participants in the national Treasury or when required or permitted security/emergency preparedness pro­ to do so by federal statute. The majority grams offered by the Department of of the work is securities-related. Homeland Security’s National Commu­ nications System, which coordinates the Electronic Access preparedness of critical telecommunica­ tions services to meet natural disasters In November 2004, the Reserve Banks and national emergencies. During the announced the general availability of year, the Federal Reserve participated in 128 91st Annual Report, 2004 the President’s National Security Tele­ to the Bank’s board of directors and to communications Advisory Committee the Board of Governors. Financial Services Task Force, which in The firm engaged for the audits of April 2004 released a report on network the individual and combined financial resilience in support of critical finan­ statements of the Reserve Banks for cial services. The Reserve Banks are 2004 was PricewaterhouseCoopers LLP currently working with telecommunica­ (PwC). Fees for these services totaled tions vendors and other government $2.0 million. To ensure auditor indepen­ agencies to identify policies that would dence, the Board requires that PwC be improve the resilience of the telecom­ independent in all matters relating to the munications infrastructure for critical audit. Specifically, PwC may not per­ financial services functions. form services for the Reserve Banks or others that would place it in a position of auditing its own work, making man­ Examinations of the agement decisions on behalf of the Federal Reserve Banks Reserve Banks, or in any other way Section 21 of the Federal Reserve Act impairing its audit independence. In requires the Board of Governors to order 2004 the Reserve Banks did not engage an examination of each Federal Reserve PwC for non-audit services other than a Bank at least once a year. The Board training session at one Reserve Bank engages a public accounting firm to per­ that was obtained at a rate available to form an annual audit of the combined the general public. financial statements of the Reserve The Board’s annual examination of Banks (see the section ‘‘Federal Reserve the Reserve Banks includes a wide Banks Combined Financial State­ range of off-site and on-site oversight ments’’). The public accounting firm activities conducted by the Division of also audits the annual financial state­ Reserve Bank Operations and Payment ments of each of the twelve Banks. The Systems. Division personnel monitor Reserve Banks use the framework estab­ the activities of each Reserve Bank on lished by the Committee of Sponsoring an ongoing basis and conduct on-site Organizations of the Treadway Com­ reviews based on the division’s risk- mission (COSO) in assessing their inter­ assessment methodology. The 2004 nal controls over financial reporting, examinations also included assessing the including the safeguarding of assets. efficiency and effectiveness of the inter­ In 2004, the Reserve Banks enhanced nal audit function. To assess compliance their assessments under the COSO with the policies established by the Fed­ framework, strengthening the key con­ eral Reserve’s Federal Open Market trol assertion process, consistent with Committee (FOMC), the division also the requirements of the Sarbanes–Oxley reviews the accounts and holdings of Act of 2002. Within this framework, the System Open Market Account at management of each Reserve Bank pro­ the Federal Reserve Bank of New York vides an assertion letter to its board of and the foreign currency operations directors annually confirming adher­ conducted by that Bank. In addition, ence to COSO standards, and a public PwC audits the schedule of partici­ accounting firm certifies management’s pated asset and liability accounts and assertion and issues an attestation report the related schedule of participated Federal Reserve Banks 129

Income, Expenses, and Distribution of Net Earnings of the Federal Reserve Banks, 2004 and 2003 Millions of dollars

Item 2004 2003

Current income ...... 23,540 23,793 Current expenses ...... 2,239 2,463 Operating expenses1 ...... 2,123 2,342 Earnings credits granted ...... 116 121 Current net income ...... 21,301 21,330 Net additions to (deductions from, −) current net income ...... 918 2,481 Assessments by the Board of Governors ...... 776 805 For expenditures of Board ...... 272 297 For cost of currency ...... 504 508

Net income before payments to Treasury ...... 21,443 23,006 Dividends paid ...... 582 518 Transferred to surplus ...... 2,783 467

Payments to Treasury2 ...... 18,078 22,022

1. Includes a net periodic pension credit of $37 million 2. Interest on Federal Reserve notes. in 2004 and net periodic pension costs of $58 million in 2003. income accounts at year-end. The exchange rates. Statutory dividends paid FOMC receives the external audit to member banks totaled $582 million, reports and the report on the division’s $64 million more than in 2003; the examination. increase reflects an increase in the capi­ tal and surplus of member banks and a consequent increase in the paid-in capi­ Income and Expenses tal stock of the Reserve Banks. The accompanying table summarizes the Payments to the U.S. Treasury in the income, expenses, and distributions of form of interest on Federal Reserve net earnings of the Federal Reserve notes totaled $18,078 million in 2004, Banks for 2003 and 2004. down from $22,022 million in 2003; the Income in 2004 was $23,540 million, payments equal net income after the compared with $23,793 million in 2003. deduction of dividends paid and of the Expenses totaled $3,015 million ($2,123 amount necessary to bring the surplus of million in operating expenses, $116 mil­ the Reserve Banks to the level of capital lion in earnings credits granted to paid in. depository institutions, $272 million in In the ‘‘Statistical Tables’’ section of assessments for expenditures by the this volume, table 5 details the income Board of Governors, and $504 million and expenses of each Reserve Bank for for the cost of new currency). Revenue 2004 and table 6 shows a condensed from priced services was $866 million. statement for each Bank for the years The profit and loss account showed a 1914 through 2004. A detailed account net profit of $918 million. The profit of the assessments and expenditures of was due primarily to unrealized gains on the Board of Governors appears in the assets denominated in foreign curren­ section ‘‘Board of Governors Financial cies revalued to reflect current market Statements.’’ 130 91st Annual Report, 2004

Securities and Loans of the Federal Reserve Banks, 2002–2004 Millions of dollars except as noted

U.S. Item and year Total government Loans 2 securities1

Average daily holdings 3 2002 ...... 621,834 621,721 113 2003 ...... 683,438 683,294 144 2004 ...... 719,647 719,494 153

Earnings4 2002 ...... 25,527 25,525 2 2003 ...... 22,598 22,597 1 2004 ...... 22,347 22,344 3 Average interest rate (percent) 2002 ...... 4.11 4.11 1.94 2003 ...... 3.31 3.31 1.00 2004 ...... 3.11 3.11 1.74

1. Includes federal agency obligations. 4. Earnings have not been netted with the inter­ 2. Does not include indebtedness assumed by the Fed­ est expense on securities sold under agreements to eral Deposit Insurance Corporation. repurchase. 3. Based on holdings at opening of business.

Holdings of Securities and Loans Reserve Bank’s Houston Branch and the Chicago Bank’s Detroit Branch. The Federal Reserve Banks’ average Security enhancement programs daily holdings of securities and loans prompted by the events of Septem­ during 2004 amounted to $719,647 mil­ ber 11, 2001, continue at several facili­ lion, an increase of $36,209 million ties. One such project is an ongoing from 2003 (table). Holdings of U.S. gov­ external perimeter security improve­ ernment securities increased $36,200 ment project at the Boston Bank that million, and holdings of loans increased involves restoration of the Bank’s prop­ $9 million. The average rate of interest erty after recently completed construc­ earned on the Reserve Banks’ holdings tion of the Central Artery, an under­ of government securities declined to ground roadway. 3.11 percent, from 3.31 percent in 2003, The Kansas City Bank purchased and the average rate of interest earned property and retained design and con­ on loans increased to 1.74 percent, from struction consultants for its new head­ 1.00 percent. quarters building project. The Board approved the project’s schematic design, Volume of Operations and work continues on the final design. Table 8 in the ‘‘Statistical Tables’’ sec­ The Board approved the St. Louis tion shows the volume of operations in Bank’s purchase of a building to be the principal departments of the Fed­ renovated as a business-continuity relo­ eral Reserve Banks for the years 2001 cation facility. through 2004. The Richmond Bank purchased and renovated a building as a relocation site Federal Reserve Bank Premises for critical staff. Design work on addi­ tional security improvements continued. In 2004, construction continued on the The Dallas Bank continues to pursue new buildings for the Dallas Federal the purchase of property behind its head­ Federal Reserve Banks 131 quarters building for the construction of The multiyear renovation program a remote vehicle screening and shipping/ continued at the New York Bank’s head­ receiving facility. quarters building. As part of its long-term facility rede­ Several Banks continue to imple­ velopment program, the St. Louis Bank ment facility renovation projects to purchased and renovated a parking accommodate the consolidation of check garage for staff parking and a warehouse activities. for remote screening of deliveries. The Agreements were reached in 2004 to Bank retained design consultants for sell the buildings housing the New York expansion of the Bank’s headquarters Bank’s Buffalo Branch, the St. Louis building, and design work began. Bank’s Louisville Branch, and the Chi­ The San Francisco Bank retained cago Bank’s Milwaukee facility. Ad­ design and construction consultants for ministration activities for the Buffalo the new Seattle Branch building and and Louisville Branches will be moved finalized an agreement to purchase prop­ to leased space. erty for the new building. Design work has begun. 132 91st Annual Report, 2004

Pro Forma Financial Statements for Federal Reserve Priced Services

Pro Forma Balance Sheet for Priced Services, December 31, 2004 and 2003 Millions of dollars

Item 2004 2003

Short-term assets (Note 1) Imputed reserve requirements on clearing balances ...... 1,115.7 1,296.4 Imputed investments ...... 9,691.9 11,332.5 Receivables ...... 75.8 77.1 Materials and supplies ...... 1.9 2.3 Prepaid expenses ...... 31.8 35.6 Items in process of collection ...... 6,107.1 5,271.9 Total short-term assets ...... 17,024.1 18,015.8

Long-term assets (Note 2) Premises ...... 471.8 494.6 Furniture and equipment ...... 152.8 179.4 Leases, leasehold improvements, and long-term prepayments ...... 107.9 103.2 Prepaid pension costs ...... 795.4 787.9 Total long-term assets ...... 1,528.0 1,565.1 Total assets ...... 18,552.1 19,580.9 Short-term liabilities Clearing balances and balances arising from early credit of uncollected items ...... 11,909.5 11,788.1 Deferred-availability items ...... 5,354.3 6,448.3 Short-term debt ...... 0 .0 Short-term payables ...... 92.2 78.1 Total short-term liabilities ..... 17,355.9 18,314.4 Long-term liabilities Long-term debt ...... 0 .0 Postretirement/postemployment benefits obligation ...... 268.6 287.5 Total long-term liabilities ..... 268.6 287.5 Total liabilities ...... 17,624.5 18,601.9 Equity ...... 927.6 979.0 Total liabilities and equity (Note 3) . . . 18,552.1 19,580.9

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. Federal Reserve Banks 133

Pro Forma Income Statement for Federal Reserve Priced Services, 2004 and 2003 Millions of dollars

Item 2004 2003

Revenue from services provided to depository institutions (Note 4) ...... 865.9 886.9 Operating expenses (Note 5) ...... 800.6 941.6 Income from operations ...... 65.3 −54.7 Imputed costs (Note 6) Interest on float ...... −.1 −.7 Interest on debt ...... 0 .0 Sales taxes ...... 11.6 12.1 FDIC insurance ...... 0 11.4 .0 11.4 Income from operations after imputed costs ...... 53.8 −66.1 Other income and expenses (Note 7) Investment income ...... 156.8 108.0 Earnings credits ...... −108.1 48.7 −113.2 −5.2 Income before income taxes ...... 102.5 −71.3 Imputed income taxes (Note 6) ...... 30.6 −21.7 Net income ...... 72.0 −49.6 Memo: Targeted return on equity (Note 6) . . . 112.4 104.7

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.

Pro Forma Income Statement for Federal Reserve Priced Services, by Service, 2004 Millions of dollars

Com­ mercial Fedwire Fedwire Com­ Noncash Item Total check funds securities mercial services collection ACH

Revenue from services (Note 4) ...... 865.9 719.7 54.1 19.3 71.1 1.8 Operating expenses (Note 5) ...... 800.6 678.5 47.2 15.2 58.6 1.2 Income from operations ...... 65.3 41.2 6.9 4.1 12.5 .6 Imputed costs (Note 6) ...... 11.4 9.7 .7 .3 .7 .0 Income from operations after imputed costs ...... 53.8 31.4 6.2 3.8 11.8 .6 Other income and expenses, net (Note 7) ...... 48.7 40.5 3.0 1.1 4.0 .1 Income before income taxes ...... 102.5 71.9 9.2 4.9 15.8 .7 Imputed income taxes (Note 6) ...... 30.6 21.4 2.8 1.4 4.7 .2 Net income ...... 72.0 50.5 6.5 3.4 11.1 .5 Memo: Targeted return on equity (Note 6) ...... 112.4 93.6 6.8 2.9 8.9 .2

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. 134 91st Annual Report, 2004

FEDERAL RESERVE BANKS

Notes to Pro Forma Financial Statements for Priced Services (1) Short-Term Assets Banks and deposit balances arising from float. Other long-term liabilities consist of accrued postemployment The imputed reserve requirement on clearing balances and postretirement benefits costs and obligations on capi­ held at Reserve Banks by depository institutions reflects a tal leases. treatment comparable to that of compensating balances Equity is imputed at 5 percent of total assets based on held at correspondent banks by respondent institutions. the Federal Deposit Insurance Corporation’s definition of The reserve requirement imposed on respondent balances a well-capitalized institution for deposit insurance pre­ must be held as vault cash or as non-earning balances mium purposes. maintained at a Reserve Bank; thus, a portion of priced services clearing balances held with the Federal Reserve is shown as required reserves on the asset side of the (4) Revenue balance sheet. Another portion of the clearing balances Revenue represents charges to depository institutions for is used to finance short-term and long-term assets. The priced services and is realized from each institution remainder of clearing balances is assumed to be invested through one of two methods: direct charges to an institu­ in a portfolio of investments, shown as imputed invest­ tion’s account or charges against its accumulated earn­ ments. For 2003, imputed investments were assumed to ings credits. be three-month Treasury bills. Receivables are (1) amounts due the Reserve Banks for priced services and (2) the share of suspense-account and (5) Operating Expenses difference-account balances related to priced services. Operating expenses consist of the direct, indirect, and Materials and supplies are the inventory value of short- other general administrative expenses of the Reserve term assets. Banks for priced services plus the expenses for staff Prepaid expenses include salary advances and travel members of the Board of Governors working directly on advances for priced-service personnel. the development of priced services. The expenses for Items in process of collection is gross Federal Reserve Board staff members were $7.6 million in 2004 and cash items in process of collection (CIPC) stated on a $6.4 million in 2003. The credit to expenses under basis comparable to that of a commercial bank. It reflects SFAS 87 (see note 2) is reflected in operating expenses. adjustments for intra-System items that would otherwise The income statement by service reflects revenue, be double-counted on a consolidated Federal Reserve operating expenses, and imputed costs. Certain corporate balance sheet; adjustments for items associated with non- overhead costs not closely related to any particular priced priced items, such as those collected for government service are allocated to priced services in total based on agencies; and adjustments for items associated with an expense-ratio method, but are allocated among priced providing fixed availability or credit before items are services based on management decision. Corporate over­ received and processed. Among the costs to be recovered head was allocated among the priced services during under the Monetary Control Act is the cost of float, or net 2004 and 2003 as follows (in millions): CIPC during the period (the difference between gross CIPC and deferred-availability items, which is the portion 2004 2003 of gross CIPC that involves a financing cost), valued at the federal funds rate. Check ...... 33.5 38.9 ACH ...... 3.4 3.3 (2) Long-Term Assets Fedwire funds ...... 2.5 2.1 Fedwire securities ...... 1.3 1.1 Consists of long-term assets used solely in priced ser­ Noncash services ...... 1 .1 vices, the priced-services portion of long-term assets shared with nonpriced services, and an estimate of the Total ...... 40.8 45.5* assets of the Board of Governors used in the development of priced services. Effective Jan. 1, 1987, the Reserve (6) Imputed Costs Banks implemented the Financial Accounting Standards Board’s Statement of Financial Accounting Standards Imputed costs consist of income taxes, return on equity, No. 87, Employers’ Accounting for Pensions (SFAS 87). interest on debt, sales taxes, the FDIC assessment, and Accordingly, the Reserve Banks recognized a credit to interest on float. Many imputed costs are derived from the expenses of $7.5 million in 2004 and expenses of private-sector adjustment factor (PSAF) model, which $21.3 million in 2003 and a corresponding increase and uses bank holding companies as the proxy for a private- decrease in this asset account. sector firm. The cost of debt and the effective tax rate from the PSAF model are used to impute debt and income taxes. The after-tax rate of return on equity is used to (3) Liabilities and Equity impute the profit that would have been earned had the Under the matched-book capital structure for assets, services been provided by a private-sector firm. short-term assets are financed with short-term payables Interest is imputed on the debt assumed necessary to and clearing balances. Long-term assets are financed with finance priced-service assets; however, no debt was long-term liabilities and clearing balances. As a result, no short- or long-term debt is imputed. Other short-term liabilities include clearing balances maintained at Reserve * Restatement of previously reported total. Federal Reserve Banks 135 imputed in 2004 or 2003. The sales taxes and FDIC balances; the increase is produced by a deduction for float assessment that the Federal Reserve would have paid had for cash items in process of collection, which reduces been a private-sector firm are also among the components imputed reserve requirements. The income on clearing of the PSAF. balances reduces the float to be recovered through other Interest on float is derived from the value of float to be means. As-of adjustments and direct charges refer to float recovered, either explicitly or through per-item fees, dur­ that is created by interterritory check transportation and ing the period. Float costs include costs for checks, book- the observance of non-standard holidays by some deposi­ entry securities, noncash collection, ACH, and funds tory institutions. Such float may be recovered from the transfers. depository institutions through adjustments to institution Float cost or income is based on the actual float reserve or clearing balances or by billing institutions incurred for each priced service. Other imputed costs are directly. Float recovered through direct charges and per- allocated among priced services according to the ratio of item fees is valued at the federal funds rate; credit float operating expenses less shipping expenses for each ser­ recovered through per-item fees has been subtracted from vice to the total expenses for all services less the total the cost base subject to recovery in 2004. shipping expenses for all services. The following list shows the daily average recovery of (7) Other Income and Expenses actual float by the Reserve Banks for 2004 in millions of dollars: Consists of investment income on clearing balances and the cost of earnings credits. Investment income on clear­ ing balances for 2004 represents the average coupon- Total float −13.5 Unrecovered float 19.4 equivalent yield on three-month Treasury bills plus a constant spread, based on the return on a portfolio of Float subject to recovery −33.0 investments. For 2003, the investment income is based on the yield of the three-month Treasury bill. In both years, Sources of recovery of float Income on clearing balances −3.3 thereturnisappliedtothe total clearing balance main­ As-of adjustments −62.8 tained, adjusted for the effect of reserve requirements on Direct charges 823.4 clearing balances. Expenses for earnings credits granted Per-item fees −915.9 to depository institutions on their clearing balances are derived by applying a discounted average coupon- Unrecovered float includes float generated by services equivalent yield on three-month Treasury bills in 2004 to government agencies and by other central bank ser­ and the average federal funds rate in 2003 to the required vices. Float recovered through income on clearing bal­ portion of the clearing balances, adjusted for the net effect ances is the result of the increase in investable clearing of reserve requirements on clearing balances. 137

The Board of Governors and the Government Performance and Results Act

Under the Government Performance and cusses data validation and verification Results Act of 1993 (GPRA), federal of results. The performance report indi­ agencies are required to prepare, in cates that the Board generally met its consultation with Congress and outside explicit goals for 2002–03. stakeholders, a strategic plan covering a The strategic plan, performance multiyear period and to submit annual plan, and performance report are avail­ performance plans and performance able on the Board’s public web site reports. Though not covered by the act, (www.federalreserve.gov/boarddocs/ the Board of Governors is voluntarily rptcongress/). The Board’s mission complying with many of the act’s statement and a summary of the goals mandates. and objectives set forth in the strategic plan and performance plan are given below. Strategic Plan, Performance Plan, and Performance Report Mission The Board’s latest strategic plan in the GPRA format, released in August 2004, The mission of the Board is to foster the covers the period 2004–08. The docu­ stability, integrity, and efficiency of the ment articulates the Board’s mission, nation’s monetary, financial, and pay­ sets forth major goals for the period, ment systems so as to promote optimal outlines strategies for achieving those macroeconomic performance. goals, and discusses the environment and other factors that could affect their Goals and Objectives achievement. It also addresses issues The Federal Reserve has five primary that cross agency jurisdictional lines, goals with interrelated and mutually identifies key quantitative measures of reinforcing elements: performance, and discusses performance evaluation. The 2004–05 performance plan and Goal the 2002–03 performance report were To conduct monetary policy that pro­ posted on the Board’s public web site motes the achievement of maximum in August 2004 for access by Con­ sustainable long-term growth and the gress, the public, and the Government price stability that fosters that goal. Accountability Office (formerly the General Accounting Office). The per­ Objectives formance plan sets forth specific targets for some of the performance measures • Stay abreast of recent developments identified in the strategic plan. The and prospects in the U.S. economy performance plan also describes the and financial markets, and in those operational processes and resources abroad, so that monetary policy deci­ needed to meet those targets and dis­ sions will be well informed. 138 91st Annual Report, 2004

• Enhance our knowledge of the struc­ • Promote adherence 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 per­ policies, and guidelines through a formance, through developmental comprehensive and effective super­ research activities. vision program. • Implement monetary policy effec­ tively in rapidly changing economic Goal circumstances and in an evolving financial market structure. To enforce the consumer financial ser­ • Contribute to the development of vices laws fully and fairly, protect and U.S. international policies and pro­ promote the rights of consumers under cedures, in cooperation with the U.S. these laws, and encourage banks to meet Department of the Treasury and other the credit needs of consumers, including agencies. those in low- and moderate-income • Promote an understanding of Federal neighborhoods. Reserve policy among other govern­ ment policy officials and the general Objectives public. • Maintain a strong consumer com­ pliance supervision and complaint Goal investigation program that protects consumers and reflects the rapidly To promote a safe, sound, competitive, changing financial services industry. and accessible banking system and • Implement statutes designed to inform stable financial markets. and protect consumers that reflect congressional intent, while achieving Objectives the proper balance between consumer protection and industry costs. • Promote overall financial stability, • Promote equal access to banking manage and contain systemic risk, and services. ensure that emerging financial prob­ • Promote community development in lems are identified early and success­ historically underserved areas. fully resolved before they become crises. • Provide a safe, sound, competitive, Goal and accessible banking system To provide high-quality professional through comprehensive and effective oversight of Reserve Banks supervision of U.S. banks, bank and financial holding companies, foreign Objective banking organizations, and related entities. • Produce high-quality assessments of • Enhance efficiency and effectiveness, Federal Reserve Bank operations, while remaining sensitive to the projects, and initiatives to help Fed­ burden on supervised institutions, by eral Reserve management foster and addressing the supervision function’s strengthen sound internal control procedures, technology, resource allo­ systems and efficient and effective cation, and staffing issues. performance. The Board of Governors and the Government Performance and Results Act 139

Goal eral Financial Institutions Examination Council (FFIEC), the most formal coor­ To foster the integrity, efficiency, and dination effort has occurred jointly with accessibility of U.S. payment and settle­ the other depository institution regula­ ment systems. tory agencies.1 In addition, a coordinat­ ing committee of the depository institu­ Objectives tion regulatory agencies was created to • Develop sound, effective policies and address and report on issues of mutual regulations that foster payment sys­ concern. This interagency working tem integrity, efficiency, and accessi­ group has been meeting since June 1997 bility. Support and assist the Board to work on issues related to those in overseeing U.S. dollar payment general goals and objectives that cross and securities settlement systems agency functions, programs, and activ­ against relevant policy objectives and ities. Whether interagency coordina­ standards. tion was effected through the FFIEC, • Conduct research and analysis that the coordinating group, or interaction contributes to policy development and between agency staff, the results have increases the Board’s and others’ been positive—resulting in improved understanding of payment system planning for the agencies and substan­ dynamics and risk. tial benefits to the public.

Interagency Coordination 1. The FFIEC consists of the Board of Gover­ Interagency coordination helps focus nors of the Federal Reserve System, the Federal efforts to eliminate redundancy and Deposit Insurance Corporation, the National lower costs. As mandated by GPRA and Credit Union Administration, the Office of the Comptroller of the Currency, and the Office of in conformance with past practice, the Thrift Supervision. It was established in 1979 pur­ Board has worked closely with other suant to title X of the Financial Institutions Regu­ federal agencies to consider plans and latory and Interest Rate Control Act of 1978. The strategies for programs such as bank FFIEC is a formal interagency body empowered to supervision that transcend the jurisdic­ prescribe uniform principles, standards, and report forms for the federal examination of financial tion of each agency. Coordination of institutions and to make recommendations to pro­ activities with the U.S. Department of mote uniformity in the supervision of financial the Treasury and other agencies is evi­ institutions. The FFIEC also provides uniform dent throughout both the strategic plan examiner training and has taken a lead in develop­ ing standardized software needed for major data and the performance plan. Given the collection programs to support the requirements of degree of similarity in the agencies’ the Home Mortgage Disclosure Act and the Com­ missions and the existence of the Fed­ munity Reinvestment Act. 141

Federal Legislative Proposals

In 2004, the Board of Governors pro­ remove a substantial portion of the posed and supported a number of legis­ incentive for depository institutions to lative initiatives that would reduce regu­ engage in avoidance measures, and the latory burden on financial institutions resulting improvements in efficiency and benefit consumers without under­ could be expected to eventually be mining the safety and soundness of passed through to bank borrowers and insured depository institutions, con­ depositors. When depository institutions sumer protection, or other important keep their balances at Reserve Banks public policy principles, such as the as low as possible to minimize the cost principle of competitive fairness. The of holding these non-interest-bearing Board recommended that Congress assets, their actions could lead to volatil­ adopt legislation that, among other ity in the federal funds rate. Payment things, would remove restrictions on the of interest on balances at Reserve Banks payment of interest on balances held at could help eliminate the need for these Federal Reserve Banks and on demand actions and help ensure that the Federal deposits. The Board also recommended Reserve can continue to implement that Congress adopt legislation that monetary policy using existing pro­ would give the Board greater flexibility cedures. The Board therefore recom­ in setting reserve requirements for mended legislation that explicitly autho­ depository institutions and would ease rizes the payment of interest on balances restrictions on interstate branching by held by depository institutions at Fed­ banks. These proposals are summarized eral Reserve Banks. below. Interest on Demand Deposits Interest on Depository Institution The Board restated in 2004 its long- Balances Held at standing recommendation that Congress Federal Reserve Banks repeal the statutory prohibition against The Board is obliged by law to establish the payment of interest on demand reserve requirements for certain depos­ deposits. Since the advent of NOW its held at depository institutions, for the accounts, the prohibition has effec­ purpose of implementing monetary pol­ tively applied only to checking accounts icy. Banks, thrift institutions, and credit held by businesses and other for-profit unions may satisfy their reserve require­ entities. At the time it enacted the ments by holding vault cash, a balance Depression-era legislation, Congress in an account at a Federal Reserve Bank, was concerned that large money center or a combination thereof. Unnecessary banks were bidding deposits away from restrictions on the payment of interest smaller community banks to make loans on balances at Reserve Banks could to stock market speculators, depriving distort market prices and lead to eco­ rural areas of financing. This rationale nomically wasteful efforts to circumvent no longer appears applicable, as funds the restrictions. The payment of interest flow freely around the country and on balances at Reserve Banks would among banks of all sizes to find the 142 91st Annual Report, 2004 most profitable lending opportunities. flexibility to adjust reserve require­ The prohibition against the payment of ments: By law, the ratio of required interest on demand deposits distorts the reserves to transaction account deposits pricing of transaction deposits and asso­ above a certain level must be set ciated bank services; to compete for between 8 percent and 14 percent. The businesses’ liquid assets, banks have set Board in 2004 supported a legislative up complicated procedures for implic­ proposal to increase the range within itly paying interest. The prohibition also which it may set transaction account distorts the pricing of other bank prod­ reserve requirements, so that it could ucts. Because banks cannot pay explicit lower the requirements to zero percent interest on demand deposits, they often if, at some point in the future, the Board try to attract those deposits by pricing believes it in the best interests of mone­ other bank services below their actual tary policy to do so. Lower reserve cost. When services are offered below requirement ratios could be possible if cost, they tend to be overused to the explicit statutory authority to pay inter­ extent that the benefits of consuming est on balances held by depository them are less than the costs to society of institutions at Federal Reserve Banks producing them. were to be granted concurrently with The prohibition against the payment greater flexibility in setting reserve of interest on demand deposits has also requirements. led to the introduction of deposit ‘‘sweep’’ services, which permit institu­ tions and their customers to avoid the Interstate Branching prohibition’s effects to a large extent. Currently, national and state banks are Banks spend resources—and charge permitted to expand into additional fees—for nightly sweeping businesses’ states through the acquisition of another excess demand deposits into money bank. However, if they do not acquire market investments. The progress of another bank, they may open a branch in computer technology has reduced the an additional state only if the host state cost of sweep services, but the expenses has adopted legislation that expressly are not trivial, particularly when sys­ permits de novo interstate branching tems must be upgraded or the diverse (an ‘‘opt-in requirement’’). As of 2004, systems of merging banks must be inte­ only eighteen states had enacted legis­ grated. From the standpoint of the over­ lation expressly authorizing interstate all economy, such expenses are a waste branching. of resources and would be unnecessary The restriction on de novo branching if the payment of interest on demand is an obstacle to interstate banking, par­ deposits was allowed. ticularly for small banks that seek to operate across state lines, and may limit competition and access to banking ser­ Depository Institution vices. Branch entry into new markets Reserve Requirements leads to less concentration in local bank­ The Federal Reserve Act requires that ing markets, which in turn results in banks and other depository institutions better banking services for households maintain reserves against certain types and small businesses, lower interest of deposit accounts, also for the purpose rates on loans, and higher interest rates of implementing monetary policy. Cur­ on deposits. Allowing banks to operate rently, the Board is constrained in its freely across state lines also benefits Federal Legislative Proposals 143 customers as they become more mobile If legislative changes were to permit and live, work, and operate in multiple ILCs to branch de novo on an interstate states. The restriction also places banks basis, companies that are not supervised at a competitive disadvantage in relation or regulated on a consolidated basis to federal savings associations, which would be able to operate a nationwide are allowed to open de novo branches in banking institution. Such a result would any state. be inconsistent with the basis on which In light of the benefits, the Board the exception for ILCs initially was recommended that Congress eliminate granted—that the activities of these the opt-in requirement for interstate institutions were, and would remain, branching by banks and affirmatively limited in scope. In addition, allowing authorize national and state banks to companies to own an ILC that operates establish interstate branches on a de a nationwide banking franchise without novo basis. Under the Board’s proposal, being subject to the type of consolidated the establishment and operation of new supervision generally required of the interstate branches by banks would con­ owners of other insured banks would tinue to be subject to the other regula­ raise significant safety and soundness tory provisions and conditions estab­ concerns and place commercial banks lished by Congress for de novo interstate and their owners at a substantial branches, including the financial, mana­ competitive disadvantage. Moreover, gerial, and Community Reinvestment because any type of firm, including a Act requirements set forth in the Riegle– commercial or retail firm, may own an Neal Interstate Banking and Branching ILC, permitting these institutions to Efficiency Act of 1994. branch de novo nationwide has the A special exception in existing law potential to undermine seriously the allows companies to own an FDIC- separation of banking and commerce. insured industrial loan company (ILC) For these reasons, the Board’s pro­ without being subject to the type of con­ posal would require the owners of ILCs solidated supervision and activities re­ that establish interstate branches to oper­ strictions generally applicable to the ate within the same supervisory regime owners of insured banks. The number, that generally applies to other compa­ size, and powers of ILCs generally were nies that own insured banks. Impor­ limited when the ILC exception was tantly, the Board’s proposal would not adopted in 1987; however, the number alter the rights of companies that own and size of ILCs operating under this ILCs that continue to operate on a lim­ exception recently have increased sig­ ited basis. nificantly, and some states have granted ILCs essentially all the powers of com­ mercial banks.