Improving Financial Reporting – Horizon 1

RECOMMENDATION 1.3: ADOPT A SET OF NEW FRC ORGANIZATIONAL PRACTICES

The antecedent of the FRC was the FDIC’s Failure Projection Working Group, an informal, interdivisional forum for discussing various failure-projection models and their implications for the FDIC. This working group developed initial contacts and working relationships between divisions at a time when the FDIC had what one participant described as a “stove-pipe culture.”¹⁷ The FDIC culture of the time and the evolving composition and objectives of the working group warranted an informal, open, and flexible process.

In 1998, the FDIC converted the working group into the Financial Risk Committee. Most of the FRC’s organizational processes and practices were inherited from the informal working group rather than being deliberately chosen, so the FRC’s processes are generally informal. These processes are described and assessed below.

The current FRC organization and process

The FRC is tasked with determining reserves the FDIC should set aside for depository institutions that may fail. The FRC obtains the most accurate, current, and complete information by bringing together a wide group of constituencies, from within and outside the FDIC (Exhibit 1-9). The primary participants of the FRC are four divisions – DIR, DSC, DRR, and DOF – each of which is represented by one to three “FRC principals,” numbering eight in total. The FRC also formally receives input from the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), and the Office of Thrift Supervision (OTS).

Exhibit 1-9

FDIC CONSTITUENCIES REPRESENTED ON THE FRC

D

The FRC operates on a quarterly cycle for two reasons. First, much of the analysis is based on data in Call Reports and Thrift Financial Reports that depository institutions file quarterly. Second, the FRC is tasked with computing the CLR, which is included in the FDIC’s quarterly financial results.

Each quarter, the FRC process begins when DIR finishes entering the Call Report data into its databases and cleaning the data to remove errors. This clean data is generally available 2 months after the start of each quarter. In the next 3 weeks, DIR and DSC calculate the input estimates (e.g., the Pro Forma Model) and compile background materials that the FRC will consider. In the last week of the quarter, the FRC holds a preliminary meeting with other federal bank regulators and a final meeting to decide on the CLR and 2-year Projection.

Calculating estimates and compiling materials. In the last month of each quarter, DIR continuously updates the reserve list,¹⁸ which is the basis for the CLR calculations. As described above, DIR runs the Pro Forma Model to project which of these institutions will have capital above and below two percent of assets after one year. DIR then gathers these results into a spreadsheet to compute the CLR estimate according to the established CLR methodology. At the same time, DIR personnel run the three models that provide inputs into the 2-year Projection of failed-bank assets, and DSC compiles its 8-Quarter list based on its supervisory assessments.

All these results are disseminated to FRC participants along with various other reports that speak to the health of insured institutions. These reports typically consist of: DSC’s Quarterly Lending Alert, DSC’s report on the Real Estate Stress Test (REST) Model, DSC’s report on the Statistical CAMELS Offsite Rating (SCOR) Model, DIR’s Market Trends Report, a report from DIR comparing the CLR for the quarter using the Research Model to the CLR as calculated under the prevailing methodology, DIR’s CAMELS Migration report, DSC’s report on Large Insured Depository Institutions (LIDI), and DIR’s Risk Case. Altogether these materials comprise 60 to 100 pages, with a 2- to 4-page summary up front.

Preliminary FRC meeting. At the beginning of the last week of each quarter, the FRC principals meet with representatives from the OCC, FRB, and OTS. The purpose of this “preliminary FRC meeting” is to gather supervisory perspective on insured institutions for which failure is reasonably possible. The other federal bank agencies provide information on the majority of insured institutions that FDIC does not supervise. During this meeting, the FRC principals are briefed on the most important at-risk institutions, and the FDIC’s reserve list is updated to reflect any recent status changes (e.g., changes in CAMELS ratings).

Final FRC meeting. In the final 1 to 3 days of each quarter, the FRC principals and some of their supporting staff meet for the “FRC decision meeting” at which the group decides on the CLR and 2-year Projection of failed-bank assets. Typical attendance at these meetings is 25 to 30 people. Discussion is informal and open to all. At the end of the meeting, the group comes to a consensus about the CLR and 2-year Projection, and these decisions are reported formally to DOF within 1 day.

Performance of the FRC process

The remainder of this section assesses the FRC’s organization and processes on nine dimensions. It scores well for using the most current information and for fostering constructive interdivisional debate. On the remaining seven dimensions, the FRC lacks formal processes and procedures that could make it more efficient.

• Purpose. All the FRC participants understand that the primary purpose of the FRC is to produce the CLR and 2-year Projection, but there is less clarity about what would constitute improvements to these estimates. For example, the trade-off between accuracy and smoothing volatility is not well understood.¹⁹ Furthermore, there is an outstanding issue about whether the FRC should report additional measures of the financial risks faced by the FDIC.
  
  
• Pace and frequency. FRC processes are compressed into the final few days of each quarter. That compression is largely dictated by data availability (which takes the first 8 weeks of the quarter) and reporting needs (which requires an output by the end of the quarter).

• Preparation and materials. The briefing materials distributed in advance are comprehensive, but they typically are too voluminous for the participants to read in the short time available before the FRC meeting. There is a summary memo, but it does not digest the materials into an easy-to-read “dashboard” of key indicators. Additionally, some of the backup material is unnecessary.

• Participants. The FRC meetings are essentially open to all who are interested, so the process is inclusive, fosters interdivisional contacts, and incorporates the best information from all parts of the FDIC. However typical attendance is 25 to 30, and this large size distracts from key issues and dampens meaningful discussion.

• Procedures. There are few formal procedures at FRC meetings. This allows substantial flexibility and fosters a collegial atmosphere, but it also leads to inefficiencies. For example, some participants do not know who is to present what material, leading to costly delays. More importantly, the consensus-driven approach sometimes makes it difficult for the FRC to come to a decision in a timely manner.

• Feedback loops. DIR recently instituted a 360-degree review of the FRC, which produced meaningful insights about FRC methodologies and procedures, but there are no systematic feedback loops in place to continuously measure the FRC’s progress and guide future improvement efforts.

• Support systems and documentation. The briefing materials are created by hand and distributed as hard copies. No central, electronic repository exists for these briefing materials or for the detailed minutes taken at each FRC meeting.

• Currency of information. The FRC relies on a variety of information to reach decisions about reserves, some of which changes daily (e.g., the status of recently downgraded institutions). The preliminary FRC meeting injects the most recent information into the FRC process, but that meeting occurs just a few days before the final meeting, which does not allow FRC participants much time for deliberation.

• Culture. The FRC has succeeded in breaking down divisional barriers, with joint problem solving, constructive criticism, and vigorous debate common.

Specifics of Recommendation 1.3 (Adopting a new set of FRC organizational practices)

The FRC will become more efficient if it adds some formal procedures and processes. At the next FRC meeting, the FRC principals should adopt the recommendations listed below. None of the proposals requires substantial effort to implement, so they can be implemented immediately.

1.3.a. The FRC should adopt a clear mission statement. The example in Exhibit 1-10 will help to clarify the activities and objectives of the FRC participants and steer their efforts toward a common goal, particularly regarding any mandate for the FRC beyond computing the CLR and 2-year Projection.

Exhibit 1-10

EXAMPLE FRC MISSION STATEMENT

Consistent with FDIC.s mission to protect insured depositors and maintain public confidence in the nation's financial system, the FRC is responsible for producing quarterly estimates of losses from failures in the following four quarters (the Contingent Loss Reserve) and for producing a 2-year loss estimate, both bounded by confidence intervals. These estimates will be supplemented, as appropriate, by additional measures that provide an indication of exposure to the insurance funds. All estimates will reflect inputs from DIR, DSC, DOF, and DRR, and will be based on a process that is systematic, transparent, well-documented, and grounded in objective analysis, and that makes use of supervisory data and market indicators. The underlying methodology will be approved by the GAO, and the Contingent Loss Reserve calculation will be in accordance with GAAP.

1.3.b. The FRC should create a standardized meeting agenda and distribute it well in advance. Discussions at FRC meetings would be more focused if the group worked from a detailed agenda that listed discussion topics (e.g., names of particular institutions), along with a designated discussion leader for each item. To ensure that all FRC principals can adequately prepare for these discussions, this agenda should be distributed one week in advance.

1.3.c. The FRC should create standardized, synthesized briefing materials and distribute them well in advance. The first page of the briefing materials should be a “FRC dashboard” depicting the most essential facts and statistics for FRC principals to consider (Exhibit 1-11). Immediately thereafter, DIR should include a synthesized memorandum interpreting what the FRC dashboard and any other relevant information imply for the FRC’s decisions at the coming meeting. The remaining briefing materials should include only those items that are relevant to specific decisions that the FRC will make. For example, if the FRC will discuss whether to reserve less for a particular institution, then the specifics of that institution should be included. If the FRC will discuss whether to deviate from historical failure rates, then materials on leading indicators of failure rates would be appropriate. All these materials should be distributed at least 2 business days in advance.

Exhibit 1-11

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SAMPLE FRC DASHBOARD AT HORIZON 1

Projections	Current	Prior	Change*	Limit
CLR 1 year	$1.0b	$2.0b	50%	25%
Confidence interval (90%)	$1.0b	$1.0b	0%	25%
CLR 2 years	$3.0b	$3.0b	0%	25%
Confidence interval (90%)	$2.0b	$2.0b	0%	25%

Realized results	Current	Prior	Change*	Limit
Insurance losses (LTM)	$1.50b	$0.5b	300%	25%
Related CLR	$1.0b	$0.75b	NA	NA
CLR error	33%	300%	NA	NA

Banking credit information	Current	Prior	Change*	Limit
CAMELS (re-rated banks)	2.6	2.90	10%	5%
** CAMELS (re-rated banks)	1.5	1.0	50%	5%
Average Default Probability, KMV, top-20 money center	0.01	0.005	100%	10%

FDIC information	Current	Prior	Change*	Limit
BIF (net of CLR)	$39b	$40b	2.5%	5%
BIF Ins. Dep.	$3,000b	$3,000b	0%	2%
BIF Ratio	1.33%	1.33%	0%	10%
SAIF (net of CLR)	$2,0b	$2.0b	0%	33%
SAIF Ins. Dep	$100b	$100b	0%	2%
SAIF Ratio	2.0%	2.0%	0%	33%

Largest contributors to reserve	Current	Prior	Change*	Limit
Big Bank 1	$.1b	$.05	100%	25%
Big Bank 2	$.1b	$.1b	0%	25%
Big Bank 3	$.05b	$.05b	0%	25%
Big Bank 4	$.03b	$.03b	0%	25%
Big Bank 5	$.05b	$.05b	0%	25%

* Exceptions and over limit conditions indicated in bold
** Standard deviation

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1.3.d. The FRC should limit attendance at its meetings. Attendance at the FRC decision meetings should be restricted to the eight FRC principals and one to two supporting participants per division. The presence of five FRC principals (or their designees) will constitute a quorum. To streamline discussions, FRC principals should discourage other participants from speaking unless recognized by the chair.

1.3.e. A chairperson should be formally designated to manage FRC meetings. A formal chairperson would increase efficiency of FRC meetings by keeping discussions on point and managing the group’s decision-making. DIR’s Deputy Director of Financial Risk Management and Research should formally chair each FRC meeting.

1.3.f. The FRC should come to each decision by a vote of the FRC principals. A formal process for reaching decisions would help the committee to restrict its Confidential attention to areas of genuine uncertainty and disagreement. As such, for each needed decision, the FRC chairperson should call for a quick voice vote by the FRC principals in attendance, with the chairperson casting the deciding vote if necessary.

1.3.g. The FRC should set thresholds for when it will discuss whether to override the CLR reserve for a given institution. One way to focus deliberations would be to decide on override criteria in advance. For example, the FRC should set thresholds that will automatically put an institution on an “override list.” The FRC would discuss each institution and vote on whether to deviate from the failure rate or loss rate applied to that institution under the CLR formula. The FRC should set such thresholds based on institution size (e.g., any institution with over $750 million in assets) and the amount of reserves under the CLR formula (e.g., the 10 institutions with the largest reserve amounts). The FRC may elect to discuss additional institutions that are nominated by FRC members because of unique characteristics (e.g., an institution whose franchise value is so large that its loss rate will likely be zero). In discussing overrides for failure rates, DSC has the most relevant information, so it should lead the discussion and take primary responsibility for informing the group. DRR should do the same for loss rates.

1.3.h. The FRC should institute formal and systematic feedback loops to assess and improve its performance. On a regular basis (e.g., March and September) DIR should provide the FRC with a brief assessment of the performance and development of the FDIC’s reserve models (e.g., the CLR methodology, the Credit Risk Model, etc.). Based on these briefings, the FRC should convey to DIR what additional improvements would most benefit the FRC. In addition, the FRC should regularly (e.g., June and December) look back on any of its departures from the CLR methodology (e.g., altering failure probabilities within the 90 percent confidence interval) to determine whether, in retrospect, those departures improved the accuracy of the FRC’s reserving decisions.

1.3.i. The FRC should decide systematically on next steps. At the end of each FRC meeting, the group should discuss and approve a set of next steps, focusing on unresolved issues that warrant further investigation and action before the next FRC meeting. The FRC Chair should take the lead role to ensure the required execution prior to the next meeting.

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¹⁷ Interview with original participant in the FDIC’s Failure Projection Working Group.

¹⁸ Institutions with CAMELS ratings 4 to 5, and those designated as certain failures.

¹⁹ For example, by making the estimates correct on average (i.e., unbiased) or correct more often (e.g., with smaller mean squared error).

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