Does Your Outsourced Audit meet Regulatory Standards?

Does Your Internal Audit Scope Meet Regulatory Standards? 

A Two Part Series-Part One:-The Regulatory Standards 

One of the areas of focus for the regulators of financial institutions in the upcoming months will be the scope of the outsourced audits.   We have recently noted a number of clients that have been criticized for audit scopes that are either inadequate based upon risk, or are simply not comprehensive.

It is well established that the safe and sound operation of a financial institution requires among other things, a well-established system of internal controls.  The regulatory agencies all have a similar definition of internal controls.  For example, the Office of the Comptroller of the Currency in the Management handbook as follows:

Internal control is the systems, policies, procedures, and processes effected by the board of directors, management, and other personnel to safeguard bank assets, limit or control risks, and achieve a bank’s objectives.[1]

Once a system of internal controls has been established by a Board of Directors, it is necessary to test the effectiveness of the controls and to make sure that bank personnel are adhering to the limits established.  This is the role of internal audit.   As the OCC handbook points out;

Internal audit provides an objective, independent review of bank activities, internal controls, and management information systems to help the board and management monitor and evaluate internal control adequacy and effectiveness.[2]

Regular, comprehensive auditing of the operations of a financial institution are a necessary part of a safe and sound operation.  All federally insured financial institutions are expected to maintain audit departments.   However, for smaller institutions that cost of employing a full time internal audit staff has proven to be prohibitive.    For most institutions with assets of less than $1 billion, the audit function have been at least partially outsourced.

Outsourcing of the audit function is a well-established a practice.  The Federal Financial Institutions Examination Council (FFIEC”) recognized this when it issued a comprehensive policy statement on the process in 2003.   The guidance is called “Interagency Policy Statement on the Internal Audit Function and its Outsourcing”.  Since its release, there has been some additional guidance that has been issued that addresses outsourcing in more general terms[3] .  However, the guidance first issued in 2003 remains the seminal guide for outsourcing audit today.

Standards for Outsourcing

The FFIEC guidance makes it clear that the responsibility for internal controls remains with the Board and senior management of the financial institution.

Furthermore, the agencies want to ensure that these arrangements with outsourcing vendors do not leave directors and senior management with the erroneous impression that they have been relieved of their responsibility for maintaining an effective system of internal control and for overseeing the internal audit function.[4]

The guidance is divided into four parts:

  1. The Internal Audit function
  2. Outsourcing Arrangements
  3. Independence of the public accountant
  4. Guidance for Regulators

The Audit Function

The guidance notes that the audit function is the mean by which the Board can test whether or not internal controls are effective.

Accordingly, directors and senior management should have reasonable assurance that the system of internal control prevents or detects significant inaccurate, incomplete, or unauthorized transactions; deficiencies in the safeguarding of assets; unreliable financial reporting (which includes regulatory reporting); and deviations from laws, regulations, and the institution’s policies. [5]

The function of internal audit, then is ultimately to inform the Board, of weaknesses in internal controls and the possibility of regulatory violations.    There is a great deal of discussion in this section about the reporting structure for the audit function.  Ultimately, the critical point from this section is that whatever reporting structure is developed, the auditor must have the ability to report directly to the audit committee.

We note that in many smaller institutions, the results of audits are read out to business line managers and the final reports are delivered directly to the Board or to the audit committee of the Board.  This process often does not allow the auditor in charge to communicate directly with the audit committee.  A comprehensive scope should include a comment on the effectiveness of management to carry out their assigned duties. The guidance is specific that in small institutions, the person responsible for testing internal controls should report findings directly to the audit committee.   As a best practice, a member of the audit committee should attend the exit meeting and allow the auditor to comment on any concerns that he/she feels should be directly communicated to the Board.

Outsourcing Arrangements

The guidance notes that even in the event that the audit function is completely outsourced, it is still the responsibility of the Board and management to ensure that internal controls are effective.    The outsourced agreement should take into account both the current and anticipated business risks of the financial institution.

The guidance details the minimum requirements for an outsourcing agreement, including the limitation that outside auditors must not make management decisions and can only act in the capacity of informing the Board.  Once again, the idea that the outside auditor should communicate directly with a representative of the Board is emphasized.

One of the areas of criticism that we are currently seeing is that the internal audit plans do not adequately consider factors that should be part of the risk assessment.  Changes in staff, new regulatory requirements, software limitations, overall training and experience of management are all factors that should be considered when developing the internal audit plan.   As a best practice, the scope of the audits to be performed by the outsourced auditor should reflect the fact that the Board has considered these factors and included them.

Independence of the Public Accountant

For many financial institutions, the temptation is to use the same accounting firm that prepares financial statements to perform internal audits.  This issue presents itself most often with institutions that are over $500 million in assets, because there is a requirement for an independent audit on financial statements by a public accounting firm.  Generally, the guidance limits the ability of public accounting firms to also be the outsourced audit firm.

For smaller institutions, there is no prohibition to use public accounting firms, however, the practice is strongly discouraged.   In large part, the reason for this is that the firm that prepares the financial statement must be completely independent.  The data that is used to prepare financial statements has to be independently verified.  When the accounting firm performs both of these functions, the appearance is that independence is lacking.  In other words, the firm that is preparing the financial statements of a bank may be auditing its own work.

There are several independent firms that specialize in auditing for financial institutions.  These firms tend to provide cost effective and comprehensive alternatives to the public accounting firms.

Guidance for Regulators

The guidance specifies the goal of the examiners review of the internal audit.  The examiners are directed to ensure that the audit scope reflects the risk assessment of the institution and the Board has directed the auditor to consider the areas that are the highest risk.  The examiners are also directed to review the work papers of the auditor to ensure that they support the findings and conclusions in the audit report.   Examiners will also review how findings are communicated to the Board and management.  There is an expectation that responses to findings are tracked and monitored.

We have recently noted that the regulators are criticizing Boards for not receiving information about the overall effectiveness of the senior managers that they have employed.   Examiners have often been critical when the audit report does not specifically draw a conclusion about the training, effectiveness and capabilities of the senior management in charge of the business line being audited.  As we noted, it is a best practice to allow an outlet for the auditor to communicate a conclusion about senior management in the audit process.

In part two, we will discuss best practices for developing the audit scope.

[1]   Comptroller’s Handbook-Internal Control 2001  page 1

[2] Ibid  Page 1

[3] See for example, Supervision and Regulation (SR) letter 13-19/CA letter 13-21, “Guidance on Managing Outsourcing Risk.”

[4] Interagency Policy Statement on the Internal Audit Function and its Outsourcing

[5] Ibid

Self -Policing- An excellent way to Control Your Compliance Destiny

Self- Policing- An excellent way to control your own destiny!

So you are the compliance officer and while doing a routine check on disclosures, you notice a huge error that the Bank has been making for the last year.  The beads of sweat form on your forehead as you realize that this mistake may impact several hundred customers.   Real panic sets in as you start to wonder what to do about the regulators.  To tell or not to tell, that is indeed the question!

Many of our clients struggle with the question of what to do when your internal processes discover a problem.  We have always believed that the best policy is to inform the regulators of the problem.    CFBP Bulletin 2013-06 discusses what it calls “responsible business conduct” and details the grounds for receiving consideration for getting enforcement relief from the CFPB.  In this case, “consideration is somewhat vague and it depends on the nature and extent of the violation, but the message is clear.  It is far better to self-police and self-report than it is to let the examination team discover a problem.

Why Disclose a Problem if the Regulators Didn’t Discover it?  

It is easy to make the case that financial institutions should “let sleeping dogs lay”.  After all, if your internal processes have found the issue, the thing is that you can correct it without the examiners ever knowing, move on and everybody is happy.  Right?  In fact, nothing could be further from the truth.   There was a time when the relationship between regulators and the banks they regulate was collegial, but that is most certainly not the case any longer.   Part of the process of rehabilitating the image of banks is to ensure that they are being well regulated and that misbehavior in the area of compliance is being addressed.

Self- Policing

It is not enough that a bank discovers its own problems and addresses them.  In the current environment, there is a premium placed on the idea that a bank has compliance and/or audit systems in place that are extensive enough to find problems, determine the root of the problems and make recommendations for change.  An attitude that compliance is important must permeate the organization starting from the top.  To impress the regulators that an organization is truly engaged in self-policing, there has to be evidence that senior management has taken the issue seriously and has taken steps to address whatever the concern might be.  For example, suppose during a compliance review, the compliance team discovers that commercial lenders are not consistently given a proper ECOA notification.  This finding is reported to the Compliance Committee along with a recommendation for training for commercial lending staff.   The Compliance Committee accepts the recommendation and tells the Compliance Officer to schedule Reg. B training for commercial lenders.  This seems like a reasonable response, right?

This does not rise to the level of self- policing that is discussed in the CFPB memo; a further step is necessary.  What is the follow-up from senior management?   Will senior management follow up to make sure that the classes have been attended by all commercial lending staff?  Will there be consequences for those who do not attend the classes?  The answers to these questions will greatly impact the determination of whether there is self-policing that is effective.   Ultimately, the goal of a Bank should be to show that the effort at self-policing for compliance is robust and taken seriously at all levels of management.  The more the regulators trust the self-policing effort, the more the risk profile of bank decreases and the less likely enforcement action will be imposed.


While at first blush self-reporting seems a lot like punching oneself in the face, this is not the case at all.   The over-arching idea from the CFPB guidance is that the more the institution is willing to work with the regulatory agency, the more likely it is that there will be consideration for reduced enforcement action.  Compliance failures will eventually be discovered and the more they are self-discovered and reported, the more trust the regulators have in the management of the bank in general and the effectiveness of the compliance program in particular.   The key here is to report at the right time.  Once the extent of the violation and the cause of it have been determined, the time to report is imminent.  While it may seem that the best time to report is when the issue is resolved, this will generally not be the case.  In point of fact, the regulators may want to be involved in the correction process.  In any event, you don’t want to wait until it seems that discovery of the problem was imminent (e.g. the regulatory examination will start next week!).

It is important to remember here that the reporting should be complete and as early as possible, keeping in mind that you should know the extent and the root cause of the problem.  It is also advisable to have a strategy for remediation in place at the time of reporting.


What will your bank do to correct the problem?  Has there been research to determine the extent of the problem and how many potential customers have been affected?      How did the Bank make sure that whatever the problem is has been stopped and won’t be repeated?  What practices, policies and procedures have been changed as a result of the discovery of the problem?  These are all questions that the regulators will consider when reviewing efforts at remediation.  For instance, if it turns out that the problem has been improperly disclosing transfer taxes, an example of strong mediation would include:

  • A determination if the problem was systemic or with a particular staff member
  • A “look back” on loan files for the past 12 months
  • Reimbursement of all customers who qualify
  • Documentation of the steps that were taken to verify the problem and the reimbursements
  • Documentation of the changed policies and procedures to ensure that there is a clear understanding of the requirements of the regulation.
  • Disciplinary action (if appropriate for affected employees)
  • A plan for follow-up to ensure that the problem is not re-occurring


Despite the very best effort at self-reporting and mediation, there may still be an investigation by the regulators.  If the regulators start to investigate an area that you have already disclosed, such an instance calls for cooperation not hunkering down.  The more the bank is forthcoming with the information about its investigation, the more likely that the regulators will determine that there is nothing more for them to do.

At the end of the day, it is always better to self-detect, report and remediate.  In doing so you go a long way toward controlling your destiny and reducing punishment!

Customer Complaints- Manage Them or the Whole World Will Know!

Customer Complaints are a Part of the Dodd Frank Act:

As many of us are well aware, the Dodd Frank Financial Regulation Act (“Dodd Frank” or the “Act”) introduced sweeping changes to bank regulation.  Many provisions of Dodd Frank were implemented immediately and are at this point well known.  However, there are several provisions that have either not yet been enacted or are less well known.  Among the less well known provisions is section 1034 of the Act.  This section directs the Consumer Financial Protection Bureau (“CFPB”) to develop a national complaint system.  The system is designed to track both the complaints of consumers that use financial products and the responses of the institutions that offer the products.  The compliant system first went live in 2011 when only complaints about credit cards were accepted.  Since that time, the CFPB has taken complaints about mortgages, bank accounts and services, private student loans, other consumer loans credit reporting, money transfers, debt collection and payday loans.

Did you know that the complaints that are made against you can be made public?   As of July of 2015, not only will complaints be public, but the narrative of the complaint can also be published at the customer’s request! While many of the lobbying groups for banks have found this last part abhorrent, we believe that this practice creates an opportunity for improvement.

The complaint process:

The complaint process is described in the Company Portal Manual that was released by the CFPB in 2011.  The basic process is as follows:

  1. Consumer submits a complaint by web, telephone, mail, or fax to the CFPB, or another agency forwards the complaint to the CFPB.
  2. Consumer Response reviews the complaint for completeness and consistency with [1] our authority and roll out schedule.
  3. Consumer Response forwards the complaint to the company identified by the consumer via the secure company portal (portal). The goal is to route complaints within 24-48 hours of receipt.
  4. Company [2] reviews the complaint, communicates with consumer as appropriate, and determines its response and any related actions.
  5. Company responds to Consumer Response via the portal.
  6. Consumer Response invites the consumer to review and evaluate the company’s response by logging into the secure consumer portal or calling the CFPB’s toll-free number. [3]
  7. Consumer Response prioritizes for investigation complaints where the company failed to respond within the requested timeframe or the company’s response is disputed by the consumer[4]

For banks and financial institutions, it is very important to respond in a complete and timely manner to complaints.  The CFPB’s system will track complaints and will show response times as past due in the event that a complete response is not received.  Make sure that your institutions complaint response policies and procedures are up to date!

When a response is a response

The requirements for a proper response are described in the guidance that was published in June 2013.  The guidance notes that is always up to the institution to decide how best to respond to the customer.  However, it is clear that any response is expected to be completely documented.   For example, if a complaint is about a credit card closing, the documentation that is expected includes the following:

Account closings:

  • Adverse Action notice, including the reasons for the adverse action *
  • Date the account was closed
  • Date the notice was sent to the customer
  • Whether notice sent by postal mail or electronically
  • If sent by postal mail, the address to which the statement (or notification, as applicable) was sent[5]

It is likely that a response that does not include all of this information will result in additional inquiries from the CFPB.  The more complete the document that is relied upon for the response, the better.

Your Complaint may become public  

As of July 2015, the CFPB has decided that the narratives from the customer’s complaints can be made public if the customer consents.  Financial institutions can also ask that their responses also be made public.  Many groups, including the American Bankers Association, expressed grave concerns about the potential for reputation harm based upon the publication of complaints.  Nevertheless, the CFPB determined that the public good was better served by allowing consumers the option to publish their complaints.[6]  The possibility that a complaint against your bank may be published means that your procedures for responding are of critical importance.  Documentation of the reasons for the response should be complete and accurate.  Remember, there will be a possibility that the whole world will see!

Turning a negative into a positive:

The good news in all of this is that one institution’s pain is another’s opportunity for growth!   The results of complaints are published on both an annual and a monthly basis.  This is YOUR opportunity!       Find out what the complaints are and treat each one like an opportunity.   If you note that complaints about debt collection are the most prominent, it will be a good idea to review your banks procedures for debt collection.   Has your bank incorporated the most recent rules and guidance in this area of your practices?  If you are using a vendor, have you completed due diligence of the vendor recently?

The CFPB has made it clear that they are reviewing complaints, compiling the results and directing resources to the areas that experience the highest level of complaints.  The complaint system will be a good barometer for determining the areas of emphasis for examinations in the near future.

[1] The “our” in this quote refers to the CFPB

[2] “Company refers to the institutions who will use the reporting system

[4] CFPB Company portal manual

[5] CFPB  Response Guidance July 2013

[6] Note:  Only “verified” complaints can be made public-there has to be a relationship with the person complaining and a valid basis for the complaint.

Changes in CRA Questions and Answers May Bring Welcome News

One of the more difficult tasks that our clients must accomplish is to try to meet the community development and community service tests in the Community reinvestment Act (“CRA”). For many community banks the opportunities to do community service that qualifies under the requirements of the CRA are very limited.  The same is true with opportunities to conduct community development activities while staying within ones assessment area.   In many cases, the service opportunities have been limited to teaching classes at organizations that serve community needs.  Lending and investment opportunities are often “gobbled up” by the large banks in the assessment area, leaving the community banks to scramble to try and comply with the requirements of the regulation.

In November of 2013, the FFIEC announced changes to the Community Reinvestment Act Q & A that have the potential to greatly expand a bank’s ability to meet the tests of CRA while doing CRA activities outside of the assessment area.  [1] In addition, the ability to perform community service has also been expanded.  Just remember along with new powers come additional responsibilities and therefore additional risks!

The Changes

There are actually several changes that were adopted in November, 2013. We are only discussing a few that we believe directly impact compliance with the community development tests for small and intermediate banks.  Large Banks are encouraged to read the full text of the changes.

In the past there was wording that suggested that banks could do community development activities outside of the assessment area, the caveat for how these activities might qualify for credit to the bank performing them was unclear.     The original Q & A stated the following:

Q&A §     .12(h) – 6 stated that examiners would consider such activities if an institution, considering its performance context, had adequately addressed the community development needs of its assessment area(s).

In particular, the language created doubt that activities outside of a defined assessment area would be given credit at all. The agencies first proposed new language that indicated that as long as these activities were performed in a safe and sound manner and weren’t done in lieu of activities within the assessment area, they would be okay.  However, because many comments were received [2] the language was changed.  The adopted new language says:

  • .12(h) – 6 states, with respect to community development activities that are conducted in the broader statewide or regional area that includes the institution’s assessment area(s), that “examiners will consider these activities even if they will not benefit the institution’s assessment area(s), as long as the institution has been responsive to community development needs and opportunities in its assessment area(s).”

The definition of what a broader statewide or regional area was left fairly open to a common sense application. There are not specific guidelines for defining these.   It is safe to say that a definition that includes contiguous counties or economic zones that cross state lines (Lake Tahoe in California and Nevada for example) would be an acceptable definition.

Another significant change is the service that can qualify as community service on the part of bank employees.   The current Q & A stated that service to a community group was defined as

  • .12(i) – 3 stated that providing technical assistance to organizations that engage in community development activities (as defined by the regulation) is considered a community development service

For many of our clients this language has been taken to limit the things that bank employees may do to get credit for the community service. The FFIEC clearly wanted to expand that definition and in particular wanted to add that serving on the Board of community service organization can indeed count as community service

  • .12(i) – 3 to clarify that service on the board of directors of a community development organization is an explicit example of a technical assistance activity that could be provided to community development organizations that would receive consideration as a community development service

The idea here is that the service on the Board of these organizations must be active and not symbolic. In what looked almost like a throw away, the FFIEC also added the following:

In addition, in response to commenters’ suggestions, the Agencies are adding the following example of a technical assistance activity that might be provided to community development organizations: providing services reflecting financial institution employees’ areas of expertise at the institution, such as human resources, information technology, and legal services.

Of course this language greatly expands the sort of services that a bank may provide to community development organizations while meeting the service requirements of the CRA.

Broader Implications

Simply put, the more work you do upfront, the more leeway you get!   For example, being able to prove that there is broader region that you serve outside of your assessment area and that this region is legitimately economically connected is an important step in being able to perform community development activities out of the assessment area.

The second step is being able to show that the plan for activities allows the bank to serve the needs of the immediate assessment area while expanding.

We believe that for a plan to expand to activities beyond the assessment must be well thought out, and there must be documentation to show that the plan does not ignore low to moderate income groups within the assessment area. However, for banks that do not have these populations directly within the established assessment area, this is a significant opportunity to expand and reach new levels of community development that had heretofore been unattainable.

The key to a successful expansion is being able to document the idea that the Bank understands the credit needs of the people within the established assessment area.   In conjunction with understanding those needs the bank must be able to show how their activities meet those needs

[1] For the full text of the changes see

[2] We continue to remind our clients that the agencies do read and consider comments they receive!

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