OCC Annual Report, Fiscal Year 2007

Contents

I.     Comptroller's Viewpoint

II.    The Comptroller and the Executive Committee

III.   History of the Office of the Comptroller of the Currency

IV.   Profile

The National Banking System

The Office of the Comptroller of the Currency

V.    National: Ensuring the Safety and Soundness of the National Banking System

Fostering Better Management of Credit Risk

Reaffirming Credit Quality

Surveys of Credit Risk

Helping To Stabilize Mortgage Markets

Addressing Concentrations in Commercial Real Estate Lending

Updating the Allowance for Loan and Lease Losses

Promoting Better Risk Management of Innovative Markets and Products

Doing Business with Hedge Funds

Complex Financial Products

Dealing in Derivatives

Sidebar: Dugan Sees Growing Role for President's Working Group on Financial Markets

Finalizing New Capital Rules

Providing Regulatory Relief to National Banks

Helping in the Fight against Terrorism and Money Laundering

Protecting National Banks against Mismanagement

Enforcement Actions against Bank Insiders and Third Parties

Strengthening the Legal and Regulatory Framework

Litigation

Sidebar: The Watters Decision Clears the Air

Legal Opinions

Licensing Decisions

Sidebar: Working To Address the Needs of Minority Banks

Events

VI.    International: National Banks and OCC Supervision in a Global Economy

National Banks' International Exposures

OCC's International Focus

Supporting International Risk Supervision

International Analysis

International Policy Development

External Supervisory Relations

Foreign Technical Assistance

Sidebar: China-U.S. Bank Supervisory Relationship Nurtured by Dugan Visit

Events

VII.    Communities: The Bedrock of a Strong National Economy

Community Banks and Examinations: Setting Standards for Safety

OCC Measures Effectiveness of Supervisory Process

OCC Outreach and Education: Creating a New Bank Director Workshop

Banks Help Meet Community Needs

Sidebar: Comptroller Dugan and Chief of Staff Walsh Participate in a Community
Bank Examination

Comptroller Brings Supervisory Message to Communities

Sidebar: OCC Facilitates Solutions to a Branch Closing Dilemma

Sidebar: OCC Staff Join the Comptroller in Improving D.C. Affordable Housing Complex

Community Banks and the Global Economy

Events

VIII.    Consumers: Promoting Fairness and Transparency

Consumer Protection through Bank Supervision

Nontraditional and Subprime Mortgage Guidance

Mitigating the Impact of Mortgage-Market Turmoil

Sidebar: Dugan Receives "Making-the-Difference" Award from Credit
Counseling Foundation

Protecting Consumer Privacy

Fair Lending

Consumer Protection through Public Information

OCC Initiatives To Improve Bank Disclosures

OCC Public Information Initiatives

Sidebar: OCC Acts To Root Out Mortgage Fraud

Sidebar: Consumers Help Themselves with a Click

Consumer Protection through Complaint Resolution

Sidebar: Comptroller Showcases OCC Consumer Complaint Process

Complaint Sharing

Events

IX.     On Making the OCC a Great Workplace

In Pursuit of Excellence

Recruitment and Retention

Developing a Highly Skilled Workforce

Equal Opportunity and Workplace Fairness

Technology

Information Technology Security and Emergency Preparedness

Process Improvement

Improving Enterprise-Wide Governance

X.     Financial Management Discussion and Analysis

Letter from the Chief Financial Officer

Historical Perspective

Strategic Focus

Strategic Goals

FM Operating Strategy

The FM Balanced Scorecard

Looking Forward

Financial Highlights

Overview

Assets

Liabilities

Net Position

Reserves

Revenues and Costs

Budgetary Resources

XI.    Financial Statements and Notes

Financial Statements

Balance Sheets

Statements of Net Cost

Statements of Changes in Net Position

Statements of Budgetary Resources

Notes to the Financial Statements

Note 1-Significant Accounting Policies

Note 2-Investments and Related Interest

Note 3-Property and Equipment, net

Note 4-Leases

Note 5-Other Actuarial Liabilities

Note 6-Net Position

Note 7-Total Program Costs

Note 8-Imputed Costs and Financing Sources

Note 9-Reconciliation of Net Cost of Operations to Budget

XII.    Independent Auditor's Reports

Independent Auditor's Report on Financial Statements

Independent Auditor's Report on Internal Control over Financial Reporting

Exhibit 1: Significant Deficiency-Improvements Needed in
Information Technology General Controls over OCC's Financial Systems

Independent Auditor's Report on Compliance with Laws and Regulations

XIII.    Other Accompanying Information

Performance Measures and Results

Improper Payments Information Act

Audits

Assurance Statement

This year's Annual Report reflects the reach - and the strength - of the national banking system and the Office of the Comptroller of the Currency.  I am pleased to report that the system remains safe and sound, and fully able to support the needs of its consumer and business customers.

FY 2007 was a year of challenge and accomplishment.  Typically, late in an economic cycle, credit problems begin to appear as lenders compete for a smaller base of creditworthy borrowers, and loans made earlier in the cycle begin to show signs of wear.  With the United States now in the sixth year of an economic expansion, it is not surprising that such trends became increasingly apparent in 2007.

One of the most significant supervisory issues this year was the continued decline in underwriting standards.  Weakened underwriting is often a leading indicator of credit problems, and we are monitoring banks closely for any evidence that relaxed standards are translating into an undue growth in problem loans. 

Problem loans did increase in national banks in FY 2007, but they remained very low by historical standards, and supervisory performance ratings remained strong.  That's no small achievement, considering the number and severity of economic troubles that emerged during the year.  The mortgage market experienced significant difficulties, especially in the subprime area, resulting in increased delinquencies and foreclosures.  While the national bank share of problem subprime loans was proportionally smaller than at other lenders, it was significant nevertheless.  

The OCC took a number of steps in response.  We joined the other federal banking agencies in urging lenders to work with troubled borrowers to modify troubled loans where appropriate, rather than resorting to foreclosure.  We also bolstered underwriting and consumer disclosure standards for nontraditional and subprime mortgage products; monitored compliance with regulatory guidance; and supported efforts to obtain flexibility under accounting standards for lenders to restructure mortgages sold to third-party investors.  I was especially concerned that we address the widespread acceptance of unverified income in providing subprime credit.  So-called "stated-income loans" have allowed too many subprime borrowers to assume more debt than they could afford, and in a market with rising rates and falling home prices, many are now facing foreclosure.  I am very pleased that the final subprime guidance we issued provides that stated income should be the exception, not the rule, in underwriting subprime loans.

Commercial real estate concentrations continued to receive our attention.  Along with the other agencies, we issued guidance that called on our banks to adopt appropriate risk management policies.  The guidance did not set limits on commercial real estate lending, but it did reemphasize that banks with higher CRE concentrations have higher levels of risk, and that they need to have risk management practices and capital commensurate with this increased level of risk.  Despite industry apprehension, our implementation of this guidance went smoothly, despite the fact that we began to observe increased CRE losses in the residential sector by the end of the year.  This trend in the credit cycle will likely continue in the next year, and commercial real estate lending will very much remain a supervisory focus for the agency. 

While commercial real estate lending concentration was primarily an issue for smaller banks, our larger institutions were challenged by leveraged lending.  Banks active in this market experienced market liquidity problems in the second half of the year.  Skeptical of underwriting standards that had relaxed significantly, investors shrank from purchasing leveraged loans in the quantities they had previously.  This unexpectedly forced banks to hold on their balance sheets large volumes of such loans or loan commitments.  It also forced them to mark down the values of the loans to reflect the declines in price caused by the lack of market liquidity, resulting in substantial charges to earnings. 

We also published guidance - and conducted training - to help banks understand the rules on the Allowance for Loan and Lease Losses (ALLL) - one of the most significant buffers against credit risk.  Some national banks have experienced issues with their auditors when they have tried to increase reserves to prudent levels.  We have not hesitated to intervene in such cases where we believed the auditor was substituting its judgment for the bank's management in determining reserve adequacy - and we will continue to do so where we believe that is appropriate.

The OCC continues to embrace the concept of risk-based supervision.  We spend more time on areas of greater risk to a bank, and conversely, less time on lower risk activities.  One promising development has emerged in the area of money laundering and Bank Secrecy Act compliance that has been a great concern to all of us.  The OCC developed a Money Laundering Risk (MLR) analysis system that provides more than 1,650 community banks with a concrete tool to help measure anti-money laundering risk.  One of our goals is to use the results of the MLR analysis to help focus our BSA compliance resources on the relatively small number of banks where risk is higher, with less intrusive examinations for the vast majority of institutions where risk is low.

New capital requirements resulting from the Basel II accord will, with respect to the very largest national banks, significantly improve both the alignment of capital with risk and risk management practices.  I was very pleased that we were able to issue a final interagency rule, implementing these so-called "advanced approaches" of Basel II, just after the end of the fiscal year.  We also plan to issue, at the beginning of 2008, a proposed risk-based capital rule to implement the so-called "standardized approach" as an option for all but the very largest banks.  This option is also intended to better align regulatory capital with risk, but in a less costly and complex way than the advanced approaches, for smaller institutions that do not have the complex risk profile of our very largest banks. 

Of course, risk-based capital is not the only issue at the OCC that has an international focus.  Few industries have been more affected by globalization than banking.  As the supervisor of most of the nation's largest banks - including three that each hold over a trillion dollars in assets - the OCC has been heavily involved in international issues for years and has developed a number of approaches to examining banks' international activities.  For example, our large bank exam teams regularly evaluate international activities and risk exposure, using specialists in such areas as capital markets, credit, and anti-money laundering compliance.  Indeed, our London office is fully staffed with such specialists, who are dedicated to evaluating key risks in national banks' European operations.

Reflecting our increased international focus, I agreed in September to serve as chairman of the Joint Forum, an organization that consists of banking, securities, and insurance regulators from many countries around the world.  As the lines between these industries have continued to blur, cross-cutting regulatory issues have emerged with more frequency and salience.  The Joint Forum provides a unique opportunity to study and address these issues with an exceptionally broad perspective.  On behalf of the OCC, I am honored to serve in this new role.  

In other international developments, I welcomed the opportunity to visit China last March to strengthen the OCC's longstanding relationship with China's banking supervisor, the China Banking Regulatory Commission, as well as to meet with bankers from our two countries.  I observed first hand the remarkable progress that China has made in creating a modern financial system, and I sought to provide useful insight to our Chinese colleagues based on the OCC's considerable experience in supervising both complex and smaller banks.

While many large national banks have increased their global operations, community banking is still at the heart of the OCC's mission.  This year we expanded our outreach efforts to improve our communications with community bankers and directors, assess the effectiveness of our examination process, and identify areas where we can reduce regulatory burden.  Our goal is to help community banks devote more of their time and resources to doing what they do best - serving their customers and their communities. 

The increased retail orientation of national banks has created a significant shift in the nature of the banking business - and in the OCC's supervisory priorities.  Consumer protection is a key element of our mission, and we devote considerable resources to examining national banks for compliance with consumer protection laws, promoting transparency and improved disclosure of customer information, and helping to resolve consumer complaints.

One of our primary goals this year was not only to expand the store of information available to the consumer, but also to make it more accessible and user-friendly.  To that end, we launched a Web site, called HelpWithMyBank.gov, that provides a single reference point for the questions and answers we hear most frequently from consumers about the issues that concern them.  It also provides a contact point to file a formal complaint with the OCC's Customer Assistance Group.

Because of the jurisdictional complexities of the U.S. banking system, consumers don't always know which agency supervises their bank, and often complain or pose questions to the wrong supervisor.  This customer confusion has cropped up frequently between the OCC and state banking supervisors, and as a result, during this past year the OCC and the Conference of State Bank Supervisors jointly developed a mechanism for expediting the exchange of consumer complaint information between our agency and state banking departments.  At the end of fiscal 2007, we had signed agreements with 28 states, which we think will significantly reduce response times for consumers.  I am pleased with this progress, but I think we can do more along these lines to make it easier for consumers to get answers from banking regulators.  For that reason, the OCC has asked the Federal Financial Institutions Examination Council, consisting of all the federal banking regulators and representative state banking agencies, to consider additional proposals that would coordinate agency efforts for consumers in other areas, for example, by using a single Web site or call center to route questions and complaints to the appropriate agency. 

Regarding the national bank charter, the Supreme Court issued a seminal decision last year confirming that the banking activities of national banks and their operating subsidiaries are subject to uniform laws established by Congress, not the states.  In Watters v. Wachovia, the court reaffirmed the separate roles of the states and the OCC in regulating the banks that each charters.  It also reaffirmed the principle, established earlier by the court in its Barnett Bank decision, that states may not significantly burden, curtail, or hinder a national bank's exercise of its powers under the National Bank Act.  The Watters decision, which ratified the OCC's longstanding position that operating subsidiaries of national banks should not be treated differently from the banks themselves, helped clarify that it is the OCC's responsibility to regulate a national bank's interaction with consumers - a responsibility we take very seriously.  

The OCC must be a strong organization if it is to continue to safeguard the interests of a safe and sound national banking system.  We continue to invest heavily in technology, training, and development of our people - the OCC's most important resource.  But, like all agencies of the federal government - and, indeed, like much of the private sector - the OCC faces demographic challenges that require us to look to the needs of the future.  We are continuing to attract large classes of talented college graduates, as well as mid-career industry professionals with specific skills, and we took several important steps this year to improve recruitment, retention, and leadership development.  Prominent among them was LeaderTRACK, a management succession development program for senior examiners. 

Independent surveys con-tinue to recognize the OCC as an outstanding place to work.  In fiscal 2006, BusinessWeek included the agency on its list of the 50 best places in the private or public sector to start a career, and last year, the Partnership for Public Service ranked the OCC 4th out of 222 peer agencies in its rankings of best places to work in the federal government.  None of this surprises me.  As a veteran of just two years at the agency - really just a rookie by OCC standards - I can firmly attest to the exceptionally strong sense of purpose, professionalism, and culture that pervades this organization.  What we do and how we do it is a source of great pride to the OCC employees I talk to all around the nation - and it certainly is to me as well.  That bodes very well indeed for the future of our agency, and even more important, for the effective regulation of national banks, the financial engines of our economy. 

II. The Comptroller and the Executive Committee

John C. Dugan
29th Comptroller of the Currency.

Director of the Federal Deposit Insurance Corporation, Federal Financial Institutions Examination Council, and Neighborhood Reinvestment Corporation. Chairman, Joint Forum. Former Partner, Covington & Burling law firm. Former Assistant Secretary for Domestic Finance, U.S. Department of the Treasury. Former Counsel and Minority General Counsel, U.S. Senate Committee on Banking, Housing, and Urban Affairs.

III. History of the Office of the Comptroller of the Currency

In February 1863, President Lincoln signed the National Currency Act into law, creating a national banking system and "a separate bureau in the Treasury Department," headed by the Comptroller of the Currency, to administer it.

The law was designed to address the country's longstanding need for a uniform national currency and a nationwide system of banks operating under uniform rules, uniform supervision and regulation, and uniformly high standards.

For most of the pre-1863 period, thousands of different bank note varieties were in circulation-some good as gold, some not worth the paper they were printed on. This diverse and irregular paper was a source of inflation and uncertainty, and a barrier to trade and economic growth.

Under the National Currency Act (revised in June 1864 as the National Bank Act), organizers were required to raise substantial capital (previously, many banks had little or no capital) and to invest a portion of that capital in U.S. government bonds, sales of which were lagging at the time. The bonds would be deposited with the Comptroller, who would deliver a proportionate quantity of bank notes of uniform design imprinted with the bank's name. The bonds served as security for the notes; if a national bank was unable to meet its obligations, the bonds were liquidated and the note holders repaid. This ingenious system served the country for many years until national currency was phased out in favor of Federal Reserve notes.

The first Comptroller of the Currency was Hugh McCulloch, a respected Indiana banker. McCulloch staffed the office, developed policies and procedures, promulgated standards of professional conduct for bankers and bank examiners, and worked to refine the legal framework under which national banks still operate -today.

Charter number one was issued to the First National Bank of Philadelphia. The First National Bank of Davenport, charter number fifteen, was first to open for business, on June 29, 1863. By 1870, more than 1,600 institutions, including hundreds of former state-chartered banks, had joined the national system, holding well over 50 percent of the country's total bank assets.

The National Bank Act provided extensive enumerated powers and such "incidental powers as shall be necessary to carry on the business of banking." The law required the Comptroller to report directly to Congress on needed improvements in the law, and modifications undertaken over the years have provided national banks with the flexibility to meet changing conditions in the financial marketplace.

The National Currency Act and subsequent laws endowed the Comptroller's Office with considerable operational independence. The Comptroller is appointed by the President to a five-year term. Throughout its history, OCC has been funded by assessments paid by the banks it supervises.

IV. Profile

The National Banking System*
National Banks:1	1,677
Percentage of Total Number of Commercial Banks:	23
Uninsured National Trust Companies:	78
Federal Branches of Foreign Banks:	49
Assets of National Banks (excluding federal branches):	$7.062 trillion
Percentage of Total U.S. Commercial Banking Assets:	68
Total Insured Deposits:	$4.397 trillion
Employees of National Banks:	1,232,243
Total Investments by National Banks under 12 CFR 24, Community Reinvestment Act:	$4.82 billion
* Based on June 30, 2007, call report data.

¹ National banks are examined every 12 to 18 months, depending on their complexity and risk profile.

The Office of the Comptroller of the Currency
Total Employees:	3,066
National Bank Examiners:	2,061
Safety and Soundness Examinations Conducted:	1,287
Specialty Examinations Conducted:	897
Consumer Assistance Personnel:	35
Consumer Complaints Processed:	26,967
Total Budget Authority:	$671.2 million
Total Revenue:	$695.4 million
Percentage of Revenue Derived from Assessments:	95.8

V. National: Ensuring the Safety and Soundness of the National Banking System

Bank supervision is the OCC's core mission. Our goal is to determine whether a national bank is operating in a safe and sound manner and whether national banks comply with applicable laws and regulations-laws that, among other things, protect consumers, support fair lending, prevent money laundering, protect critical bank and customer information, and promote community reinvestment.

Each national bank's supervisory strategy is customized to its condition and circumstances, and is continually modified as appropriate. When a bank's risk profile or condition changes, the supervisory strategy for that institution changes with it. For example, examiners may decide some banks need more frequent reviews, or they may target specific bank activities that warrant supervisory attention.

The OCC's approach to bank supervision evolved over nearly a century and a half. Soon after the agency was created, its leaders realized that proper supervision required examiners to do more than simply inspect the bank's ledgers. In the 1880s, Comptroller Henry W. Cannon admonished examiners to evaluate the overall competence and prudence of a bank's management, as well as its asset quality. Since that time, the OCC has built on this foundation, focusing not only on how individual loans are underwritten and administered, but also on how bankers assess and manage risks across the institution.

In FY 2007, the OCC continued to implement and strengthen its risk-based approach to bank supervision. Our supervision emphasizes the need for strong risk controls, clearly defined objectives, and a well-developed business strategy. We work to promote effective management and strong corporate governance, ensuring that bankers and directors understand the critical role that each of them plays, and that they have the skills and the tools they need to effectively carry out those roles. The board and management must also ensure that the bank maintains adequate reserves and capital levels to cover both expected and unexpected losses.

In the "national" section of this report, we look at the issues that shaped the OCC's supervisory strategies in FY 2007 and the steps that were taken by the agency to strengthen the national banking system's legal and regulatory framework.

Fostering Better Management of Credit Risk

Reaffirming Credit Quality

National banks face many different forms of risks. None poses greater potential for financial loss than credit risk-the possibility that a loan or investment will not be fully repaid.

FY 2007 was a year of rising, but still moderate, credit risk. The percentage of loans that were noncurrent rose, and provisions for loan and lease losses increased nearly 90 percent over the 12 months ending June 30, 2007. As a result, national bank earnings were not as strong in the first half of this year as they were last year. Annualized year-to-date return on equity at national banks (as of the second quarter of calendar year 2007) was 12.73 percent-nearly 1 percent lower than it was for 2006. (See chart 1.)

This rise in credit risk was not unexpected. The U.S. economy has been expanding for six years, and it is typical for loans booked early in an economic cycle to show increasing signs of weakness as the expansion matures. Also, loan underwriting standards customarily slip in the later stages of an expansion as lenders compete for a shrinking pool of the most creditworthy borrowers and begin to dip deeper into the risk pool for customers. In recent years, a highly liquid secondary loan market intensified that competition, as did the growth in the number of nonbank lenders, such as mortgage brokers, who packaged and sold loan products to third-party investors. All these factors helped increase credit risk and put pressure on bank earnings.

The dip in earnings must be viewed against the long-term profitability of national banks. National bank earnings have been strong for the past 15 years, and these strong earnings have contributed to healthy capital ratios. In a statement before the House Committee on Financial Services on September 5, 2007, Comptroller Dugan underscored the system's strength, noting that "national banks remain active in major markets and continue to extend credit to corporate and retail customers, including mortgage credit." He pointed out that "the worst problems we have seen in the markets-insufficient liquidity resulting in substantial declines in capital and sometimes in failure-have occurred outside the commercial banking system."

By historical standards, the loan portfolios of national banks showed low levels of losses and problem assets. Supervisory performance ratings of national banks remained strong (see table 1). This is partly because national banks were proportionally less involved in the increasingly troubled market for subprime mortgages. Still, these troubles offered an object lesson in the importance of sound underwriting. Even before these problems began to emerge, the OCC was reemphasizing the need for national banks to verify the mortgage borrower's capacity to repay and to set aside prudent provisions for losses.

Performance Measures	Target	Actual (9/30/07)1
Percentage of national banks that are categorized as well capitalize2	95%	99%
Percentage of national banks with composite CAMELS rating of 1 or 23	94%	97%
Rehabilitated problem national banks as a percentage of the problem national banks one year ago (CAMELS 3, 4, or 5)4	40%	52%
Percentage of national banks with consumer compliance rating of 1 or 25	94%	97%

¹ Numbers in italics are estimates.
² The Federal Deposit Insurance Act established a system of prompt corrective action that classifies insured depository institutions into five categories-well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, based on their capital levels relative to their risks.
³ The composite CAMELS rating reflects the overall condition of a bank. It is based on the Uniform Financial Institutions Rating System. Evaluations are made on Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk. Ratings are on a scale of 1 through 5, 1 being best.
⁴ The OCC's early intervention can lead to successful remediation of problem banks. More than half of the problem banks on 9/30/2006 were rehabilitated within a year after following the OCC's recommendations for corrective action.
⁵ Each bank is assigned a consumer compliance rating based on an evaluation of its present compliance with consumer protection and civil rights statutes and regulations, and the adequacy of its operating systems designed to ensure continuing compliance. Ratings are on a scale of 1 through 5, 1 being the best.

Commercial real estate portfolios were another focus of credit risk concerns in FY 2007. Growing concentration levels in these portfolios, particularly at mid-size and community banks, raised concerns. The banking supervisory community responded by publishing guidance providing that banks with commercial real estate concentrations should maintain robust risk management systems and should preserve prudent underwriting standards in the face of competitive pressures.

Surveys of Credit Risk

The OCC conducts regular surveys to identify and monitor systemic trends in credit risk and emerging credit risk. In FY 2007, as in previous years, the OCC produced its annual Survey of Credit Underwriting Practices, participated in the interagency Shared National Credit Review, and conducted a series of horizontal reviews of large banks.

Survey of Credit Underwriting Practices

This survey identifies trends in lending standards and credit risk for the most common types of commercial and retail credit products offered by national banks. It assesses how factors such as competition are affecting the pricing and underwriting of loans and whether OCC examiners believe that the inherent credit risk in banks' portfolios is increasing or decreasing.

The 2007 survey, released in October 2007, covered the 12-month period ending March 31, 2007, and includedresults from the 78 largest national banks, representing more than 85 percent of all outstanding loans in the national banking system.

The survey found that retail and commercial credit underwriting standards eased for a fourth consecutive year, primarily from competitive pressures. The easing that occurred in retail banking was most notable in home equity lending (conventional and high loan-to-value loans) and residential real estate lending. Although commercial underwriting standards eased in general, the amount of easing in commercial real estate underwriting declined slightly.

Not all sizes of national banks eased underwriting standards. While large banks continued to do so, especially for leveraged and large corporate products, and mid-size banks eased modestly, the community banks that were included in the survey tightened underwriting standards.

Shared National Credit Review

The Shared National Credit (SNC) review is a joint program of the OCC, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS). Published annually (this year on September 25, 2007), the review evaluates the classification of large syndicated loans held by multiple banks. The 2007 review covered approximately 7,700 loans (or 5,265 borrowers) with commitments totaling $2.3 trillion. SNC commitments increased by nearly $401 billion, or 21.4 percent.

Although FY 2007's review showed an increase in the volume of criticized commitments, they remained at less than half of their peak dollar level in 2002. Criticized credits were 5 percent of total commitments, about the same rate as in the past three SNC reviews.

This year's review also examined the quality of underwriting of a representative sample of shared credit. This review disclosed a significant increase in underwriting weaknesses, especially in the syndicated leveraged loan market and particularly in non-investment grade or leveraged credit facilities.

Horizontal Reviews of Large Banks

The OCC's Large Bank Supervision Department conducted three horizontal reviews to determine how well large banks are complying with interagency guidance that addressed credit risk. A horizontal review is an examination across a portfolio of banks with similar characteristics. Horizontal reviews offer many benefits, notably the opportunity to exchange best practices and to ensure consistent expectations and supervisory practices across all the banks. Typically conducted by experts in the area of focus, horizontal reviews provide an independent assessment. These reviews not only provide the OCC with information on systemic risks, but also afford a quick assessment of how banks are complying with laws, regulations, and other regulatory guidance. They also allow the OCC to focus on higher risk banks and to adjust supervisory strategies and staffing.

In FY 2007, horizontal reviews focused on the guidance on nontraditional mortgages (OCC Bulletin 2006-41, "Nontraditional Mortgage Products: Guidance on Nontraditional Mortgage Product Risks"); the guidance on managing credit risk in home equity lending (OCC Bulletin 2005-22, "Home Equity Lending: Credit Risk Management Guidance"); and the guidance on managing credit card accounts (OCC Bulletin 2003-1, "Credit Card Lending: Account Management and Loss Allowance Guidance").

Helping To Stabilize Mortgage Markets

The OCC has long discouraged abusive and irresponsible lending practices in the national banking system. That's one reason why national banks were relatively less involved in the subprime mortgage market, and why OCC-supervised institutions were not as significantly affected by the setbacks many subprime lenders experienced during FY 2007. Only 10 percent of new subprime loans in 2006 were originated by national banks, and the rate of default among national bank subprime borrowers was significantly lower than that of subprime borrowers generally.

Nevertheless, the OCC has been active in regulatory efforts to address issues in the mortgage markets and to assist troubled subprime borrowers. These latter efforts are discussed in detail in part VIII of this report, "Consumers: Promoting Fairness and Transparency." Throughout 2007, the OCC and the other federal banking regulatory agencies also issued guidance to lenders to encourage arrangements with at-risk borrowers that would enable them to remain in their homes whenever possible.

OCC efforts included:

• Working with individual borrowers seeking information or assistance through the OCC's Customer Assistance Group (CAG).

• Issuing interagency guidelines to lenders regarding underwriting and consumer disclosure practices for nontraditional and subprime mortgage products.

• Monitoring compliance with regulatory guidance and potential adverse affects on bank earnings, liquidity, and capital markets activities.

• Working with community groups and bankers to identify and promote foreclosure prevention strategies.

• Working with the Financial Accounting Standards Board and the Securities and Exchange Commission to clarify how financial institutions and mortgage conduits can modify loan terms of borrowers unable to meet the terms of their original mortgage obligations.

• Working with two nonprofit organizations, NeighborWorks America and the Ad Council, on a series of public service announcements encouraging delinquent mortgage borrowers to get help from their lenders or a trusted housing counselor.

Addressing Concentrations in Commercial Real Estate Lending

Examiners increased their attention on credit risk arising from concentrations in commercial real estate loans in 2007. The emphasis followed the publication in December 2006 of final interagency guidance, "Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices." The guidance, which was a response to the increasing numbers of small- and medium-sized banks enlarging their portfolios of commercial real estate loans, was especially timely in light of the turmoil in the real estate-related markets in 2007.

The guidance was intended to make sure that banks enhance their risk management systems to accommodate concentrations of such loans, especially if the primary source of repayment for many of the loans is cash flow from real estate collateral. Although the federal banking agencies support the effort to supply credit for business and real estate development, they grew increasingly concerned about the potential effects of such concentrations on earnings and capital if commercial real estate markets were to weaken.

The guidance provided supervisory criteria, including numerical indicators, to help identify commercial real estate loan concentrations that warrant enhanced risk management. The OCC and its examiners emphasized that the criteria do not constitute limits or caps on a bank's ability to make commercial real estate loans.

Updating the Allowance for Loan and Lease Losses

The federal banking regulatory agencies and National Credit Union Administration (NCUA) published a comprehensive  "Interagency Policy Statement on the Allowance for Loan and Lease Losses" (ALLL) in December 2006. This updated guidance came just as many banks were preparing to increase their loss provisions in the first half of 2007.

A valuation reserve charged to a bank's operating income, ALLL is one of the most significant buffers against credit risk. ALLL is the sum of two estimates: 1) estimated credit losses on individually evaluated loans determined to be impaired, and 2) estimated credit losses on the remainder of the loan and lease portfolio. Although maintaining adequate reserves is always important to safety and soundness, it takes on special significance as the credit cycle matures.

Before the latest update, the last comprehensive interagency statement on ALLL had been published in 1993. Much about ALLL policy has changed since then: the banking agencies published significant updates in 1999, 2001, and 2004. The December 2006 statement incorporates those changes.

The statement describes the ALLL-related responsibilities of boards of directors, management, and examiners (including the factors that must be considered when estimating the ALLL), and the objectives and elements of an effective loan review system, including a sound credit-grading system. The agencies issued a series of frequently-asked questions to help institutions apply the guidance (see OCC Bulletin 2006-47, "Allowance for Loan and Lease Losses: Guidance and Frequently Asked Questions on the ALLL").

To ensure that OCC examiners fully understand the guidance, the OCC conducted ALLL training at each of its field offices in FY 2007. The OCC gave ALLL training to large bank examiners throughout the nation in the fall of 2007.

Promoting Better Risk Management of Innovative Markets and Products

Many national banks are leaders in developing new products and services to better serve their customers and compete effectively in today's global economy. But innovation brings risks as well as opportunities, and the OCC expects national banks to have people and systems in place to manage any increased risk they have assumed.

In FY 2007, OCC executives and examiners paid particular attention to large national banks that do business with hedge funds, engage in complex structured finance transactions, and deal in derivatives. They worked to ensure that the banks' risk management systems were capable of controlling the risks of these complex activities.

Doing Business with Hedge Funds

Hedge funds are private pools of capital that often combine aggressive investment strategies with the use of innovative financial instruments. Some large banks provide credit to hedge funds as counterparties in over-the-counter derivatives transactions and by financing transactions such as repurchase agreements.

Doing business with hedge funds presents attractive revenue opportunities for banks, but it also poses heightened credit and price risk. As a result, hedge fund relationships generally are appropriate for only the largest and most sophisticated banks. In February 2007, Comptroller Dugan participated in the President's Working Group on Financial Markets (PWG), which called on highly sophisticated lenders, investors, and counterparties to impose "market discipline" on hedge funds. The group offered guidelines for doing so embodied in the "Agreement among PWG and U.S. Agency Principals on Principles and Guidelines regarding Private Pools of Capital," and OCC examiners expect large national banks to follow those guidelines in 2007 and beyond. Accordingly, banks doing business with hedge funds should carry out appropriate due diligence before entering into a credit relationship with a hedge fund and should establish information flows that enable them to monitor credit exposures effectively.

Comptroller Dugan explained why the PWG chose guidelines over regulation: "When deciding between requirements and guidelines, governments must determine which will have a more positive long-term effect on the markets. The PWG chose guidelines rather than a prescriptive regulatory approach to avoid discouraging financial innovation. But the success of that approach depends on hedge fund investors and creditors exercising appropriate due diligence."

For more on the PWG, see the sidebar "Dugan Sees Growing Role for the President's Working Group on Financial Markets."

Dugan Sees Growing Role for President's Working Group on Financial Markets

A stable financial sector is essential to a well-functioning U.S. economy. Ensuring that public policies are conducive to that stability is the job of the President's Working Group on Financial Markets (PWG), in which the OCC participates. In February 2007, the PWG released a set of principles and guidelines to guide U.S. financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds. The agreement among the PWG and U.S. agency principals, which concentrates on how to provide investor protection and control systemic risks, serves as a framework for evaluating other market developments. Chaired by the Secretary of the Treasury, the PWG includes the chairs of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The PWG has been prominent in addressing a number of high-profile problems facing the financial markets, such as the near collapse of Long-Term Capital Management, a highly leveraged hedge fund, in 1999. That potential collapse posed considerable risk to market stability. Comptroller Dugan sees an even larger role for the PWG as markets become more global and sophisticated: "When it comes to controlling systemic risks to the U.S. economy and responding to market uncertainty, it's important for the federal government to develop a concerted strategy quickly and to respond with a consistent message," said the Comptroller. "That's what makes the Working Group an essential part of the nation's financial supervisory system."

Complex Financial Products

Large national banks use and offer an expanding array of complex financial products. The OCC's resident examination staffs at these banks closely monitor the use of these products to ensure that banks have adequate risk management policies and controls in place to govern them.

Certain complex structured finance transactions (CSFTs), such as those that appear designed to achieve questionable tax objectives, pose heightened reputation and legal risk. In January 2007, the federal banking agencies and the Securities and Exchange Commission (SEC) issued the "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Transactions."This final statement describes the types of internal controls and risk management procedures that are needed for financial institutions to identify, manage, and address the heightened risks that may arise from certain CSFTs. OCC examiners require banks engaging in CSFTs to ensure that their risk management systems can identify the elevated risk of CSFTs during new product approval and transaction approval processes and that the banks implement appropriate risk controls.

OCC examiners often work with staff in the OCC's Credit and Market Risk Division and the OCC Law Department's Securities and Corporate Practices Division to determine whether the products or activities in question raise supervisory or legal issues that must be addressed. Before banks use novel derivatives products, for example, the OCC is often required to write legal opinions on their use. (See "Legal Opinions" under "Legal and Regulatory Framework" for more on the legal and regulatory opinions that the OCC issued during the past year.)

Additionally, examiners review a bank's control processes for new derivative products to assess whether the bank can conduct the activity in a safe and sound manner. A bank cannot begin to engage in a novel derivatives activity until the examiner-in-charge (EIC) determines that the bank has a satisfactory risk management and control framework for the product's risks.

Dealing in Derivatives

Dealing in derivatives-instruments whose value is tied to that of underlying securities or other assets-is big business in the banking industry, and the OCC supervises the five largest bank derivatives dealers in the United States. As Comptroller Dugan pointed out in a November 2006 speech to the New York Bankers Association, "such a large and concentrated credit exposure has the potential to affect both markets and systemic stability."

In FY 2007, OCC examiners evaluated the adequacy of the systems used by these bank dealers to monitor and control the collateral with which they mitigate their risk exposures in these transactions. Examiners also worked to determine whether dealer banks were performing adequate stress testing and scenario analysis to measure derivatives' credit and price risk. (Price risk is the possibility that a dealer bank will incur trading losses, especially in market downturns.) Stress testing and scenario analysis allow banks to simulate adverse financial events, helping them to identify potential contagion or "spillover" effects and loss exposures.

 To help keep the industry and examiners abreast of derivatives activity, the OCC compiles and issues the Quarterly Report on Bank Derivatives Activities, which tracks the volume and trends of derivatives and trading activities within the U.S. commercial banking system.

In FY 2007, the OCC worked with other U.S. and international regulators and major dealers to improve the trade and settlement processing systems that support the global derivatives market. The objective of these efforts is to reduce the level of unconfirmed transactions and make manual processing systems increasingly electronic, decreasing the time it takes to confirm and settle derivatives transactions. The result will be more reliable operations systems as derivatives markets continue to grow.

Finalizing New Capital Rules

Capital-the amount by which assets exceed liabilities-is a broad measure of a bank's ability to withstand financial difficulty. Modern risk management systems calculate capital adequacy by weighting bank assets according to their risk.

The OCC, Federal Reserve Board, the FDIC, and OTS worked to finalize the regulatory aspects of risk-based capital in FY 2007. The final rule would implement within the United States the Basel Committee on Banking Supervision's revised capital accord known as Basel II.

The Basel II framework is designed to incorporate information from the advanced risk management and measurement systems used by large banks. In September 2006, the agencies issued for comment a notice of proposed rulemaking to implement Basel II and published revisions to their rules on market risk capital. In February 2007, the agencies sought comment on proposed supervisory guidance for Basel II (OCC Bulletin 2007-10, "Supervisory Guidance Related to Basel II Implementation: Proposed Supervisory Guidance").

When the Basel II proposal was issued, the agencies contemplated that the largest, internationally active U.S. banks ("core banks") would be required to use the Basel II rule. Certain other banks ("opt-in banks") could use the Basel II rule with the permission of their primary federal supervisor. Banks that were neither core banks nor opt-in banks would be subject to an alternative rule. In December 2006, the agencies sought comment on this alternative proposal (see OCC Bulletin 2006-50, "Risk-Based Capital: Domestic Capital Modifications: Notice of Proposed Rulemaking"). The proposal came to be known as Basel 1A.

In July 2007, Comptroller Dugan and the principals of the other three federal banking agencies announced their agreement on how Basel II would be finalized. The agreement included a plan to propose a new standardized approach to replace the proposal known as Basel 1A. Although a standardized approach was part of the original Basel II framework, such an approach had not previously been proposed for U.S. banks. Work to finalize the Basel II rule and to issue this new standardized proposal concluded just after the end of the fiscal year.

Providing Regulatory Relief to National Banks

Regulations are intended to enhance safety and soundness. Yet regulations that impose an excessive compliance burden have the potential to undermine, rather than enhance, the system's viability. That's why the OCC conducts regular reviews of its regulations and continually searches for ways to achieve its regulatory objectives at reduced cost to the institutions it supervises.

The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (EGRPRA) requires the federal agencies that are members of the Federal Financial Institutions Examination Council (FFIEC) to review their rules every 10 years, to revise rules that are outdated, and to eliminate ones that are unnecessary. The EGRPRA further requires the agencies to submit a report on the review's findings to Congress. Accordingly, in FY 2007, the OCC reviewed its regulations and issued the following proposed and final regulations:

• 18-Month Examination Cycle (12 CFR 4; 72 Federal Register 17798; April 10, 2007). On September 21, 2007, the OCC finalized an interim rule raising the $250 million ceiling for 18-month examinations to $500 million for qualified, well-managed banks. (The general prescript calls for national banks to receive a full-scope, on-site examination at least once during every 12-month period.) The rule, which was finalized by the Federal Reserve Board, the FDIC, and OTS as well, implements section 605 of the Financial Services Regulatory Relief Act of 2006 and related legislation.

• Regulatory Review Amendments (74 Federal Register 36550; July 3, 2007). The OCC published a proposed rule that would revise several OCC rules to reduce unnecessary regulatory burden, update certain rules, and make certain technical, clarifying, and conforming changes to OCC regulations. This review of OCC regulations, and the resulting notice of proposed rulemaking, is consistent with EGRPRA. The comment period for this proposed rule closed on September 4, 2007.

• Lending Limits Pilot Program (12 CFR 32; 72 Federal Register 31441; June 7, 2007). The OCC issued an interim final rule that makes permanent a lending limits pilot program. That program permits a national bank to use a higher lending limit for one- to four-family residential real estate loans, small business loans, and small farm loans if the state where the bank is located allows its state-chartered banks to use a higher lending limit for those types of loans.

Helping in the Fight against Terrorism and Money Laundering

The OCC is committed to preventing criminals and terrorists from misusing the financial system and to supporting law enforcement efforts to detect and prosecute criminal activities. This work is often carried out in partnership with other federal financial institutions regulatory agencies and the Financial Crimes Enforcement Network (FinCEN).

OCC examiners evaluate each national bank's compliance with Bank Secrecy Act/Anti-Money Laundering (BSA/AML) requirements; when they observe weaknesses, they seek corrective action from the bank. The OCC investigates national banks that fail to meet BSA/AML requirements and takes enforcement actions against them. Such enforcement actions in FY 2007 included:

• A cease and desist order by consent, and a $10 million civil money penalty (CMP) assessed concurrently with a FinCEN CMP assessment, against a bank for violations of the Bank Secrecy Act and its implementing regulation. The enforcement actions were part of coordinated actions with the U.S. Department of Justice, which entered into a Deferred Prosecution Agreement with the bank, and an accompanying $21,600,000 forfeiture in connection with charges that the bank failed to maintain an effective anti-money laundering program. The OCC determined that the bank failed to monitor adequately certain Mexican casa de cambio accounts, to identify suspicious activity and file suspicious activity reports in a timely manner, and to comply with requirements that it improve its processes for identifying and reporting suspicious transactions. The bank's violations resulted in the movement of millions of dollars of suspected proceeds of drug sales through the foreign accounts without detection.

• A cease and desist order by consent and a $500,000 CMP against a federal branch of a foreign bank for failure to meet BSA/AML requirements, including failure to identify suspicious activities and file suspicious activity reports.

• A $250,000 CMP by consent against a bank for failing to meet BSA/AML requirements and for engaging in unsafe or unsound practices in the bank's capital markets division. In addition, the OCC issued cease and