Office of Inspector General Presentation to Workshop for

Office of Inspector General Presentation to Workshop for Internal Auditors of Financial Sector Supervisory and Regulatory Authorities Tallinn, Estonia June 29, 2004 1

Presentation Objectives n Overview of the Federal Reserve System n OIG Mission, Functions, and Organization n Case Studies: OIG Work in Supervision and Regulation 2

Federal Reserve System n n Created by Congress in 1913 Four essential functions: n Conducting Monetary Policy n Maintaining the stability of the financial system and containing systemic risk in the financial markets n Performing banking supervision and regulation n Providing financial services 3

Federal Reserve System (con’t) n Structure of the System: n n n Board of Governors in Washington, DC Twelve Federal Reserve Banks in major cities throughout the U. S. Federal Open Market Committee n n n Board members President of FRB NY Four other Reserve Bank Presidents 4

Federal Reserve System (con’t) 5

OIG Legal Authority n n The Inspector General Act of 1978 provides certain powers and authorities to help ensure OIG’s independence, objectivity, and access to information and records. The Federal Reserve Board OIG was established in 1987 in accordance with this Act. 6

OIG Mission (as stated in the IG Act) n n n Conduct, supervise, and coordinate audits and investigations of Board programs and operations. Promote economy and efficiency in the administration of Board activities. Prevent and detect fraud, waste, abuse, and mismanagement. Review and make recommendations regarding existing and proposed legislation and regulations. Keep the Chairman and Congress fully informed. 7

Additional OIG Responsibilities n Other legislation provides additional responsibilities: n n Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires a review of failed financial institutions that result in a material loss to the Bank Insurance Fund. Federal Information Security Management Act (FISMA) requires annual reviews of the agencies information security program. 8

OIG Relationships n n Inspector General is appointed by and reports to the Chairman. OIG has authority to review any Board program or activity, including functions specifically delegated to the Reserve Banks. OIG may coordinate with Reserve Bank General Auditors on Systemwide projects, but there is no supervisory relationship. OIG provides semi-annual reports to Congress summarizing the results of significant OIG activities. 9

OIG Organizational Structure Barry R. Snyder Inspector General Donald L. Robinson Deputy Inspector General Sue Souvannavong Manager Information Technology Margaret L. O’Reilly Manager Administrative Services Elizabeth A. Coleman Senior Program Manager Communications & Quality Assurance Anthony J. Castaldo Senior Program Manager Inspections & Evaluations William L. Mitchell Senior Program Manager Audits & Attestations OIG Staff Donna M. Harrison Senior Program Manager Investigations Laurence A. Froehlich Counsel to the Inspector General 10

Audits and Attestations OIG Organizational Structure • Conduct financial and performance audits • Evaluate economy, efficiency, and effectiveness • Evaluate the effectiveness of internal controls Barry R. Snyder Inspector General Donald L. Robinson Deputy Inspector General • Determine compliance with laws and regulations • Perform attestations (examinations, reviews, or agreed. Sue Souvannavong Margaret L. O’Reilly Manager upon procedures Manager Information Technology Administrative Services Elizabeth A. Coleman Senior Program Manager Communications & Quality Assurance Anthony J. Castaldo Senior Program Manager Inspections & Evaluations William L. Mitchell Senior Program Manager Audits & Attestations OIG Staff Donna M. Harrison Senior Program Manager Investigations Laurence A. Froehlich Counsel to the Inspector General 11

Inspections and Evaluations OIG Organizational Structure • Draw on methodological techniques from a variety of disciplines • Provide timely and relevant analyses and assessments of current policy, programmatic, and operation issues; offer rapid response to inquiries made by management or external parties Barry R. Snyder Inspector General Donald L. Robinson Deputy Inspector General • Conducts inspections, which are generally narrowly focused on a particular issue or topic Margaret which L. O’Reilly • Perform evaluations, are generally focused Manageron a specific Manager Information Technology Administrative Services program or function Sue Souvannavong Elizabeth A. Coleman Senior Program Manager Communications & Quality Assurance Anthony J. Castaldo Senior Program Manager Inspections & Evaluations William L. Mitchell Senior Program Manager Audits & Attestations OIG Staff Donna M. Harrison Senior Program Manager Investigations Laurence A. Froehlich Counsel to the Inspector General 12

OIG Organizational Structure Investigations • Perform criminal and administrative investigations • React to possible wrongdoing identified through the OIG Hotline Barry R. Snyder Inspector General Donald L. Robinson Deputy Inspector General • Respond to referrals from OIG auditors, Board program functions, or other sources Sue Souvannavong Manager Information Technology Margaret L. O’Reilly Manager Administrative Services • Conduct prevention and detection activities Elizabeth A. Coleman Senior Program Manager Communications & Quality Assurance Anthony J. Castaldo Senior Program Manager Inspections & Evaluations William L. Mitchell Senior Program Manager Audits & Attestations OIG Staff Donna M. Harrison Senior Program Manager Investigations Laurence A. Froehlich Counsel to the Inspector General 13

OIG Organizational Structure Communications and Quality Assurance • Manage the OIG’s strategic planning process • Oversee implementation and execution of a comprehensive quality assurance and internal control Barry R. Snyder Inspector General oversight program Donald L. Robinson Deputy Inspector General • Take a lead role in OIG communications and reporting Sue Souvannavong processes. Margaret L. O’Reilly Manager Administrative Services Information Technology • Serve as the liaison to the IG community Elizabeth A. Coleman Senior Program Manager Communications & Quality Assurance Anthony J. Castaldo Senior Program Manager Inspections & Evaluations William L. Mitchell Senior Program Manager Audits & Attestations OIG Staff Donna M. Harrison Senior Program Manager Investigations Laurence A. Froehlich Counsel to the Inspector General 14

OIG Projects n u OIG identifies projects to be accomplished during the year in a variety of ways: § Strategic and annual planning processes § Congressional requests/new legislative mandates § Customer requests § Hotline complaints and other investigative referrals Audits, inspections, evaluations, and investigative projects may result from any of the above 15

Projects Supervision and Regulation n n To date, we have reviewed four failed financial institutions as part of our material loss review responsibilities n Two failures resulted from fraud n Two were the result of economic downturns Also reviewed two holding companies 16

Projects Supervision and Regulation n Other supervision and regulation work has focused on: n Risk-focused examination process n Bank holding company inspections n Applications process n Bank Secrecy Act n Commercial Real Estate n Enforcement Actions 17

Case Studies n Review two case studies based on recent OIG work: n Material loss review of the failure of Oakwood Bank n Review of Internal Control Assessments at Community Banks 18

Case Study – Oakwood MLR n n n Oakwood Bank was a small, two-office community bank located in rural Ohio Bank was closed in February 2002 after the bank’s Executive Vice President confessed to fraudulent activity of a magnitude sufficient to render the bank insolvent Estimated loss to the bank insurance fund was $60 million 19

Case Study – Oakwood MLR (con’t) n n n OIG is required by law to review supervision of failed institutions if loss is “material” Material is defined as the greater of $25 million or 2 percent of the institution’s total assets OIG is to review the agency’s supervision of the failed institution to: n Ascertain why the institution’s problems resulted in a loss to the insurance fund n Make recommendations for preventing any such loss in the future 20

Case Study – Oakwood MLR (con’t) n n n Interviewed staff and officials at the Board, FRB Cleveland, the state’s regulatory agency, and the FDIC Reviewed examination reports, off-site surveillance information, examination workpapers, and investigative files Analyzed bank records 21

Case Study – Oakwood MLR (con’t) n n n Oakwood failed because of weak corporate governance and an inadequate internal control structure This created an environment in which a senior executive was able to conduct a check kiting scheme and embezzle funds Although fraud can be difficult to detect, particularly when senior executives are involved, our work found that… 22

Case Study – Oakwood MLR (con’t) n n n Examiners did not properly apply risk-focused examination principles that warranted more in-depth testing Examiners relied on an outside CPA without reviewing the scope, methodology, or reliability of the work Examiners overlooked obvious red flags that could have uncovered the fraud earlier 23

Case Study – Oakwood MLR (con’t) n Lapses in appropriately applying the risk-focused approach to examinations were caused by n Inexperienced examination staff n Inadequate examiner supervision n Failure to consistently exercise appropriate professional skepticism 24

Case Study – Oakwood MLR (con’t) n No recommendations made; report provided “matters for the Board to consider”: n Communicate lessons learned to all Reserve Bank examiners n Expand the use of surprise examinations n Require independent financial statement audits n Enhance examiner training 25

Case Study – Review of Internal Controls n n n As a result of Oakwood, we initiated a review of internal control assessments performed during community bank examinations Our objective was to determine if Oakwood represented an anomaly or a systemic deficiency in examination practices To accomplish this, we: n n n Reviewed policies, procedures, and guidelines Reviewed workpapers for 36 examinations at 4 Reserve Banks Interviewed staff and managers 26

Case Study – Review of Internal Controls (con’t) n n We found that examiners had performed internal control assessments and had appropriately applied risk-focused principles Depth of the examiners’ review was commensurate with the institution’s risk profile 27

Case Study – Review of Internal Controls (con’t) n n Each Reserve Bank we visited had initiatives underway to augment internal control reviews based on the results of our report on Oakwood We suggested that the Board review and evaluate all initiatives and determine if there are “best practices” that should be implemented Systemwide 28

Questions?