Financial Update (April-June 1996)

Risk-Management Plans
Must Make the Grade

It's report-card time—for banks.

As of Jan. 1, the Federal Reserve System began requiring formal ratings of risk-management practices during examinations and inspections of state member banks and bank holding companies.

The purpose of the ratings is to ensure that banks are employing adequate measures to manage risk—whether in the area of credit, market fluctuations, liquidity, operations, legal decisions, or reputation. Failing to identify, measure, monitor, and control risks has long been considered an unsafe and unsound practice. The rating system is intended to help banking supervisors identify and reduce unmanaged risk before problems occur.

The ratings emphasize findings in four primary areas:

  • Active board and senior management oversight.
  • Adequate policies, procedures, and limits.
  • Adequate risk-measurement, risk-monitoring and risk-management systems.
  • Comprehensive internal controls.

The increased attention to risk management does not diminish attention to evaluating the financial performance of institutions; rather, the rating highlights findings in each area and summarizes conclusions about an organization's practices.

The addition of a formal rating for risk management complements the interagency CAMEL (capital, asset, management, earnings, liquidity) framework, which remains in effect for assessing safety and soundness. The new rating is a key factor in determining the management rating in the CAMEL framework, particularly for larger institutions whose activities and organizational structures require more formal and extensive procedures.

As with the CAMEL rating, the risk-management rating is assigned on a scale of 1 to 5, with 1 reflecting sound performance and 5 representing unsatisfactory conditions and supervisory concerns.

The Federal Reserve's Guidelines for Rating Risk Management at State Member Banks and Bank Holding Companies recognizes that the elements of adequate risk-management programs vary depending on the size and sophistication of an organization. The review of risk management is not a "one-size-fits-all" analysis but it is tailored to the characteristics of each organization.

The new rating policy reflects an increased emphasis on risk management given the rapid evolution of the financial services industry. The Federal Reserve System will continue to refine examination techniques and guidelines as needs change.

For more information concerning the risk-management rating, banks can contact their Federal Reserve representative.

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